A complex trust is any trust that does not meet the conditions to be a simple trust.

Simple Trusts
A simple trust is a trust that must distribute all its income in the same year it receives the income. A simple trust cannot accumulate income, cannot distribute out of corpus (also called principal), and it may not distribute funds for charitable purposes. If a trust distributes corpus during a year, as in the year it terminates, the trust becomes a complex trust for that year.[1]

For many people, perhaps the most salient “simplicity” of a simple trust is the fact that the simple trust distributes its income, and therefore, you would expect, the trust itself would have no income and no tax.

Until 2017 and the enactment of the TCJA[2] law, it was pretty much a certainty that a simple trust wouldn’t have to pay tax. However, due to changes in the deductibility of miscellaneous items, it is possible that a simple trust’s distributable net income (DNI) can differ from its trust accounting income (TAI). Without going into the gritty details, it is possible that both trust accounting income and actual distributions can be less than distributable net income. When this is the case, the trust itself may owe income tax on the amount of distributable net income not actually distributed.

So much for “simple.”

Complex Trusts
As the above discussion suggests, even a “simple” trust might not be simple in the ordinary meaning of the word.

Similarly, just because a trust is a “complex” trust, it is not necessarily complex in the ordinary meaning of that word.

A complex trust, by definition, is any trust which is not a “simple” trust.

There are a variety of distinguishable types of complex trusts. They are typically used when a trust is desired and a simple trust will not suit the purpose. Complex trusts can accumulate income, distribute principal, and make charitable contributions, among other features.

Taxation of Complex Trusts
The major rule to keep in mind for a complex trust is that “income required to be distributed currently” is deductible from the trust’s taxable income.

For example, suppose a trust is required to distribute all its income each year to beneficiaries.

That income, then, would be deductible by the trust. It would also be taxable income to the beneficiaries receiving it.

Even if the trustee has discretion to “sprinkle”[3] income among several beneficiaries, if the income must be distributed it is deductible from the trust’s income.

In addition to deducting income that must be distributed, a complex trust may generally deduct trustee fees and administrative expenses actually paid. Depending on the specifics of the trust, charitable contributions made by the trust may be deductible from the trust’s income.

A “personal exemption” of $100 is allowed under §642(b).

Tax Rates for Complex Trusts
Complex trusts are subject to the same tax brackets as individuals, but the higher rates take effect at much lower income levels. For tax year 2024, the highest federal income tax rate of 37% applies to trust income over $14,450. Additionally, trusts may be subject to the Obamacare or Net Investment Income Tax (NIIT) of 3.8% on investment income, adding to the tax burden.

Because of the higher rates at lower levels of income, the effective tax on income taxed to a complex trust can be significantly higher than the tax on the same income if earned by a couple.

Form 1041
Most complex trusts must file IRS Form 1041, U.S. Income Tax Return for Estates and Trusts, annually. This form reports the trust’s income, deductions, gains, and losses, as well as the distributions to beneficiaries. The trust must also provide each beneficiary with a copy of that beneficiary’s form K-1. The K-1 provides details of the recipient’s share of the trust’s income, deductions, and credits, thus allowing the beneficiary to report his or her share of the trust’s income items on that beneficiary’s personal tax return (generally form 1040).

State Taxes
In addition to federal taxes, complex trusts may be subject to state income taxes. State tax rules vary significantly, with some states imposing taxes based on the trust’s residence, the trustee’s residence, or the beneficiaries’ residence. This complexity requires careful consideration of state tax laws in the trust’s overall tax planning.

Some Uses of Complex Trusts
We’ve seen that in many circumstances, the total federal income tax on a given amount of income will be higher at the complex trust level than if the same income were earned by individuals.

But there are also a number of situations where this is not the case. Many of these situations apply to high-net-worth investors.

Family is in the Top Tax Bracket
Many high-net-worth families are also high-income families and are in the top tax bracket. In these cases, there is no additional tax cost of using a complex trust, and conceivably there could even be a savings of a few dollars, though that saving is unlikely to be material.

State Income taxes
Forty-three states (as of 2024) have an income tax. Complex trusts may be arranged so that there is no state income tax on the income. In these cases, the use of a complex trust, if it avoids state income tax on the income, can actually generate a large, significant overall tax saving.

This is a complex (no pun intended) area, and we plan a future post (or posts) discussing it in more detail

Non-Tax Reasons
There are many non-tax reasons to prefer using a complex trust, including the desire to provide for charity, to provide discretionary distributions, to protect certain assets, and to take care of special needs.

Conclusion
For more information, call us at 703 437 9720 and ask for Connor or Katherine, or email [email protected]. You can also click here to request a copy of our advisor guide.

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[1] IRS Regs. Sec. 1.651(a)-1

[2] “Tax Cuts and Jobs Act”

[3] A trustee’s power to “sprinkle” is the trustee’s authority to decide how, when (and even “why” though a trustee is rarely required to explain why when the trustee is given sprinkle powers) to distribute trust income among trust’s beneficiaries.