In Australia, trusts are routinely used as an investment or trading vehicle. There are several different types of trust structures available, but the most commonly used is a discretionary trust such as a family trust. Helena Yuan, Tax Manager at HLB Mann Judd Sydney, explains more about family trusts in Australia.
What is a family trust?
In essence, a family trust, or a discretionary trust, is an alternate investment structure to a company. It is usually set up for creating or holding wealth to benefit multigenerational family members. At the creation of a family trust in Australia, there must be three groups of people: settlor, trustee and beneficiary. In recent times, the ATO has released several publications to curb the misuse of family trusts in Australia. While a family trust remains an appealing investment structure, you should seek tax advice to ensure a family trust is well suited to your situation.
Who is a trustee?
A trustee is the legal owner of assets in a family trust who can be a person or company. The trustee is responsible for managing a trust’s affairs, including fulfilling the trust’s tax obligations, such as lodging an annual tax return for it, because while a trust is not a legal entity like a person or company, it does need to be registered in the tax system.
When carrying out their responsibilities, a trustee is bound by the deed of the trust, as well as the relevant Australian tax legislation. These obligations can include distributing the net income or profit of the trust among the eligible beneficiaries at the end of each financial year.
The best way of doing this may vary depending on the particular trust deed, but typically a well-advised trustee would seek to ensure they distribute all the trust’s net income by the end of the year, to avoid paying a high tax rate on the residual money.
What are some potential benefits of a family trust?
Family trusts are a popular choice for families and their advisors in Australia because they inherently provide asset protection, allow income to be distributed flexibly in line with family wishes, and enjoy a range of possible tax concessions.
Because the beneficiaries of a family trust don’t own any of the assets sitting in the trust, these assets can potentially remain relatively safe even if, for example, a beneficiary becomes bankrupt or owes money to someone under a court order.
However, to achieve the maximum level of asset protection, the trustee must also consider any debts the trust owes to members of the family. For example, a common situation occurs when a mum and dad lend money to their family trust so the trustee can use it to make investments, with the money being recorded as a liability of the trust. In this case, creditors of the mum and dad may still be able to access the assets in the trust in a debt recovery procedure.
Income distribution flexibility
A trust usually has a broad class of beneficiaries who can be found in the trust deed. In any given income year, by splitting the trust income among various eligible adult beneficiaries, the family group can potentially achieve an overall tax saving, compared to if all income were taxed in one person’s hands.
A family making an investment using a trust structure can access a 50% capital gains tax concession. As such, a big incentive remains for families who want to choose an investment structure to pass down wealth to the next generation.
Does a family trust or trustee need to pay tax on its income?
A family trust in Australia is often seen as a flow-through entity, meaning trust income is usually taxed in the hands of beneficiaries who have a ‘present entitlement’ to it; that is, the beneficiaries who have the ability to demand payment.
There are several situations where a trustee may be liable to pay tax on trust income, however, including:
- Non-resident beneficiary. When a portion of the trust income is distributed to a beneficiary who is not an Australian resident for tax purposes, the trustee must pay tax on behalf of the non-resident beneficiary.
- Minor beneficiary. The trustee must pay tax on behalf of beneficiaries who are under 18 years old as at 30 June of the relevant financial year. Where the distribution to a minor is greater than $1,308, the top marginal tax rate of 45% is imposed on that portion of the trust income. The high tax rate is designed to deter families from making trust distributions to minors. Income from a testamentary trust is an exception to this rule.
- Undistributed trust income. If the trust income is not fully distributed to beneficiaries, either by choice or inadvertently, the trustee would have to pay tax on the income retained in the trust, also at the top marginal rate of 45%.
There is also another important type of tax – family trust distribution tax – associated with trust income distribution that is often overlooked. We explain how this works in more detail below.
Does my trust have to make a family trust election?
A family trust election, or FTE, is a declaration a trustee can make to the Australian Taxation Office (ATO) asking for their trust to be treated as a family trust for tax purposes. It’s completely voluntary to make an FTE, and when a trust is created, the trustee does not automatically make an FTE. In fact, the opposite is true, and the trustee should consider seeking professional advice to weigh up the advantages and disadvantages before making an FTE. The advantages of making an FTE include that it can enable the trustee to pass franking credits to eligible beneficiaries, and allow the trustee to access concessional rules to more easily recoup trust tax losses from prior years.
More specifically, the rules around franking credits mean the trustee of a discretionary trust normally can’t give more than $5,000 per year in franking credits to a beneficiary. However, a trustee may be able to overcome this issue by making an FTE.
Likewise, there are usually complicated rules that govern how a trustee can recoup prior year tax losses. By making an FTE, a trust becomes subject to a set of simplified rules which are designed to be easier for a family trust to recoup these losses.
