Trusts, and in particular Trust Funds, tend to conjure up images of young people driving around in Porsches and having never-ending champagne lunches. And while that may sound like heaven (Ooo, it really does), the reality for most people is that discretionary trusts (and other types of trusts) are valuable tools that can be used to protect assets and make things more tax efficient.
Trusts in their most basic form are 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 but typically include property, shares, businesses, and business premises. The creator of the trust, known as the settler, sets out the specific rules as to how these assets should be managed in a document called the trust deed.
There are a number of Trusts that can be used in Australia, but in this article we’re going to look at what is a discretionary trust.
Why create a trust?
Trusts are mainly created to separate a person’s assets from their personal estate. Once a settlor assigns those assets to a trust, they no longer own them, effectively shielding the assets from creditors in bankruptcy proceedings or plaintiffs in lawsuits.
Other reasons for creating a trust include:
- Controlling the assets of individuals who are too young or incapacitated to manage their own financial affairs.
- Protecting people from squandering their fortunes.
- Managing and distributing pension/retirement funds during an individual’s employment years
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What is a discretionary trust?
A discretionary trust (also known as a family trust), is a trust established to hold a family’s assets or operate a business. Generally, they are established for asset protection and/or tax purposes.
‘Discretionary trusts are the most common type of trust used by business owners in Australia.’
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.
Other types of trusts
Before we dive further into discretionary trusts let’s take a quick look at the other Trusts used in Australia. In addition to Family or Discretionary Trusts, there are also the following:
Unit or Fixed Trusts
A unit trust (also known as a fixed trust) differs from a family trust in that the trustee generally does not hold discretion over the distribution of assets to beneficiaries. These structures divide the trust property into units, similar to shares. Each beneficiary (known as a “unit holder”) owns a given number of those units, and at the end of each year, each unitholder receives a distribution from the trust.
Hybrid Trusts
A hybrid trust bears characteristics of both discretionary and unit trusts. The trustee is empowered to distribute trust income and capital among nominated beneficiaries – as with discretionary trusts.
However, the income and capital are proportionally distributed – as with unit trusts – based on the number of units each beneficiary holds. Hybrid trusts are often the favoured structures when there are significant investment assets involved, due to their income tax and capital gains tax benefits.
Special Disability Trusts
The special disability trust allows immediate family members and carers to set up a trust to benefit another family member. Before the trust can be set up, the prospective beneficiary must be assessed as severely disabled per the requirements of the trust’s legislation.
Family members are then allowed to make private financial contributions for the future and current care of the beneficiary.
Discretionary trust benefits
The key benefits of having a discretionary trust, include:
- Flexibility on income distributions. The trustee decides before June 30 each financial year how that year’s trust income is to be distributed between the various beneficiaries. Generally, income will be distributed to beneficiaries in lower tax brackets.*
- Ability to distribute income to adult children (aged over 18 years) who are either studying or working part-time and are in low tax brackets.
- Ability to stream capital gains and franked dividends to specific beneficiaries.
- Provides asset protection from creditors, ex-spouses, legal claims, etc.
- Ideal structure for owning capital appreciating assets (such as land and shares) as the beneficiaries can access the 50% CGT discount on any realised capital gains (if the assets were owned for more than 12 months).
- Allows for succession planning and the transfer of wealth to future generations without immediate tax consequences.
- Ability to hold personal use assets such as holiday homes, boats, racehorses, etc.
- Reduces the land tax payable on multiple properties by owning each property in a separate family trust (thereby having each family trust access the tax-free threshold for each individual property).
- There are no investment rules, no contribution rules, and no preservation rules (unlike superannuation).
The downside is that to the extent that they don’t distribute the income of the trust, the trustees themselves are liable to tax on the undistributed income and a rate of tax usually higher than the beneficiaries themselves would have to pay.
* As of February 2022, the ATO has implemented new rulings (Taxpayer Alert TA 2022/1) affecting distributions to adult children. In some cases, the tax rate for these distributions may be 47% rather than their individual marginal tax rate. Due to these changes, it is best to seek professional tax advice to ensure you are aware of the tax obligations for your trust. Learn more >>
Establishing a discretionary trust
Establishing a discretionary trust is fairly straight-forward and involves a number of key steps. Some basics to remember upfront are:
- Individuals who originally provide the assets are generally referred to as settlors. Those charged with managing trusts and distributing their assigned assets are known as trustees.
- Those who ultimately receive the assets contained within the trusts are known as beneficiaries.
In establishing trusts, settlors must take the following steps:
Step 1: Decide upon original trust assets
List all the holdings, along with their current value, to be placed in the trust.
Step 2: Appoint trustee(s)
Designate an individual or financial institution to serve as trustee. Choose wisely, as this person or entity will wield significant legal authority and control over your trust assets.
Since trustees of discretionary trusts have wide powers, it is essential to choose a responsible and impartial individual to embody this position. For this reason, it may be best to appoint an independent trustee, who has no allegiance to any of the beneficiaries listed in the trust deed document.
Step 3: Determine beneficiaries
Compile a list of people or entities entitled to receive benefits. Include the percentage breakdown of assets intended for each recipient.
Step 4: Draft the trust deed
A trust deed is a legal document prescribing the rules that govern your fund and the powers of the appointed trustee. It includes the fund’s objectives, specifies original trust assets, identifies the beneficiaries, outlines how benefits are to be paid (either via lump sum or an income stream), details how the trust may be terminated, and establishes rules for operating the trust bank account.
Trust deeds must be signed and dated by all trustees, executed according to state or territory laws, and regularly reviewed and updated as required. Deeds should be created by a qualified professional.
Step 5: Stamping
Stamp duty is a state-based tax that may be payable on the trust deed, depending on the state or territory. Stamping can be arranged directly through the relevant revenue authority or via a lawyer or accountant in your given state or territory.
Step 6: Register as a business
As with other Australian business structures, you will need an ABN (Australian Business Number), TFN (Tax File Number), and a business name for the trust. Depending on the trust type and complexity, you may be required to register it as a company.
Step 7: Open a bank account
Once the trust has been established, a trust bank account should be opened in the trustee’s name. The bank may require personal details about the trustee(s) and other parties involved before it will open the account.
Step 8: Commence trust activity
Once the bank account has been established, the trust becomes operational and can accept contributions or make investments, subject to terms outlined in the trust deed.
Additional scrutiny for trusts
While trusts provide significant benefits they are not all sweetness and light. It’s fair to say that trusts have become synonymous with tax avoidance, particularly where they are used by the highly wealthy. And this means the ATO have a keen focus on ensuring trusts are not being used to hide income altogether, conceal the underlying ownership of assets and/or to facilitate transfers of funds tax free between family and business groups through mechanisms such as interest free loans.
Getting good advice is key
Trusts have become a common way of structuring financial affairs, and a logical, tax-efficient means of distributing earnings that protect wealth for future generations.
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 having one, and if you already have a trust structure in place, now is probably the time to do some due diligence to look at what you’ve got, how the structure has been used and if it’s meeting your goals.
Expert discretionary trust support from POP Business
While online platforms can offer some guidance on trusts, seeking professional advice is highly recommended to ensure you understand the pros and cons, your obligation’s and ATO requirements.
Need help? The team at POP Business can provide expert advice on all types of trusts, including discretionary trusts. To find out more, call us today on 1300 180 630.
