Discretionary (family) trusts explained

Discretionary trusts are one of the most common structures for Australian family businesses and investments, and one of the most misunderstood. They can offer flexibility and a degree of asset protection, but they come with annual obligations and tax rules that catch out trustees who treat the trust as a set-and-forget arrangement.

What a discretionary trust is

A trust is not a separate legal entity. It is a relationship: a trustee holds assets and runs the business for the benefit of beneficiaries, under the rules set out in the trust deed. In a discretionary trust, the trustee decides each year which beneficiaries receive income or capital, and how much. No beneficiary has a fixed entitlement.

The main roles are:

• Trustee. Often a company set up for the purpose, so that the trust's liabilities sit with a limited liability trustee rather than an individual.
• Appointor. The person who can remove and replace the trustee. This is the real control of the trust, and it deserves careful thought.
• Beneficiaries. Usually a broad class: family members, their relatives, and related companies and trusts.
• Settlor. The person who establishes the trust with a nominal amount and then plays no further role.

The deed governs everything. It must be prepared by a lawyer and kept safe, and any amendment should also go through a lawyer, because a poorly drafted change can have serious tax consequences.

Why business owners use them

Flexibility in distributing income

Because the trustee can choose who receives income each year, profit can be directed to beneficiaries in a way that suits the family's circumstances that year. Beneficiaries pay tax at their own rates on what they receive.

There are firm limits. Minors are taxed at penalty rates on most trust distributions. Distributions must be genuine, and income allocated to one person but enjoyed by another can fall foul of section 100A, discussed below.

The CGT discount

A trust that holds an asset for at least 12 months can generally pass the 50% CGT discount through to individual beneficiaries. A company cannot access that discount, which is one reason trusts are often preferred for holding growth assets.

Asset protection

Because beneficiaries of a discretionary trust have no fixed entitlement, trust assets are generally not treated as theirs. That can help keep assets out of reach of a beneficiary's personal creditors. It is not absolute: courts, including the Family Court, can look through a trust in some circumstances, and the trust's own business creditors can pursue the trust assets through the trustee.

What a trust cannot do

• Distribute losses. Losses stay in the trust and can only be carried forward against future trust income, subject to the trust loss rules.
• Retain profits cheaply. Income that is not distributed is generally taxed in the trustee's hands at the top marginal rate. In practice, a trust distributes all of its income every year.
• Give certainty to outside investors. Because no one has a fixed share, a discretionary trust is a poor vehicle for unrelated co-owners. A unit trust is usually better; see Unit trusts for co-owners and joint ventures.
• Last forever. Most deeds set a vesting date, after which the trust must be wound up and its assets distributed. Check yours.

The annual distribution resolution

The trustee must decide how income is to be distributed, and record that decision in writing, by the deadline the deed and the tax rules require. For most trusts that means before the end of the financial year on 30 June. If the resolution is late, missing or inconsistent with the deed, the income may be taxed to default beneficiaries or to the trustee at the top rate.

A sensible routine:

1. Review the year's expected profit in May or early June.
2. Check who is eligible to benefit under the deed.
3. Decide the distribution and make sure each beneficiary will actually receive the benefit.
4. Sign the resolution before 30 June and keep it with the trust records.
5. Pay out or properly document the entitlements once the accounts are finalised.

Section 100A and distribution risk

Section 100A is an anti-avoidance provision aimed at arrangements where income is distributed to one beneficiary, usually on a lower tax rate, while the money is actually paid to or used by someone else. Where it applies, the trustee can be taxed on that income at the top rate.

The ATO has published its views on how it applies, and ordinary family dealings are treated differently from arrangements designed to shift tax. The principle to remember is simple: a beneficiary who is distributed income should actually receive and benefit from it. Distributions to adult children who then hand the money back to their parents, or to beneficiaries who never see the cash, are the patterns that attract attention. Talk to your adviser about current ATO guidance before setting your distributions.

Corporate beneficiaries

Many family trusts distribute some profit to a company beneficiary, often called a bucket company, to cap the tax on that income at the company rate. This works only when the company is actually paid, or the unpaid amount is dealt with properly. See Bucket companies: how they work and where they go wrong.

A family trust is a working structure, not a filing-cabinet structure. The deed, the trustee's annual decisions and where the money actually goes all matter.

Other things to get right

• Family trust election. Often needed to pass franking credits through to beneficiaries and to use the trust's losses, but it narrows who can benefit without extra tax. Get advice before making one.
• Separate bank accounts and records. Trust money must not be mixed with personal money.
• Succession. Plan who becomes appointor and director of the trustee company if you die or lose capacity. A will does not automatically control the trust.
• State taxes. Some states apply land tax surcharges or different duty rules to trusts, depending on the deed's terms.

Is a discretionary trust right for you?

It may suit you if you have a family business with steady profits, family members on different tax rates, growth assets you expect to sell one day, and a willingness to maintain the paperwork. It may not suit you if you have unrelated co-owners, expect early losses, or want to retain most of your profit in the business.

How we can help

We help families decide whether a trust fits, set it up alongside your lawyer, and run the annual distribution process so the decisions are made on time and on the right basis. To talk it through, contact us or see our business structuring services.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.