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. What are the legal and tax considerations when setting up a family trust?
Who is a trustee?
A trustee is a person or company responsible for managing a trust’s affairs. The trustee is also responsible for 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?
Trusts are a popular choice for families and their advisors because they inherently provide asset protection, allow income to be distributed flexibly in line with the family’s wishes and enjoy a range of 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 which can be found in the trust deed. In any given income year, by making splitting the trust income amongst several eligible adult beneficiaries, the family group can potentially result in an overall tax savings as oppose to all income being taxed in one person’s hands.
A family making an investment using a trust structure can access the 50% capital gains tax concession, as such, this remains a big incentive for family when choosing 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 trust 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.
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 however it is outside the scope of this article.
- 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 asking for the 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 the beneficiaries, and allow the trustee to access concessional rules to more easily recoup trust tax losses from prior years, these two are further explained below.
With the exception the total franking credits for any given year is less than $5,000, a person or an entity can claim franking credits attached to a dividend only when they have held the shares continuously ‘at risk’ for at least 45 days, However, a family trust usually is a discretionary trust, the beneficiaries of a discretionary trust are deemed to fail the 45-day rule and the trustee would not be able to pass the franking credits to the beneficiaries. The trustee can overcome this issue by making an FTE.
There are complicated rules govern how a trustee can recoup prior year tax losses, by making an FTE, a trust is subject to a set of simplified rules which are designed to be concessional for any trust with an FTE.
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, 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 distribution is made to an ineligible beneficiary, for example, the beneficiaries may bring legal actions against the trustee for failing its fiduciary duties towards the beneficiaries; the distribution made to an ineligible beneficiary would be deemed to be ineffective and depending on the deed, the tax on that portion of the distribution would be borne by the trustee at the top marginal rate.
However, the author is not a lawyer and the readers should seek their own legal advice if there is any concern raised by comments on legal matters.
Once a trust has an FTE in place, the trustee would have 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 a nominated individual for tax purposes. This is because a distribution made outside the nominated individual family group would attract family trust distribution tax.
Therefore, 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.
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, his or her 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 the 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.
If you would like to talk to an expert about setting up a family trust please reach out to us.
This article was authored by Helena Yuan, Tax Manager, HLB Mann Judd Sydney.