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With trusts, simple is not always better

Some estate planning strategies allow you to integrate income tax reduction and personal goals. For this reason, your planning should consider the pros and cons of complex trusts.

A trust is a relationship wherein one person holds assets for the benefit of another. The first person is the “trustee”; the second is the “beneficiary.” For the following examples, let’s say Tom is the trustee and Ben is the beneficiary.

Key Points

• Learn the basics of “simple” and “complex” trusts.

• Check tax brackets to determine how much income to pass to beneficiaries.

• Sometimes, trust income can be taxed at a lesser rate than personal income.


One trust might state: “Tom shall give Ben all of the income of the trust and any of the principal Tom believes Ben needs.” A second trust example might authorize: “Tom, give Ben as much of the income from the trust as you deem appropriate; when Ben is 40, give him half of the principal, and when he dies give his children the balance.”

“Income” is generally the earnings, such as rent and interest. “Principal” means the underlying assets. There are innumerable variations on trust design. Distributions of income and principal can be imaginative. There may be two or more trustees. There could be two or more beneficiaries. There can be a current beneficiary and another future beneficiary, such as Ben’s children in the second example.

But, only one thing really determines whether a trust is what accountants call “simple” or “complex.” A simple trust is one in which all income must be distributed every year. In a complex trust, income distribution is optional; some income might be retained within the trust.

“Why would I ever retain income in trust?” you might ask. Protection. Assets held in trust are often safe from liabilities such as lawsuits or divorce. Trust assets can pass to future beneficiaries without estate tax. Trust assets may be protected from catastrophic health costs such as nursing home care. So in the second example, Tom might reinvest retained income inside the trust to grow the amount of protected wealth.

Income taxes

Enter the world of income taxes. Annual income is taxed to the party who gets it. In the first example, the trust does not pay income tax because it doesn’t end up with the income. All income goes to Ben, who reports and pays tax on it. But the second example is a complex trust. Tom could give Ben all, some or none of the income annually.

Imagine the trust holds farmland and CDs, receiving $12,000 rent and $6,000 interest annually. Tom has to decide how much to give Ben. The first consideration should be whether Ben actually needs the money, of course. But, if Ben doesn’t need the income, the second consideration is income taxes.

Federal income taxes tend to be high for income retained in trusts. The tax brackets are the same as individual rates — 10%, 15%, etc., up to 35% — but trusts zoom through those brackets, hitting the 35% bracket at $11,200. In other words, if the trust retains more than $11,200 of earnings in a given year, everything over $11,200 will be taxed at 35%. An individual hits 35% at $373,650.

What tax would be paid if the income is distributed to Ben? That’s determined by his individual tax bracket. The distributed trust income is tacked on top of his personal income. If he is in a low bracket, one might assume all income should be distributed. But not necessarily.

The first $2,300 of income left in the trust is taxed at 15%; if Ben is in the 15% personal bracket, the trust pays no more tax than he would. If Ben is in the 25% tax bracket, the trust would pay less tax on the first $2,300 than if it were distributed to him, and the same 25% on the next $3,050. We could analyze each step this way. If Ben is personally in the 35% bracket, he should ask Tom to retain all income in the trust!

65-day rule

If Ben didn’t need income during the year, Tom might come to Dec. 31 and wonder, “Should I distribute the income?” He won’t even know how much income the trust had until he gets 1099s in January.

Fortunately, the law gives Tom 65 days into each year — roughly through the end of February — to determine last year’s net trust income and Ben’s personal income. Armed with that information, Tom can distribute to Ben whatever income they want to shift onto Ben’s return, or retain it in trust for maximum protection.

Complex trusts offer flexibility for balancing income taxation against protections. Just remember: Simple isn’t always best!

Ferguson helps Illinois farm families protect what they value. He owns The Estate Planning Center in Salem. Learn more at www.tlcplanning.com.

This article published in the February, 2010 edition of PRAIRIE FARMER.

All rights reserved. Copyright Farm Progress Cos. 2010.