A Trust has an obligation on a person to hold property or income for a particular purpose on behalf of another person or people. There are a number of different types of Trusts:
- Discretionary trusts;
- Unit trusts (public and private);
- A combination of a unit and discretionary trust (hybrid);
- Fixed trusts;
- Testamentary trusts; and
- Inter vivos trusts.
The essential elements of a Trust are:
- A constituent document (Trust Deed), although a Trust can be created orally or be implied;
- Trust property;
- Principal or Appointor;
- Settlor; and
- Obligations in relation to the Trust property as set out in the Trust Deed.
For Tax Law purposes, a Trust is considered to be a separate legal entity, although this is not the case in general law. In any event, the Trust is required to determine its Net Trust Income and lodge an Income Tax Return. If the Trust has net distributable income, then that income will generally be distributed to the Trust Beneficiaries and returned as income by them in their respective Income Tax Returns.
The advantages and disadvantages of Trusts vary depending on the type of Trust. A major disadvantage of a Trust partnership is that it cannot distribute losses to Beneficiaries. The major advantage, particularly in the case of a Discretionary Trust, is the ability to split income amongst the Trust pool of Beneficiaries.
A written Trust Deed is very important. The Tax Office is very reluctant to accept the existence of a Trust that has not had its terms reduced to writing.
The term “Family Trust” usually refers to a type of Trust that is legally known as a Discretionary Trust. Discretionary Trusts typically have a full discretionary class of Beneficiaries made up mostly of family members, however, they may have Beneficiaries that fall outside the family group for tax purposes, if the Trustee makes distributions outside the family group.
A Discretionary Trust is a structure which allows someone (the Trustee) to hold assets on behalf of others (the Beneficiaries), and distribute the income generated from those assets to potential Beneficiaries at the discretion of the Trustee. The Trustee decides who receives income from the Trust each year and how much each person will receive. The Trustee may exercise his, her or its discretion for the benefit of one Beneficiary to the exclusion of another.
The Beneficiaries have no legal right to the capital of the Trust, and only receive distributions at the discretion of the Trustee. The right to income in the Trust is merely an expectation.
Generally, the Trustee of the Trust does not pay tax on the income earned by the Trust. However, any income that the Trustee distributes to a Beneficiary will be assessable to the Beneficiary. The income distribution may include franking credits, and also some tax-free or tax deferred components that may reduce the Beneficiary’s personal income tax liability.
For tax purposes, a Trust becomes a “Family Trust” if the Trustee makes an election to treat it as such. The election must specify a year of income from which it is to take effect. It must also specify one individual whose family group is to be taken into account.
Once the individual is specified, the Trust can only make distributions to this individual’s family group. Distributions made to others outside the family group may include penalty tax of 46.5%.
The two main advantages of a Discretionary Trust becoming a Family Trust (by making the Family Trust election) are as follows:
A Trust’s loss cannot be distributed to Beneficiaries but must be carried forward to offset future year Trust income. To carry forward a loss, there are a number of tests that the Trust must satisfy, which can often prove very difficult.
By making a Family Trust election, the provisions of the Trust’s loss rules are effectively 1/8th, provided the Trust only makes distributions within the family group. Family Trusts only need to satisfy one test to carry forward losses (a modified income injection test).
- Franking Credits
By making a Family Trust election, you can ensure that franking credits on any dividends paid on shares held by the Trust can be passed onto Beneficiaries. Otherwise, this may not be the case.
Some of the main advantages of a Discretionary Trust include:
- The ability to split Capital Gains and Franked Dividend Income between family members in order to take advantage of tax-free thresholds and lower rates of marginal tax among family members;
- The ability to stream certain types of income to nominated individuals (although the ability to stream has been curbed somewhat);
- Asset protection;
- Estate planning issues; and
- Social security planning.
Contact us to find out more or to arrange a consultation with an experienced lawyer in Sydney CBD.