Trust Tax

A “trust” can be best described as an obligation imposed on a person or other entity to hold property for the benefit of beneficiaries. In a legal sense a trust is a relationship not a legal entity, trusts are also treated the same way as taxpayer entities for the purposes of tax administration.

The person enlisted as the trustee is responsible for managing the trust’s tax affairs. This includes registering the trust in the tax system, lodging trust tax returns and also paying some of the tax liabilities.

Beneficiaries (excluding some minors and non-residents) include their share of the trust’s net income as income in their own tax returns. There are special rules for some types of trust including family trusts, super funds and deceased estates.

A trust it is essentially a relationship that is recognised and enforced by the courts in the context of their “equitable” jurisdiction. Not all countries recognise the concept of a trust, as it is an English invention.

To put it simply, a trust is a relationship which exists where A holds property for the benefit of B. A is known as the trustee and is the legal owner of the property which is held on trust for the beneficiary B. The trustee can be an individual, group of individuals or a company. There can be more than one trustee and there can be more than one beneficiary. Where there is only one beneficiary the trustee and beneficiary must be different if the trust is to be valid.

The courts will very strictly enforce the nature of the trustee’s obligations to the beneficiaries so that, while the trustee is the legal owner of the relevant property, the property must be used only for the benefit of the beneficiaries. Trustees have what is known as a fiduciary duty towards beneficiaries and the courts will always enforce this duty rigorously.

The nature of the trustee’s duty is often misunderstood in the context of family trusts where the trustees and beneficiaries are not at arm’s length. For instance, one or more of the parents may be trustees and the children’s beneficiaries. The children have rights under the trust which can be enforced at law, although it is rare for this to occur.

 

Why are Trusts So Popular?

There are four major reasons why trusts are so popular in Australia.

  • A trust offers asset protection. Beneficiaries don’t own the trust assets; this makes it harder for creditors to pierce through.
  • A trust doesn’t fall under the Corporations Act. This means there is less red tape to deal with.
  • A discretionary trust offers flexibility around the distribution of income and capital.
  • And a trust is entitled to the Div 115 50% CGT discount, while a company isn’t.

 

Ways Trusts Are Used In Everyday Life

  • Cash management trusts and property trusts are used by many people for investment purposes
  • Money held in accounts for children may involve trust arrangements
  • Joint ventures are frequently conducted via unit trusts
  • Superannuation funds are trusts
  • Many businesses are operated through a trust structure
  • Executors of deceased estates act as trustees
  • There are charitable trusts, research trusts and trusts for animal welfare
  • Solicitors, real estate agents and accountants operate trust accounts
  • There are trustees in bankruptcy and trustees for debenture holders
  • Trusts are frequently used in family situations to protect assets and assist in tax planning.

Different Types of Trusts

When understood properly, trusts can assist people successfully plan finances, provide security for families, or achieve confident investing. There are a large number of different types of trusts and it is important to identify which type of trust will best suit the overall goal for having one. Here is a list of the most common types of trusts and their purpose. 

Fixed Trust

Fixed trusts are the most known of all trust types as they are simple in form. Fixed trusts provide for a specific proportion of assets to be distributed to specific beneficiaries. A trustee is bound to distribute the assets as beneficiaries have an automatic entitlement of their portion and can enforce the administration of the trust. This format is useful in avoiding potential conflicts between multiple beneficiaries over their interest in the trust. Beneficiaries will also enjoy a 50% discount off their capital gains tax over any assets received from the trust.

Hybrid Trusts

A hybrid trust is a great alternative to fixed and discretionary trusts as it is a mix of the two. It allows for beneficiaries and trustees to enjoy the benefits that come with both trusts which mainly are that beneficiaries enjoy a fixed interest to assets and trustees have discretion over its distribution. 

Discretionary Trusts (Family Trusts)

Discretionary trusts main disparity to fixed trusts is the fact that the beneficiaries do not possess a fixed interest over the assets in these trusts. These types of trusts give trustees the power to decide when, how much, and to whom to distribute assets. This flexibility provided to trustees goes even further in that they can remove or add a beneficiary to the trust at any time. However, with this power comes at a price as it is the trustee who is liable for any loss or debt incurred through the trust.  

