When considering tax planning, asset protection and wealth distribution, the question of structures naturally arises. A discretionary trust has many advantages; however, it also has limitations. Considerations should be given to the pros and cons of discretionary trusts prior to deciding on which structure best suits your needs.
A discretionary trust is a trust that gives the trustee the discretion to determine which beneficiaries are to receive the capital and/or income, and how much each beneficiary is to receive. Discretionary trusts do not give beneficiaries a fixed entitlement or interest to the trust’s funds.
The trustee does not, however, have complete discretion and can only distribute to beneficiaries within a nominated class as set out in the terms of the trust deed. Discretionary trusts provide several advantages, however, to maximise the advantages it must be set up correctly.
Often discretionary trusts are called family trusts, this is not technically correct. A family trust only exists once a family trust election (FTE) has been made. Once a FTE has been made any distributions made outside of the family group incur a family trust distributions tax FTDT (essentially tax is imposed at the highest marginal tax rate). When making a FTE or an Interposed Entity Election (IEE), there must be a Test Individual specified. The Test Individual defines the ’family group ‘. The Test Individual cannot be changed and cannot be deceased when the FTE is made.
Test Individual Groups
Family of the test individual include:
- Grandparents (and their spouses)
- Parents (including spouses)
- Siblings (includes siblings of the test individuals spouse)
- Children (of both the test individual and their spouse; includes adopted, step and ex nuptial children)
- Nieces and Nephews (of both the test individual and their spouse)
- Former members of the test individual’s family (who are no longer members due to family breakdown)
- Entities can also be added to a family group by making an IEE
Some of the advantages and disadvantages of using a discretionary trust are listed below.
Advantages of a discretionary trust structure
- Distribution of trust income is done at the trustee’s discretion, which creates flexibility of asset and income distribution.
- Income can be distribution to beneficiaries with the lowest marginal tax rates;
- Beneficiaries can be identified but don’t have to be included at the establishment of the trust (they can be added later).
- The assets are owned by the trust, providing protection from a beneficiary’s third-party creditors but also creates accumulation benefits within the trust rather than in the beneficiaries’ own hands.
- Capital Gains Tax (CGT) discount is available on the disposal of assets held for more than 12 months.
- A trust's capital gains and franked distributions can, if not prevented by the trust deed, be streamed to beneficiaries for tax purposes by making them specifically entitled to the amounts.
Disadvantages of a discretionary trust structure
- Setting up costs as well as ongoing legal and accounting fees can be expensive depending on the complexity of the trust.
- Losses cannot be distributed but must be carried forward.
- Profits must be distributed to beneficiaries annually. If profits are not distributed, the trustee will incur tax at the highest marginal tax rate on the undistributed income within the trust.
- Financing opportunities within the trust may be limited.
- Careful consideration should be put into selecting the trustee who are responsible for managing and safeguarding the trusts on behalf of the potential beneficiaries;
- It is important to note that a beneficiary cannot demand an asset or income from the trustee.
- Franking credits on dividends are not allowed to pass through a discretionary trust unless the trust has made a Family Trust Election (FTE) (an exception applies if the franking credits flow to a beneficiary who has not received more than $5,000 in franking credits in the income year in question).
Due to the number of regulatory changes to Superannuation, discretionary trusts are back in favour as they are seen by some as a ‘sexier’ alternative. Whilst they may not carry the same tax advantages as a Self-Managed Superannuation Fund (SMSF) they do offer a greater level of flexibility and are simpler to manage, in addition there are no restrictions imposed on contributions, withdrawals and the type of investment options available.
Depending on the number of beneficiaries there are circumstances in which a discretionary trust may give rise to a better tax outcome than a super fund. Adult beneficiaries can earn up to $20,542 (includes the tax-free threshold plus low income tax offset) without paying tax. If distributions can be made to adult beneficiaries (such as Uni students) with full tax-free threshold available, significant income can be earned before that income is taxed.
An example would be a non-income earning spouse, 2 Uni student children and possibly an older self-funded retiree parent all receiving up to $20,542, bringing total distributions to $82,168 before any tax is payable.
Prior to setting up a discretionary trust, consideration should be given to both the pros and cons listed above as well as an individual’s personal circumstances.