The main disadvantage of making an FTE is that if the trustee makes a distribution to a beneficiary outside the family group of a ‘nominated individual’, the trustee will be charged a special tax – known as family trust distribution tax – on the value of the trust distribution made.
Family trust distribution tax is payable at the top personal marginal tax rate, plus the Medicare levy (for a total of 47% at the time of writing), and the beneficiary cannot claim this tax as a credit. If the trustee is a company, the trustee and the directors of the company are jointly liable for the tax.
Legal considerations for trustees of family trusts
A trust deed is a legal document created at the start of a trust’s life. A trustee of the trust is obliged to act in accordance with the terms contained in the deed and, as such, they must always check the trust deed before distributing any trust income, to identify which beneficiaries are eligible to receive the distribution.
There may be unwanted legal and tax consequences if a trustee makes a distribution to an ineligible beneficiary, so seeking professional legal advice is recommended if you have any concerns about legal matters.
Once a trust has an FTE in place, the trustee often has to deal with an added level of complexity when making distributions. In addition to checking the trust deed, the trustee must also carefully check to confirm any beneficiaries are also included in the family group of the person listed as the ‘nominated individual’ for tax purposes in the FTE. This is because, as the ATO explains, a distribution made outside the nominated individual’s family group would attract family trust distribution tax. So, choosing the nominated individual – also referred to as the specified individual or the test individual – is central to making an FTE, which is more of a tax law concept than a trust law one.
Please keep in mind that I am a tax manager, not a legal professional. It’s important to seek professional legal advice if you have any concerns about legal matters, including those relating to family trusts.
Whose family is it anyway?
So, who can be the nominated individual in an FTE? This requires careful thought on the part of the trustee. One important consideration is that the trust must satisfy the family control test, meaning either the nominated individual, their family, and/or their legal or financial advisors must have the ability to control the trust in one of three prescribed ways. Working out whether a trust meets this test will involve reading the trust deed carefully.
Who is in the family?
By making an FTE, the trustee is restricting which beneficiaries can potentially receive a distribution from the trust, and excluding those who are deemed by the applicable tax legislation to be ‘outside’ the family group.
Fortunately, the range of people who can be considered part of the nominated individual’s family group is quite broad, and can include the nominated individual’s parents, grandparents, spouse, children and their lineal descendants (direct descendants, including adopted and stepchildren). The nominated individual’s siblings, nieces, nephews and their lineal descendants, as well as their spouse’s parents, grandparents, siblings, nieces and nephews and their lineal descendants are also included. Even former spouses and former stepchildren make the list.
However, some relatives are excluded, including step-brothers, step-sisters, uncles, aunts and cousins of the nominated individual. Therefore, selecting the right person to be the nominated individual could prevent future family disputes.
Importantly, entities such as companies, partnerships and trusts can also be included in the nominated person’s family group for a family trust, provided an additional election – an interposed entity election (IEE) – is also made.
An IEE acts as a bridge connecting the other entity to the family trust, so that income distribution from the family trust to that entity does not attract family trust distribution tax. The downside is that this can add another layer of complexity for the family trustee when choosing the nominated individual, especially in a blended family situation.
Trust taxation is a complex area. Over the years, various governments have introduced more tax legislation to tighten the tax-effectiveness of the trust structure, and there will likely be further reform in the future.
While a trust structure still has many benefits, it’s a complicated arrangement. Trustees should consult the trust deed and consider seeking professional legal and tax advice in order to properly discharge their responsibilities.
Cover image source: Jacob Lund/Shutterstock.com.
Thanks for visiting Canstar, Australia’s biggest financial comparison site*
About Helena Yuan
Helena Yuan is a Tax Manager in the tax consulting division at HLB Mann Judd Sydney. She has over 23 years of experience in taxation and business services, working with clients across industries including retail, professional services, manufacturing, property development and the not-for-profit sector.
Helena’s experience enables her to consider a breadth of issues when advising clients. Her current focus is on family businesses, including advising for succession planning, estate planning and compliance. Helena also advises multinational groups for their Australian tax structure and compliance needs. You can follow Helena on LinkedIn.
Australian family trusts do pay capital gains tax (CGT). Fortunately, family trusts benefit from a 50% CGT discount. For example, if you were to sell your business or its assets, you would trigger a CGT event in which a tax would be levied upon the profits of your sale.Who are the beneficiaries of a family trust in Australia? ›
The beneficiaries are usually named in the terms of the trust deed - this may include spouses and other relatives but will always include any minor children (even if they're not yet born).How does a family trust work in Australia? ›
In Australia, family trusts are established by trustees: in this instance, parents. The trustees can fill their family trust with profit from their family business, and the trust will then distribute that income to its beneficiaries: the children, grandchildren and their spouses.