The income tax, capital gains tax and asset protection attached to trusts means that they are often the preferred method of structuring a business or investment activity.
This is particularly appropriate where more than one un-related party is involved. An example may be where two separate family groups who are buying a commercial property together.
However, it is also relevant when the business is of modest size. Most Australian businesses are carried on in trusts.
Trusts can be small, for example, a family trust may own a small property unit with a cost of less than $80,000, or they can be very large: some of the managed investment trusts (i.e. Australian Unity Property Funds) have more than 20,000 unit holders or beneficiaries.
Advantages of Family Trusts
The major advantages of a family trust are:
- income tax advantages;
- capital gains tax advantages;
- asset protection advantages; and
- as retirement planning vehicles.
Each of these advantages are examined in the following paragraphs.
Income Tax Flexibility
A major advantage of a family trust is the ability of the trustee to select the person to whom the trust’s net income will be distributed each year.
Provided certain formalities are observed, which are discussed below, and subject to one qualification, which is also discussed below, trust net income may be distributed amongst the beneficiaries in a way which minimises the total income tax payable on it.
For example, a family trust controlled by a financial planner may have two beneficiaries who are over the age of eighteen and who have no other taxable income. These may be the planner’s adult children. The trust has net income of $10,000 attributable to administration services provided to the planner’s professional practice. The trustee may resolve to distribute $5,000 to each of the two beneficiaries and, if it does so, no income tax will be paid on the $10,000 so distributed. Had the planner derived the $10,000 of income personally, income tax of $4,500 would have been payable.
The family trust has therefore saved the planner $4,500 in tax each year.
Capital Gains Tax Flexibility
Family trusts have capital gains tax advantages compared to companies. This is because the 50% discount factor on capital gains received for assets retained for at least a year applies to trusts but does not apply to companies.
That said, specific advice should be sought from an accountant or lawyer before acquiring a specific asset in the name of a trustee of a family trust. (Other legal entities have different advantages).
Family trusts can be combined with private companies to achieve the benefit of the flat tax rate currently applying to private companies. This is done by arranging for the trust to distribute net income to the company each year. The main rule here is that the cash must be actually paid over to the corporate beneficiary, and then retained in the corporate beneficiary. If this does not happen there is a risk that special anti-avoidance rules applying to private company loans may apply.
Specific advice should be sought from an accountant or lawyer before deciding to distribute net income to a corporate beneficiary.
Another major advantage of a family trust is the ability to put valuable assets beyond the reach of potential creditors. We have seen family trusts ‘save the day’ in this way many times.
In most cases assets transferred to a family trust cannot be accessed by creditors if the transferor gets into financial difficulty or even goes bankrupt. This is because the transferor has no interest in the transferred property and has no interest in the family trust which is recognised at law.
Asset Protection: A Case Study
For example, a client named John acquired a home worth $1,300,000 through a family trust and rented it back off the trustee. John also acquired a share portfolio worth $200,000 as an inheritance from a grandparent: John’s family trust was the beneficiary under the grandparent’s will. Some years later John guaranteed a large business loan for his brother, Darren. Darren’s business collapsed and the bank called up the guarantee. The bank could not touch the family home and the share portfolio. These assets simply did not belong to John. They belonged to the trust. As a result the bank could not do anything to get its hands on these assets.
This asset protection can continue through the generations. Over time, John’s adult children take over the family trust.
This is better, for example, than John owning the home and shares himself, and when he dies leaving these assets to a daughter. If that happens, the assets will be hers. If she marries, they will probably become a marriage asset (and almost certainly will if she inherits them after she has become married). Should her husband one day divorce her, he may have a claim on these assets.
If these assets remain in the family trust they will normally not be marriage assets in a divorce situation. This means that the (ex) son-in-law gets nothing. The same thing happens if a son (or another brother) gets into business difficulties or investment difficulties and is sued by creditors.
If necessary, a family trust’s deed can be amended to make it more restrictive and protective of the next generation once control passes to it. For example, special rules can be inserted to guard against spendthrift children or their spouses.
Family Trusts as a retirement vehicle
Increasingly family trusts are being seen as retirement vehicles, either in conjunction with a self-managed superannuation fund (SMSF), or as an alternative to a self-managed superannuation fund. Family trusts have the advantages of being able to acquire assets from related parties, borrow money, hold lifestyle assets such as holiday homes and company cars, are not subject to heavy prudential regulation, and do not need to be audited each year.
Careful tax planning can mean the effective tax rate on the trust’s income is less than 15%, being the tax rate faced by most self-managed superannuation funds. The planning can be as simple as paying a deductible superannuation contribution to a self-managed fund each year, sufficient to reduce the trust’s net income to a level where the effective tax rate is less than 15%.
There are no death duties or similar imposts in Australia at present. However, if death duties are reintroduced then the ownership of assets through family trusts may have some advantages over the ownership of assets by individuals.
