A common question we get asked is “what is the difference between a family trust and a discretionary trust?”
The answer is both simple and complex, with legal and tax considerations.
A discretionary trust is one that is set up with a broad range of the beneficiaries and the trustee of the trust can decide how much money each beneficiary can receive. That is, the trustee has discretion over these decisions.
Most family trusts are a type of discretionary trust, although it is possible to call any trust a “family trust” if it has been set up for the benefit of a family group.
However there are legal and tax requirements, including reports and documentation, for discretionary trusts that must be complied with. One of the most important documents is the trust deed which is the legal document governing the trust. Trustees are obliged to act in accordance with the terms of the trust deed and must always check it before distributing any trust income, to identify who is eligible to receive a distribution.
From a tax perspective, whether to make a ‘family trust election’ (FTE) is an important decision for the trustee in managing the trust’s affairs.
An FTE is when the trustee elects one of the people within the family to be the ‘test individual’. This person then become the reference point for the ‘family group’ that can be beneficiaries of the trust.
The decision to make an FTE cannot be revoked once made and the decision must be reported to the ATO. The test individual nomination can only be varied in limited situations.
An FTE has an effect of limiting the pool of beneficiaries that the trustee can distribute income to, regardless of what the trust deed says. In recent years, we have seen some undesirable practical implications for some of our clients, especially with the number of inter-generational wealth transfers taking place.
A typical situation involves an original family trust set up decades ago with a grandparent elected to be the ‘test individual’. Fast forward to now, a grandchild has also set up their own family trust with the grandchild as the ‘test individual’. There can be significant tax issues when the grandparent’s trust wants to distribute income/capital to the grandchild’s family trust if this is not correctly managed.
There are both pros and cons to making a family trust election.
Advantages
From a tax perspective, a typical discretionary trust enjoys many tax concessions, but is unable to pass franking credits to beneficiaries if the credits total more than $5000 for the year. This can be a significant limitation for many family groups who use discretionary trusts as an investment vehicle. Making an FTE allows trustees to pass franking credits to beneficiaries.
Another benefit is that an FTE allows the trustee to bypass the complicated rules around recouping prior year’s tax losses, including accessing concessional rules.
Disadvantages
The main disadvantage of making an FTE is that if a distribution is made to a beneficiary outside the family group (as defined by the tax legislation) they will be liable for a special tax – the ‘family trust distribution tax’.
This tax is payable at the top personal marginal tax rate, plus the Medicare levy, and the affected beneficiary cannot claim this tax as a credit.
Trustees must therefore manage an added level of complexity if they make an FTE, ensuring beneficiaries are eligible to receive a distribution under the trust deed and is in the family group of the ‘test individual’ for tax purposes.
There can be legal and tax consequences if a distribution is made to an ineligible beneficiary. For example, other beneficiaries may bring legal action against the trustee for failing its fiduciary duties. In addition, the distribution to an ineligible beneficiary would be deemed to be ineffective and the tax on that portion of the distribution could be borne by the trustee at the top marginal rate.
This article was first published in Financial Times – Winter 2024.
For further information on the legal and tax considerations of a family trust please read more here.