Discretionary trusts also receive a 50 percent discount off the capital gains tax and allow for asset preservation as the assets in the trust are separate to the assets of the beneficiary. This means that if a creditor is collecting assets from a beneficiary to repay debt, their assets in the trust will be safe from this as the beneficiary has no entitlement over the trust. 

Testamentary Trusts

Testamentary trusts hold assets that are distributed once the set who set it up (the testator) dies. This type of trust is created through a will and only operates once the death occurs. A trustee has full discretion over the assets and their distribution. A person may choose to set up a testamentary trust for several reasons such as to prevent a challenge to a will, to ensure a person’s estate it passed to the desired relatives, or to take advantage of its tax benefits.

Superannuation Trusts

Superannuation trusts are made for the purpose of providing security during retirement. All superannuation funds in Australia are superannuation trusts and will be subject to federal legislation that set standards for all superannuation trusts to satisfy. The most well-known of these legislative requirements is that access to these trusts is prohibited until the age of 65.  

Superannuation trusts are a great alternative to public superannuation trusts (superannuation funds) as this type of trust allows a person to control their own retirement funds and determine investments. The administrative costs associated with managing a superannuation trust can also be less than the continued fees set by public superannuation trusts. However, these types of trusts require continuous and vigilant attention to the fund’s investments, the economy, and legislative changes to ensure compliance with legal requirements over trusts. 

Charitable Trusts

As you can probably gather from its name, charitable trusts are trusts set up for a purpose of something charitable. This purpose can be for a range of things such as to reduce poverty or improve social and public welfare. An example of this is when a person (the donor) nominates an organisation to whom the funds of the trust will be distributed once they die. This type of trust allows for donors to claim tax deductions on any donations made to the trust and unlike most trusts, does not wound up after 80 years. However, as the charitable focus of a trust will inevitably affect the public, these types of trusts will be heavily monitored. 

Bare Trusts

Bare trusts are often used by beneficiaries who want to have someone else hold their assets on their behalf without giving them any control. There will only be one trustee and one beneficiary in a bare trust and the beneficiary will have complete control over the nominated trustee. Therefore, the trustee will only be responsible for holding the assets and must follow the beneficiary’s instructions. As the beneficiary has an absolute right to the assets in the trust, these trusts do not provide the same level of asset protection compared to other forms of trusts and creditors will have access to it. 

Unit Trusts

Unit trusts operate a little differently to the other types of trusts as the beneficiaries are the ‘unit holders’ who have interest over their ‘holding units’ within the trust. These units are similar to shares as it allows unit holders to divide their interest in clear and fixed percentages. Therefore, if someone has 50 units in a unit trust, they will have a 50% interest in the trust’s assets against the other unit holders. This is a fixed entitlement and the unit holders can transfer their units to a buyer if they wanted to. This type of trust is commonly adopted by people seeking to put their money together with other people in a ‘pool’ of assets for investment purposes. An example of this would be a retail investment fund. However, unit trusts can be used by smaller investors for small scaled property investments. Overall, unit trusts provide security for people investing their money alongside other investors and also provides unit holders with a 50% discount on their capital gains tax.  

Special Disabilities Trusts

A 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 will then be allowed to make private financial contributions for the future and current care of the beneficiary. The trust beneficiary can use the money from the trust to help pay for a variety of expenses, such as medical and accommodation expenses.

 

What Kind of Trust is best for your situation?

The range of trust types allows people to establish a trust that best suits their needs. It is important that a person wishing to set up a trust evaluates their goals and motives. Particularly, look at whether the trust is to provide family with financial stability, gather investments or to rearrange assets.

 

Establishing a Trust

Setting up a trust can be a straightforward process that you might be able to accomplish using a do-it-yourself online service for a small fee of about $150. Additionally, you’ll pay the stamp duty—a state-based tax. Slightly more complicated structures that require the active management of a corporate trustee can start at around $1,500 + GST

In establishing trusts, settlors must take the following steps:

Step 1: Decide Upon Original Trust Assets – List all the holding, 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 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, delineates 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 crafted by professionals with specialized legal and financial knowledge of trusts.

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.

 

The Trust Fund

In simple terms, the trust fund can include any property at all ranging from cash to a huge factory, from shares to one contract, from operating a business to a single debt. Trust deeds usually have wide powers of investment; however, some deeds may prohibit certain forms of investment.

