01 Apr Discretionary Trusts Explained by Grow Accounting
A trust exists where there are assets legally owned by “a person” (trustee) for the benefit of another “person or persons” (beneficiaries); note that the definition of “a person” can include a company.
While this article will focus on discretionary trusts there are various forms of trusts including:
- A Unit Trust is where beneficiaries have a fixed interest in the capital and income of the trust, which is represented by units.
- A “discretionary” Trust is where the beneficiaries’ entitlement to the capital and income of the trust is at the discretion of the trustee.
- A trust that has both fixed and discretionary interests is usually referred to as a hybrid trust.
Trusts usually have a trust deed which is essentially an agreement between the settlor (entity that provides the asset to establish the trust) and the trustee, which:
- Defines how the trustee can deal with the assets of the trust
- Defines who can benefit from the trust
- Defines the life of the trust
- Determines how changes (including the trustee) can be made.
The major benefits of a trust are its ability to distribute income to other structures and protect assets.
A trust does not usually have to pay income tax on income that is distributed to the beneficiaries, but does have to pay tax on undistributed income and distributions to nonresident beneficiaries. It is the beneficiaries that have to declare in their tax returns & pay tax on the “taxable distribution” declared in the trusts tax return. Please note you do not pay tax on money that you withdraw out of the trust bank account this is perceived by the ATO as a future or past drawing of your distribution.
The trustee of a discretionary trust is free to distribute trust income to as many beneficiaries as possible, as long as they fit the definition of a beneficiary as described in the trust deed. It may also choose the distribution proportions that take best advantage of those beneficiaries’ personal marginal tax rates. For e.g. if you have a couple & person A has a large income but person B has a lower income when the trust tax return is prepared we would ensure that Person B receives more of the distribution.
If you are a student of Dymphna Boholt the trust structures she refers to as a Flipper Trust, Trading Trust or Investment Trust are all discretionary trusts with a Company as trustee. A piggy bank trust is a discretionary trust with individuals as a trustee.
Functions & Requirements of Trusts
1. Ownership & equity funding
- To understand the concept of ownership for a trust it is important to understand the difference between the legal owner and the beneficial ownership of property.
- In a trust, the legal owner is the trustee and the beneficial owners are the beneficiaries identified in the trust deed. In respect to a discretionary trust, the beneficial ownership of the assets and income for a particular beneficiary is subject to the exercise of a discretion by the trustee.
- Day to day control of the trust resides with the trustee.
The extent to which stakeholders (including beneficiaries) can control the trustee is determined by the trust deed. In the case of Discretionary Trusts, the beneficiaries usually have no control of the trustee (other than enforcement of the trust deed).
- Often the trust deed will nominate an appointor, who has the power to appoint and change the trustee.
3. Risk management
- The trustee of the trustee bears most of the risk and is held liable for the debts of the trust (in the event of a deficiency in trust assets). This risk can be reduced by the use of a company to act as trustee.
- Risk for beneficiaries is usually limited to the loss of their investment in or entitlement to assets.
- A Trust provides an effective means of managing risk for individuals who themselves are exposed to risk. This is achieved by accumulation of assets in a trust for the discretionary benefit of the individual at risk.
4. Return on investment (to stakeholders)
- The extent to which a trust can control the distribution of profits to stakeholders (beneficiaries) is determined by the trust deed. In respect to a Discretionary Trust, distribution of profits is controlled by the trustee and the limited to entities that fall within the meaning of beneficiary (under the trust deed).
- The ability of the trust to distribute capital gains on the sale of a property is excellent for a Discretionary Trust as if distributed to individuals they can still use any relevant capital gains tax concessions.
5. Tax efficiency
- For trusts to be tax efficient they must distribute income to beneficiaries, otherwise they will pay tax at 46.5%
- Discretionary trusts have the ability to stream certain types of income such as dividends and capital gains. This means they can choose to allocate those types of income in different proportions to the other income of the trust. This can be helpful if specific beneficiaries have carried forward capital losses they can use to offset a capital gain.
- Trusts are subject to strict rules for the use of losses. Trust losses cannot be distributed and must be carried forward to be offset against future income. Carried forward losses may become unclaimable if the trust undergoes major changes in its structure or closes.
- A trust minute MUST be prepared BEFORE 30th June declaring the beneficiaries that will receive income & how much income they will receive. This is an ATO requirement & if not done can result in ATO overruling who get paid the distributions as tax time.
6. Initial setup & operations
- The name of the trust does not have to be unique in Australia. There are probably thousands of Smith Family Trusts! You can call your trust whatever you want but please remember that it makes it easier for the banks, accountants & lawyers to get the details right if its easy to spell. We have clients that have called their trusts after fish, flowers, whales or a combination of their childrens name.
- The name of the trustee if it is a company MUST be unique in Australia.
- Only the trust has a tax file number (and ABN if applicable). If there is a company as trustee it does NOT have a tax file number & it doesn’t lodge a tax return.
- The name on legal documents (e.g contracts) & bank accounts must read XXXX as trustee for XXXXX trust. For e.g if you have a trust called Smith Family Trust and the company trustee is called Smith Pty Ltd than the correct way to write this is Smith Pty Ltd as trustee for Smith Family Trust. Sometimes on less formal documents (never on a bank account or contract) you will see the abbreviation ATF – this stands for “as trustee for”.
We hope you have found this article useful but please remember it is not a substitute for advice relevant to your circumstances.