A beginner's guide to discretionary trusts and taxes
Few structures are as widely used but as little understood as trusts, especially when it comes to the potential tax consequences which can arise when they are misused.
Here's what you need to know.
What is a trust?
A trust is basically a structure that allows a person or company to hold an asset for the benefit of others. The person who controls the asset is the trustee and those who benefit are the beneficiaries.
The assets held in a trust can vary - cash, property, shares, businesses and business premises are all commonly held in trust structures. The creator of the trust (the settlor) sets out the specific rules as to how these assets should be managed in a document called the trust deed.
By putting assets in a trust, you don't own the assets in your name. The assets are legally controlled by the trustee. However, you can potentially control exactly how those assets are managed now and in the future.
You have the power to set out who receives the income arising from the assets and when they receive it, as well as who receives the underlying capital represented by the assets themselves and when.
Whilst the trustee of a trust is the legal owner of the property within the trust, the trustee can only deal with the trust property for the benefit of the trust beneficiaries.
How do discretionary trusts work?
Discretionary trusts (sometimes known as family trusts) are the most common type of trust used in Australia. They are generally created to hold a family's assets and/or business so as to protect those assets and to facilitate tax planning for family members.
The trustee has the discretion to distribute trust income (or the underlying assets in the trust, known as trust capital) to whichever beneficiaries they choose. Alternatively, they also have the discretion not to distribute anything at all, although as we will see this is not a desirable outcome from a tax perspective.
With regards to tax, the main advantage is that any income generated by the trust from business activities and investments, including capital gains, can be distributed to beneficiaries in lower tax brackets (often to spouses or children).
Because the trustees of the trust have the "discretion" to distribute income and capital as they see fit - and no beneficiary has a fixed entitlement to receive anything - the trustees are able to "stream" income in a tax-effective way on a year to year basis.
For example, the ABC trust has two beneficiaries, Mr X and Mrs X. Mr X works part-time in a supermarket and earns $20,000 per annum. Mrs X is a partner in a large accounting practice and earns $400,000 per year. It makes sense for the trustee of the ABC trust to stream any income arising from the trust's assets to Mr X since he will pay less tax on that income.
As a trust can last for up to 80 years, trusts are useful vehicles for facilitating succession planning.
Once an asset is within a trust, that trust can span several generations, enabling each succeeding generation to benefit from the income of the trust, whilst protecting the underlying assets from the vagaries of "events", such as divorce, profligate children and bankruptcy.
In most cases, from an asset protection perspective, assets held in a family trust cannot be attacked by creditors or lawsuits so they are ideal for protecting assets from business or personal disputes and they can also facilitate the transfer of assets from generation to generation tax free.
Settling assets in a discretionary trust
Where assets are transferred into a trust, this will be treated as a disposal for capital gains tax (CGT) purposes and the transferring taxpayer will be subject to CGT.
The transfer value will generally be the market value so it makes no difference for tax purposes whether the asset is gifted to the trust, sold at full market value or transferred at some value between nil and market value.
That rule applies where most assets are transferred, such as shares or real property (land or a building). The most obvious exception is where cash is put into the trust. Cash is not a CGT asset so there are no tax implications on transferring cash into a discretionary trust.
Where property is transferred, a stamp duty liability will also arise (based on market value) to the trustee of the acquiring trust. Stamp duty is an issue for land and buildings in all states; in some states, stamp duty may also arise on the transfer of shares.
Taxing the income of a discretionary trust
The income of a trust is taxed in the hands of the beneficiaries of that income, based on their share of the income of the trust as at the end of each tax year.
That means that each beneficiary records their share of the income of the trust in their personal tax return and pays income tax on it at their marginal rate. In normal circumstances, the trust itself doesn't pay any tax at all.
If a particular beneficiary is under a "legal disability" (such as those under 18, those who are mentally incapacitated and those who are bankrupt), the income will be taxed to the trustee at the relevant individual rates (which may be higher than usual, since the law imposes punitively high tax rates on some income paid to under 18s).
That beneficiary may then need to declare the income in their tax return and claim a credit for the tax paid by the trustee.
For income to which no beneficiary is "presently entitled", tax will generally be payable by the trustee at the highest marginal rate of 47% (including the Medicare levy).
If a trustee resolution setting out the respective entitlements of the beneficiaries is not prepared by June 30, no beneficiary will be "presently entitled" and the higher tax rate will be applied to the trustee. It is therefore important to meet that June 30 deadline (see below).
If the beneficiary is "presently entitled" but not an Australian tax resident, the trustee must pay income tax on their share of the trust income at the non-resident tax rates (which are generally higher than the rates for residents). This excludes the Medicare levy.
Tip: Where a beneficiary is "presently entitled", they have the right to demand payment of that entitlement.
Where a trust makes a capital gain by disposing of an asset, the 50% CGT discount will arise where the asset has been held for at least 12 months. This discount then flows through to beneficiaries who are individuals.
Tip: If a trust makes a capital gain, it makes sense to distribute it to beneficiaries who have capital losses, which can be used to absorb the gain and minimise the tax.
Where a trust receives dividend income, the trust deed may specify that those franked distributions can be streamed to particular beneficiaries (such as those on lower tax rates, who can get a refund of the franking credit).
Where no such stipulation is included in the trust deed, the franked distributions should be streamed proportionately to all beneficiaries in accordance with their overall entitlement to distributions.
Your tax obligations as a trustee
Where a trust is a closely held trust - which all discretionary trusts are - all beneficiaries of the trust are required to provide their TFN to the trustee, who must in turn pass that information to the ATO in a TFN report by the last day of the month following the end of the quarter in which the beneficiary provided their details.
For example, if a beneficiary passes their TFN details to the trustee on the last day of May 2022, the end of the quarter to which that information relates is June 2022. A TFN report must be sent to the ATO by July 31, 2022.
The TFN report must include for each beneficiary:
- full name
- date of birth (individuals only)
- postal address
- residential address for individuals
- business address for non-individuals
The ATO uses this information to match trust distributions to the disclosure of those distributions in the tax returns of beneficiaries.
Where the trustee decides to make distributions from the trust, they must produce a written resolution recording their decisions by June 30 each year. Where this doesn't happen, the trustee will then be assessed to income tax on the income of the trust at the highest marginal rate of tax (currently 47% including Medicare levy).
The resolution does not need to specify an actual dollar amount for each distribution unless the trust deed requires it; provided a clear methodology is set out to calculate who receives what (such as a percentage share), that will suffice.
If you have substantial personal and/or business assets and have never considered setting up a trust for the benefit of your family, there is plenty to be gained by talking to your tax adviser or lawyer about the pros and cons.
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