The crucial point is that whatever the nature of the underlying assets, the trustee must deal with the assets having regard to the best interests of the beneficiaries. Failure to act in the best interests of the beneficiaries would result in a breach of trust which can give rise to an award of damages against the trustee.

A trustee must keep trust assets separate from the trustee’s own assets.

 

The Trustee’s Liabilities

A trustee is personally liable for the debts of the trust as the trust assets and liabilities are legally those of the trustee. For this reason, if there are significant liabilities that could arise a limited liability (private) company is often used as trustee.

However, the trustee is entitled to use the trust assets to satisfy those liabilities as the trustee has a right of indemnity and a lien over them for this purpose.

This explains why the balance sheet of a corporate trustee will show the trust liabilities on the credit side and the right of indemnity as a company asset on the debit side. In the case of a discretionary trust it is usually thought that the trust liabilities cannot generally be pursued against the beneficiaries’ personal assets, but this may not be the case with a fixed or unit trust.

 

Powers and duties of a trustee

A trustee must act in the best interests of beneficiaries and must avoid conflicts of interest. The trustee deed will set out in detail what the trustee can invest in, the businesses the trustee can carry on and so on. The trustee must exercise powers in accordance with the deed and this is why deeds tend to be lengthy and complex so that the trustee has maximum flexibility.

 

Who can be a trustee?

Any legally competent person, including a company, can act as a trustee. Two or more entities can be trustees of the same trust.

A company can act as trustee (provided that its constitution allows it) and can therefore assist with limited liability, perpetual succession (the company does not “die”) and other advantages. The company’s directors control the activities of the trust. Trustees’ decisions should be the subject of formal minutes, especially in the case of important matters such as beneficiaries’ entitlements under a discretionary trust.

 

The Advantages of a Trust

  • A trust provides asset protection and limits liability in relation to the business.
  • Trusts separate the control of an asset from the owner of the asset and so may be useful for protecting the income or assets of a young person or a family unit.
  • Trusts are very flexible for tax purposes. A discretionary trust provides flexibility in the distribution of income and capital gains among beneficiaries.
  • Beneficiaries of a trust are generally not liable for the trust debts, unlike sole traders or partnerships.
  • Beneficiaries of a trust pay tax on income they receive from a trust at their own marginal rates.

 

The Disadvantages of a Trust

  • Establishing a trust costs significantly more than establishing sole traders and partnerships.
  • A trust is a complex legal structure, which must be set up by a solicitor or accountant.
  • The trustee has a strict obligation to hold and manage the property for the exclusive benefit of the beneficiaries.
  • Operation of the business is limited to the conditions outlined in the trust deed.
  • As with companies, there are extensive regulations that trusts must comply with.
  • Losses derived in a trust are not distributable and cannot be offset by beneficiaries against other income they may have.
  • Unlike a company, a trust cannot retain profits for expansion without being subject to penalty rates of tax.

 

Trust legislation

All states and territories of Australia have their own legislation which provides for the basic powers and responsibilities of trustees. This legislation does not apply to complying superannuation funds (since the Federal legislation overrides state legislation in that area), nor will it apply to any other trust to the extent the trust deed is intended to exclude the operation of that legislation. It will usually apply to bare trusts, for example, since there is no trust deed, and it will apply where a trust deed is silent on specific matters which are relevant to the trust  for example, the legislation will prescribe certain investment powers and limits for the trustee if the deed does not exclude them.

 

Income tax and capital gains tax issues

Due to the fact that a trust is not a person, its income is not taxed like that of an individual or company unless it is a corporate, public or trading trusts as defined in the Income Tax Assessment Act 1936. In essence the tax treatment of the trust income depends on who is and is not entitled to the income as at midnight on 30th June each year.

If all or part of the trust’s net income for tax purposes is paid or belongs to an ordinary beneficiary, it will be taxed in their hands like any other income. If a beneficiary who is entitled to the net income is under a “legal disability” (such as an infant), the income will be taxed to the trustee at the relevant individual rates.

Income to which no beneficiary is “presently entitled” will generally be taxed at highest marginal tax rate and for this reason it is important to ensure that the relevant decisions are made as soon as possible after 30th June each year and certainly within 2 months of the end of the year. The two month “period of grace” is particularly relevant for trusts which operate businesses as they will not have finalised their accounts by 30th June. In the case of discretionary trusts, if this is done the overall amount of tax can be minimised by allocating income to beneficiaries who pay a relatively low rate of tax.

