You might be surprised to learn that the concept of a trust dates back to medieval England. Needles to say, trusts have been around for a long time.

There are various types of trusts. However, the most common is a discretionary trust, also known as a family trust.

Family trusts have become a very popular way for Australians to invest and manage their wealth.

According to the ATO’s statistics, approximately 1 million family trusts currently exist in the Australian tax system, managing circa $3 trillion in wealth. This means that 1 in 25 Australians has a family trust.

However, there is one major misconception about family trusts which I hear time and time again and that is the idea that you need to be super wealthy to have one. This is far from true.

How does a family trust work?

Unlike a company, a trust is technically not considered a separate legal entity for common law purposes, although it is for tax purposes.

A trust is like a relationship, where one party (the trustee) holds assets for the benefit of another party (the beneficiary).

It’s important for each party to understand their roles in this relationship and their responsibilities/entitlements.  

Who is the trustee?

• Administers the trust and has the power to make decisions about the trust, such as who to distribute the income to. They have a duty to act in the best interests of the beneficiaries.
• The trustee is also liable for the debts of the trust. This is why we would usually recommend having a corporate trustee (i.e. a company) as this limits any potential exposure to personal liability.

Who are the beneficiaries?

• These are the individuals or entities that receive benefits from the trust via distributions. The trust essentially exists for their benefit.
• The beneficiaries of a family trust would typically be family members such as your spouse, children, grandchildren etc.

The relationship between the trustee and beneficiaries is documented in a trust deed. It would be very wise to engage with your accountant or solicitor to ensure the trust deed is properly drafted.

Now that you’ve understood the basics of a family trust structure, let’s look at how trusts operate for tax purposes.

How do family trusts operate for tax purposes?

Trusts don’t typically pay tax. This is because they are 'flow through' vehicles. Just like how the water in a river flows, so does the income in a trust.

By this analogy I mean to say that the income flows from the trust to the beneficiaries through trust distributions. Therefore, the trust income is usually taxed in the hands of each beneficiary.

However, this flow through is only possible when the trustee has made a decision to distribute the income of the trust to the beneficiaries at the end of each year. This decision needs to be formally documented in the form of trust distribution minutes.

The trust can get itself into an adverse tax situation if it fails to make this decision prior to 30 June. This could lead to the trustee being liable to pay tax on trust income at the top marginal tax rate of 45% + 2% Medicare levy. You definitely want to avoid that!

That said, it’s important to remain on top of the administrative requirements of the trust. A good accountant should be able to take this burden off your shoulders by assisting you with all the paperwork.

What are the benefits of a family trust?

Due to this ‘flow through’ feature, family trusts have traditionally been used as a legal means to reduce tax within a family group.

The concept of ‘income splitting’ in trusts means that the trustee has the flexibility to split/divide the income of the trust among beneficiaries with different marginal tax rates. For example, if one beneficiary earns low income personally, the trustee could consider distributing more income to that beneficiary in an effort to reduce the family group’s tax bill.

The concept of ‘income streaming’ also means that you can distribute different types of trust income to different beneficiaries. For example, one beneficiary might have capital losses available and so it would be wiser to distribute the capital gains from the trust to that beneficiary in order to reduce capital gains tax paid across the family group.

However, there may be situations where the trust deed prevents income splitting or income streaming so it’s important to be across the terms of the trust deed and determine these finer details with your accountant or solicitor when establishing a trust.

Last but certainly not least, a family trust also provides asset protection, particularly where a corporate trustee is used as mentioned earlier in this article.

Are there any disadvantages to having a family trust?

It may come as a surprise, but a trust has an expiration date. All states in Australia, except South Australia, limit the lifetime of a trust to 80 years. Again, this detail will be included in the trust deed and can be shorter than 80 years.

After the 80 year period, the trust will vest and any assets that are still held in the trust will need to be distributed to the beneficiaries. This can trigger a capital gains tax event.

Another disadvantage is that tax losses and capital losses are trapped in the trust. They cannot be distributed to the beneficiaries but can be carried forward and used to reduce income or capital gains derived from the trust in the future.

As you may have gathered already, the trust structure and rules are a lot more complicated to navigate. This can make it more expensive to establish or maintain a trust, particularly where you need to include custom clauses in the deed for your situation. However, the cost of maintaining a trust would not be too far off from the costs of a company structure.

Closing remarks

Before you go ahead and establish a family trust, it is worth mentioning that the ATO has recently started cracking down on trusts, particularly looking at the intention behind trust distributions.

One very common area of interest for the ATO is where distributions are made to adult children or where tax avoidance schemes are perceived to be in place.  

That said, family trusts currently operate in a highly uncertain and changing environment, as the traditional practices that have been applied and accepted by accountants for decades are now being challenged by the ATO.

If you choose to establish a trust, be wise and seek proper advice before jumping into it.  

‍‍As a Chartered Accounting firm and Registered Tax Agent, Hive Wise can help you with all your accounting and tax needs.

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