Other advantages of a family trust include:
- Confidentiality of information, particularly regarding the financial affairs of the trust. There are no statutory disclosure requirements for trusts in the way that there are for companies under the ASIC database. There is also no requirement for a trustee dealing with other persons to disclose that it is acting as a trustee of a trust and not in its own right. Thus bank accounts can be opened, leases signed, investments made etc, for the benefit of the trust without other people needing to know this. In most cases we suggest that other people should not know that the trustee is acting for a trust;
- There are no formal audit requirements. Accounts have to be prepared but this is only to facilitate the preparation of an annual income tax return;
- The absence of any formal legislative framework, such as the Corporations Law, to control the activities of the trustee. Trusts are of course subject to the various Trustee Acts and all other relevant law, for example, the Trade Practices legislation and the Income Tax Assessment Act. But the Corporations Act does not directly apply. This makes trusts very flexible entities to use for business activities;
- The easy entry and exit of beneficiaries, particularly in terms of who gets income and capital each year and on the winding up of the trust;
- Trusts are cheap to establish and run each year, and
- Trusts are relatively simple to wind up.
Disadvantages of Trusts
The major disadvantage of a trust is that it cannot distribute capital or revenue losses to its beneficiaries. As a result, should a trust incur a net loss its beneficiaries will not be able to offset that loss against any other assessable income that they may derive.
Expert advice should be sought if it is expected that a trust may make a revenue loss or a capital loss for taxation purposes.
Some Tax Concerns
From time to time concerns are expressed as to whether the income splitting advantages really do exist, and whether the tax avoidance rules apply to family trusts used for income splitting purposes. Traditionally advisors have found some comfort in the words of then Treasurer John Howard when the anti-tax avoidance rules were introduced. He said that the anti-tax avoidance rules would only apply to particularly blatant, artificial and contrived schemes and would not apply to ordinary commercial and family dealings.
It is unlikely these rules will apply to a person organising or re-organising their business and investment activities to achieve all of the non-tax advantages attached to family trusts as well the tax advantages. It is even less likely that the ATO will try to apply them. Most tax advisors believe that family trust arrangements are outside the tax avoidance rules, provided there are sound commercial reasons for their use, such as the protection of assets and optimal estate planning.
If you have any concerns here you should discuss them with your accountant or lawyer.
The August 31st Deadline
Most family trust deeds require the trustee to distribute net income to the trust’s beneficiaries prior to 30 June each year.
In practice, however, this is rarely done. Most trustees (and, perhaps more importantly, their advisors) rely on the ATO’s administrative practice of allowing trustees to distribute trust net income at any time up to 31 August. However, this leads to the strange position whereby most trust distributions are ineffective for income tax purposes, albeit with the indulgence of the ATO.
Although the ATO will in most cases follow the 31 August administrative practice, tax lore (which is not the same thing as “tax law”) contains many examples of the ATO not doing so when it suits: for example, when confronted with a large distribution to a non-resident beneficiary, or some other unusual circumstance. For this reason, clients should ensure that any trust distributions in which they are involved follow both the strict letter of the trust deed and the strict letter of the law. Care in this area now may avoid a lot of pain and angst in the future should the ATO decide to challenge the efficacy of a particular trust distribution.
As an example of the ATO abandoning established practice to enforce the strict law, doctors should note the Administrative Appeals Tribunal decision in Case X87. In this case the taxpayer relied on the statement made by the ATO in Taxation Ruling IT 2480 that if certain so-called “variable income annuities” were terminated within a specified period then concessional tax treatment would be applied, notwithstanding that they were not strictly annuities at all. Nevertheless, the ATO later denied the taxpayer this concessional tax treatment.
The Tribunal showed some sympathy for the taxpayer but in the end had to apply the strict law, not IT 2480. The taxpayer did not appeal from the Tribunal’s decision (although he may have taken up the Tribunal’s suggestion that he pursue the issue with the Ombudsman).
In whose name should the assets be held?
The trustee is the legal owner of the trust’s property. This means the trustee’s name should appear on all ownership documents, such as shares in private companies, units in private trusts, or title deeds for land ownership.
You may add the tag “… as trustee for the (name) family trust” if you wish, and this has the advantage of informing or reminding all concerned that the asset is held on trust and does not belong to the trustee personally. However, in some cases this will not be possible. For example, most property Title Offices will only register a title in the name of the trustee, i.e. the legal owner, and will not allow the tag “… as trustee for the (name) family trust” to be used.
Estate Planning: Testamentary Trusts
Family trusts are useful tools for estate planning purposes. This means that their benefits may be available to subsequent generations as well, long after the founders have passed on. This means assets left to children and grandchildren via family trusts can be protected against divorce, business failure and litigation.
It also means children under the age of 18 can get significant tax advantages: income derived from trusts created on death is excluded from the rules set out in Division 6AA of the Income Tax Assessment Act regarding the taxation of unearned income for minors. This means the penalty tax rate normally applying to unearned income of a minor does not apply to this type of trust.
Assets transferred to or acquired by a discretionary trust are not owned by any individual person. This means they are not controlled by an individual person’s will. Setting up a family trust and transferring assets to it does not mean that a will is redundant. The role of the family trust and its relationship with your will should be properly understood, and the two should as far as possible be consistent, both with each other and your general wishes and intentions.
Disabled children are a special case. The tax law allows disabled children (under age 18) to receive distributions from family trusts and to pay tax on these distributions as if they are adults. For example, $18,200 can be distributed tax-free to a ten-year-old child with a vision problem, whereas normally most of this income would be taxed at penalty rates under the rules for unearned income derived by minors.
Please fill in our free online enquiry form or call us on 1300 733 942 to discuss your situation and get tax advice from our accountant on your family trust, SMSF, or company structure.