The concept of “present entitlement” involves the idea that the beneficiary could demand immediate payment of their entitlement.

It is important to note that a company which is a trustee of a trust is not subject to company tax on the trust income it has responsibility for administering.

In relation to capital gains tax (CGT), a trust which holds an asset for at least 12 months is generally eligible for the 50% capital gains tax concession on capital gains that are made. This discount effectively “flows” through to beneficiaries who are individuals. A corporate beneficiary does not get the benefit of the 50% discount. Trusts that are used in a business rather than an investment context may also be entitled to additional tax concessions under the small business CGT concessions.

Since the late 1990s discretionary trusts and small unit trusts have been affected by a number of highly technical measures which affect the treatment of franking credits and tax losses. This is an area where specialist tax advice is essential.

 

Absolute entitlement

If a beneficiary is absolutely entitled to a trust asset, the asset is treated for CGT purposes as if it is owned directly by the beneficiary and not the trustee. Any actions taken by the trustee in relation to the asset are taken to have been done by the beneficiary directly. This means that if a capital gains tax (CGT) event happens in relation to the asset, any capital gain or loss will be made directly by the beneficiary and doesn’t form part of the trust’s net income.

A beneficiary is absolutely entitled to an asset of a trust if they have a ‘vested and indefeasible’ interest in the entire trust asset – that is, they can direct the trustee to immediately transfer the asset to themselves or to someone else.

For example, on 30th July a trustee makes a beneficiary absolutely entitled to a property held by the trustee. On 30 September the trustee sells the property for $100,000. For CGT purposes, the asset is treated as being the beneficiaries from 30th July and the beneficiary (not the trustee) is taken to receive the capital proceeds of $100,000 from the sale of the property on 30th September.

 

Specific entitlement

A capital gain can be streamed to a particular beneficiary by making them specifically entitled to the gain.

If a beneficiary is made specifically entitled to a trust capital gain, the capital gain is taken into account in working out their net capital gain for the income year with the benefit of any discounts or concessions they are entitled.

Note that a beneficiary may be specifically entitled to a capital gain even if they don’t have an entitlement to income of the trust (for example, because they had an entitlement to trust capital).

 

Registering and Reporting For Tax

The trustee is held responsible for managing the trust’s tax affairs, including registering the trust in the tax system, lodging trust tax returns and paying some tax liabilities.

The beneficiaries include their share of the trust’s net income in their tax returns and may need to pay instalments on their expected tax liability through the pay as you go (PAYG) instalment system.

Special rules apply to closely held trusts or where a beneficiary is a non-resident.

If a trust is carrying on a business, the trustee may have employer obligations.

Registration

A trust should have its own Tax File Number (TFN), which the trustee uses in lodging income tax returns for the trust. A trust is also entitled to an Australian business number (ABN) if the trust is carrying on an enterprise.

The trustee registers for the trust’s TFN and ABN in their capacity as trustee. This registration is separate from any registration the trustee may require for other capacities they may act in, including acting on their own behalf.

All trusts will automatically have ‘The Trustee for…’ added to the name of the trust when the ABN is registered, as the trustee is responsible for the tax obligations of the trust.

PAYG instalments

Trusts are not liable to pay PAYG instalments. Instead, the beneficiaries (or the trustee when assessed on their behalf) may have to pay instalments based on their share of the trust’s instalment income.

Non-resident withholding tax

If a non-resident beneficiary is presently entitled to dividends, interest or royalties included in the trust income, the trustee must withhold tax and remit it to the ATO. The trustee may need to lodge a PAYG withholding from interest, dividend and royalty payments paid to non-residents annual report.

Tax returns

A trustee is required to lodge a trust income tax return, regardless of the amount of net income involved, unless we advise that a return is not required.

If the trustee is liable for tax they will receive an income tax assessment as trustee that is separate to their own assessment as an individual or corporate tax entity.

 

Summary

To summarise a trust is a valuable tool available for Australians who are wanting to more efficiently structure their financial affairs. Trusts are a common strategy utilised to distribute a family’s earnings to ensure the protection of wealth for future generations.

The large variety of different trusts enable an individual or a group of people to establish a trust that best suits their specific needs. It is important for the person wishing to set up a trust to evaluate their goals and motives. It is also critically important to crystallize legal relationships and obligations associated with any trust because they are typically irrevocable.