Trust U/W - Simple or Complex?

[Arkayem]

My wife passed away five years ago, and her will created a trust with me as the trustee. The Will allows me to distribute income, capital gains, and even corpus to myself for the rest of my life, as needed, to maintain my status of living at the same level as when she passed.

Each year I have filed a 1041 and K-1 identifying this as a 'Simple Trust', distributing income and capital gains to myself (as beneficiary).

Now, I think that based on the IRS rules this Trust should have been classified as a 'Complex Trust'.

Will it raise an red flags with the IRS if I simply begin calling it a Complex Trust in this year's 1041?

 

[TrustUser]

actually, a trust is not simple or complex, per se. so i dont think there will be a problem this year.

whether a trust is simple of complex in ANY PARTICULAR YEAR, depends on what happens

a simple trust distributes all of its income, without distributing corpus. not sure about capital gains.

so a trust can go back and forth every year, regarding whether it is simple or complex

however, just so you know - i think your trust is somewhat borderline

in that it allows the beneficiary a lot of leeway as to what to do

it is fine to have a trust with a sole trustee/beneficiary

but once that trustee/beneficiary has the ability to do almost anything he wants, it begins to stop functioning as a trust

almost certainly creditors could attach to it, if they had a legal lien

 

[Taxing Matters]

Will it raise an red flags with the IRS if I simply begin calling it a Complex Trust in this year's 1041?

Probably not, but if it is a complex trust then you need to identify it that way, so whether it raises red flags or not you need to report it correctly. I disagree with Trust User a bit however. While it is true that a trust might be a simple trust one year and a complex trust another, that is not all that common. It is not just the actual distributions that are made that determines a simple trust, as Trust User indicated. For it to be a simple trust, the trust document must require that the trust distribute all its income for that year. Specifically, the Treasury regulations under IRC § 651, which govern simple trusts, states:

Section 651 is applicable only to a trust the governing instruments of which:​

(a) Requires that the trust distribute all of its income currently for the taxable year, and​

(b) Does not provide that any amounts may be paid, permanently set aside, or used in the taxable year for the charitable, etc., purposes specified in section 642(c),​

and does not make any distribution other than of current income. A trust to which section 651 applies is referred to in this part as a “simple” trust.​

Treas. Reg. § 1.651(a)-1. That is the definition of a simple trust. So to know if you have simple trust, you need to start by looking at the trust document to see if requires the distributions described above, i.e. distributions of all the current income and nothing else. If the trust document does not have that requirement for the year in question then for that year it is a complex trust even if in a particular year it only distributes current income. The same regulation goes on to say:

A trust may be a simple trust for one year and a complex trust for another year. It should be noted that under section 651 a trust qualifies as a simple trust in a taxable year in which it is required to distribute all its income currently and makes no other distributions, whether or not distributions of current income are in fact made. On the other hand a trust is not a complex trust by reason of distributions of amounts other than income unless such distributions are in fact made during the taxable year, whether or not they are required in that year.​

​

Id. Because it is unusual for trust documents to require distribution off all current income in one year but not the next (although it can happen) you don't see trusts flipping from simple to complex or vice versa very much.

 

[Arkayem]

Thanks for the comments. That clears up a lot for me.

I am only beginning to understand how unusual this Trust really is, and as you pointed out, how potentially vulnerable it is to outside forces. I wonder if there is any way to reduce that vulnerability?

 

[Arkayem]

Probably not, but if it is a complex trust then you need to identify it that way, so whether it raises red flags or not you need to report it correctly. I disagree with Trust User a bit however. While it is true that a trust might be a simple trust one year and a complex trust another, that is not all that common. It is not just the actual distributions that are made that determines a simple trust, as Trust User indicated. For it to be a simple trust, the trust document must require that the trust distribute all its income for that year. Specifically, the Treasury regulations under IRC § 651, which govern simple trusts, states:

Section 651 is applicable only to a trust the governing instruments of which:​

(a) Requires that the trust distribute all of its income currently for the taxable year, and​

(b) Does not provide that any amounts may be paid, permanently set aside, or used in the taxable year for the charitable, etc., purposes specified in section 642(c),​

and does not make any distribution other than of current income. A trust to which section 651 applies is referred to in this part as a “simple” trust.​

Treas. Reg. § 1.651(a)-1. That is the definition of a simple trust. So to know if you have simple trust, you need to start by looking at the trust document to see if requires the distributions described above, i.e. distributions of all the current income and nothing else. If the trust document does not have that requirement for the year in question then for that year it is a complex trust even if in a particular year it only distributes current income. The same regulation goes on to say:

A trust may be a simple trust for one year and a complex trust for another year. It should be noted that under section 651 a trust qualifies as a simple trust in a taxable year in which it is required to distribute all its income currently and makes no other distributions, whether or not distributions of current income are in fact made. On the other hand a trust is not a complex trust by reason of distributions of amounts other than income unless such distributions are in fact made during the taxable year, whether or not they are required in that year.​

​

Id. Because it is unusual for trust documents to require distribution off all current income in one year but not the next (although it can happen) you don't see trusts flipping from simple to complex or vice versa very much.

Of course, the reason I need to flip it is that I made a mistake in prior years. I found out about the requirements of section 651 before posting my original questions. I realized that the provisions in the will did not REQUIRE distribution of all income, and that's why I posted my original question. I will switch it to Complex for the 2018 1041 and then decide how much to distribute to myself and how much to leave in the trust and let the trust pay the taxes. I think, since my personal income puts me in a high marginal tax bracket, that allowing the trust retain $2550 of capital gains (new 2018 tax rules) and distributing the rest, will mean the trust will not have to pay any tax on those $2550 capital gains. Hopefully I won't get audited over that.

 

[TrustUser]

just to be clear, i never said anything about it being common

i said it can be done

whether a trust is common or simple in any particular year is all gauged upon what it distributes

 

[Taxing Matters]

whether a trust is common or simple in any particular year is all gauged upon what it distributes

No, it's not. That was my point. Read carefully the regulation I quoted. It is not just what the actual distributions made are that determines a simple trust. It also matters what distributions the trust document requires. If the trust document does not require distribution of all current income the trust will not be a simple trust even if the trust only distributes current income during the year.

 

[TrustUser]

okay, i will buy that

i did not mean to even argue that point

i write up all my trusts to distribute the income each year (cuz i dont want the income to stay in the trust and pay trust rates, if for no other reason)

so i have never encountered the situation of distributing all the income, but not being required to do so. although to be honest, i think my first guess would have been that it was considered simple, if it did that, even if not required.

my main point was to answer the main question of the op

was a change in status for this year apt to trigger anything with the irs

and my point was because trusts can change from year to year, i doubt that the irs would even look at how the trust was labeled the previous year

plus the irs is not gonna come after you to get a couple nickels from you

how much money difference could there be from flagging the trust as simple or complex, if all the income was reported ?

 

[TrustUser]

once again, i am gonna point out

if there was ever a legal battle, i do not think that this would be considered a trust

and would receive no trust protection

and i am more than happy to battle you on this point, if you think differently

once a beneficiary has much control over the funds, the trust loses it's trust status

i used to write up my trusts giving the trustee some discretion

i no longer do this, because of that reason

i do not want to take any chances that the trust will be ruled as being too lenient, and losing protection from creditors, etc.

so i no longer give the trustee any discretion at all

 

[Taxing Matters]

once again, i am gonna point out

if there was ever a legal battle, i do not think that this would be considered a trust

and would receive no trust protection

and i am more than happy to battle you on this point, if you think differently

I'd want to read the actual terms of the trust. The exact powers given the trustee/beneficiary matter and all we have here is the OP's summary, which may or may not accurately reflect what the trust provides.

However, it is pretty clear that the extent the beneficiary can exercise power to make distributions to himself that gives room to a creditor of the beneficiary to reach those funds by forcing the exercise of that power and attaching the distributions. So even if it remains a trust, if the goal was to help protect against the beneficiary's creditors, providing the beneficiary with a lot of power to get distributions will screw that up.

so i no longer give the trustee any discretion at all

Well, that's a bit extreme. If the trustee is not a beneficiary then you don't run into the problem you mentioned, and even if the trustee is a beneficiary, he or she can still have some discretion in distributions without it rendering the trust invalid. The trick is knowing under the applicable state law how much the trustee/beneficiary can do before crossing the line. There are certainly things the trustee/beneficiary could decide that would be clearly on the safe side of things. I don't fault your approach if it works for you though. It certainly eliminates the risk you are worried about.

 

[Arkayem]

OK, let me copy (re-type) the actual wording.

quote *
Section 5.01 Distributions of Income and Principle: The Trustee shall distribute to or apply for the benefit of my husband, and my surviving descendants, so much of the income and the principle of the Family Trust as the Trustee determines to be appropriate to provide for the continued health, education, support and maintenance of such beneficiaries in accordance with the standard of living that each enjoyed at the date of my death. The Trustee shall not be bound to observe equality in making distributions to or for the benefit of the respective beneficiaries, and may make disproportionate distributions based upon the Trustee's evaluation of the relative needs of each beneficiary.

For purposes of determining whether to make any distribution of principle or income from the Family Trust, the Trustee may consider, but shall never be required to consider, the other income or principle resources that are reasonably available to a beneficiary, including income and principle that may be available from other Trusts or, for any beneficiary other than my husband, that reasonably could be available from gainful employment that is available to such beneficiary. I would prefer the Trustee not to consider any incidental income earned by a beneficiary while securing education, but the Trustee may give consideration to earnings from permanent employment.
unquote

And to re-emphasize, I am the Trustee, husband, and beneficiary.

 

[TrustUser]

even if the trustee is not a beneficiary, you can run into problems. just depending on what the trustee is allowed to be discretionary about, and to what extent

you are right - i am taking no chances - LOL

 

[Arkayem]

even if the trustee is not a beneficiary, you can run into problems. just depending on what the trustee is allowed to be discretionary about, and to what extent

you are right - i am taking no chances - LOL

Your comment "just depending on what the Trustee is allowed", are you referring to what the state laws allow?

 

[TrustUser]

being that a trust is regulated by the state, i suppose so - in a very general way

from what i can see though, you seem to have an almost unlimited ability to do whatever you want

at least from the way that you are describing it

if you dont get into any trouble, there is probably no one who is gonna challenge anything

i am just letting you know ahead of time

about the worst type of problem to have is one that a person feels he is protected from, only to realize that is not so AT THE TIME THAT HE NEEDS IT !!

 

[TrustUser]

the bottom line is that when the beneficiary has too much say so, then those funds will be considered to be his own personal funds, as opposed to trust funds

meaning that a creditor can attach to them, in the same way that he would be able to attach to the rest of your wealth

i am fairly certain your situation has crossed that line A LONG WAY !!