This article provides an introductory guide to trusts in Australia - what are they and what different types of trusts are commonly used. Read on...
What is a Trust?
A trust is established whenever there is a separation of the legal ownership from the beneficial or real ownership of an asset. It is established under State Law.
A trust of property or income may be described as a fiduciary obligation imposed upon a person (trustee) to hold trust property or income for a particular purpose, or for the benefit of others (beneficiaries). In legal terms, a trust is a relationship and not a legal entity.
Trusts are widely used for investment, estate planning, and business purposes - and come in many forms such as:
- Trusts created to hold investment assets separately from personal or business assets, to provide staff and/or equipment, or to act as an employer entity.
- Trusts set up under a will to ensure that the members of the deceased's family are provided for from the deceased's estate.
- Superannuation (trust) funds established to provide superannuation benefits.
- Property trusts used to hold property for the benefit of unit holders.
A trust will end at a time, or upon an event, specified in the trust deed (for example when the primary beneficiary dies or once all beneficiaries are over a certain age, or at the expiry of 80 years since the trust was established). The ATO is unlikely to accept the existence of any trust that has not had its terms set out in writing in either a trust deed or in a will.
To understand the establishment and taxation of trusts you must be familiar with the terminology peculiar to trust law. Following are some of the most important terms.
Settlor - The settlor is also called the creator and is the person who creates the trust and who transfers property to a trustee. The settlor is usually a family friend, or someone who will never be a beneficiary of the trust. Under a trust deed the settlor is expressly excluded from ever being a beneficiary of the trust.
Trust Deed - The terms and conditions under which a trust is established and maintained are set out in its trust deed. It is the written document that sets out various matters relating to the trust (e.g. the name of the settlor, trustee, beneficiaries, how long the trust is to last, and the powers of the trustee).
Trust Property - Trust property is the property to which trust obligations arise. It may consist of money, real estate, shares, or personal property. Unlike a person or a company, a trust is not a legal entity that can own property because a 'trust' is just a relationship between the legal owner (trustee) and the beneficial owners (the beneficiaries). As such, documents including a house title, share certificate, etc. will list the trustee as the owner of the property.
Trust Estate - Trust estate is the term used to describe the trust property from which income is derived.
Trustee - A trustee may be a natural person or a company. Legal title to the trust property is held by the trustee who owes a duty of care to the beneficiaries in relation to that property. The trustee is responsible for the trust and its assets. The trustee has broad powers to conduct the trust and manage its assets under the terms of the trust deed. A trustee's duty is to strictly comply with, and not step outside the terms of the trust deed.
Under trust law, trustees are:
- personally liable for the debts of the trusts they administer; and
- entitled to be indemnified out of the trust property for liabilities incurred in the proper exercise of the trustee's powers (except where a breach of trust has occurred).
Under tax law, the trustee is 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.
In a family trust, the trustees are often Mum and Dad (or a company of which Mum and Dad are the shareholders and directors). Their children and any other dependants are usually listed as beneficiaries.
Beneficiaries - Beneficiaries are the persons, objects or purposes nominated to receive the benefit of the trust property. This benefit can be either an income or capital distribution or both. A beneficiary does not have to be a natural person. A company, another trust, or a charitable entity can be named as a beneficiary. For example, a trust could nominate the RSPCA as its beneficiary so as to provide "care and attention for stray dogs".
A sole trustee cannot be the sole beneficiary because a trust is a legal relationship between a trustee and the beneficiary or beneficiaries. If a sole trustee were also the sole beneficiary, then this would be an agreement that a person had with themselves. The laws say that no trust can exist in these circumstances.
A trustee can be a beneficiary of the trust as long as there is at least one other beneficiary as well. Beneficiaries (except some minors and non-residents) including their share of the trust's net income as income in their own tax returns - regardless of when or whether the income is actually paid to them.
There are special rules for some types of trusts including family trusts, deceased estates, and superannuation funds.
Present Entitlement - A beneficiary is presently entitled to trust income for an income year where they have, by the end of that year, a present or immediate right to demand payment from the trustee. The entitlement will depend on the trust deed and any discretion that the trustee has under the deed to allocate income between beneficiaries.
Inter-Vivos Trust - An Inter-Vivos Trust is established by someone during their lifetime to manage certain assets or investments and support beneficiaries, such as family members (for example, a family discretionary trust established to conduct family business). These trusts are governed by a trust deed, rather than a Will. They allow assets to be managed on behalf of beneficiaries and, in some cases, generations of a family, without having to pass through the estate of family members that have passed away.
Will Trusts - Will trusts are trusts arising from the death of the taxpayer. They are also known as testamentary trusts. The income and assets of the estate of the deceased are distributed in accordance with the terms of the will. In Will trusts, the trustee is normally called the executor or administrator.
Vesting day - Vesting day is the day that the Trust is to terminate, as stipulated in the Trust Deed or at such earlier date as determined by the Trustee. On Vesting Day, the beneficiaries appointed by the Trustee in accordance with the terms of the Trust Deed are entitled to the whole of the Trust Fund.
Liability of the Trustee
A trustee has legal title to trust property, but does not derive any benefit from that property. In relation to taxation law, a trustee is answerable as the taxpayer for the doing of all things in relation to income derived by the trustee in a representative capacity, including its tax obligations.
The trustee may become liable for damages for any failure to comply with the terms of the trust deed. Due to this potential liability, the trustee is often set up as a company structure. This allows the protection on limited liability to the controller of the trust.
Types of Trusts
Discretionary Trusts - A discretionary trust is the most common type of trust. Discretionary trusts are used as a tax planning tool and are a very flexible means of splitting income between family members with the aim of achieving maximum tax savings. The trustee has the discretion to vary proportions passed on to beneficiaries, or even vary the beneficiaries.
In effect, the trustee decides who receives income, when and how much. Discretionary trusts are used in tax and asset protection planning and may be set up during a person's lifetime (inter vivos) or by a person's Will.
Discretionary powers give the trustee flexibility to vary income and capital distributions to the beneficiaries each year to minimise overall family tax. This is very useful where income of individual family members fluctuates from year to year. Note that beneficiaries do not have a claim to any trust distributions, rather a 'mere expectancy' that the trustee may distribute income if they so choose (hence the term "discretionary" trust).
The attraction and advantage of a discretionary trust is that it allows the trustee (parent or benefactor) to retain control over distribution of both trust income and assets.
Fixed Trusts - A fixed trust exists where, under the terms of the will or trust instrument, the beneficiaries receive specific proportions of the trust estate. The trustee has no authority to vary these proportions.
Unit Trusts - Unit trusts are a variation of fixed trusts. The beneficial ownership of the trust property is divided into a number of fixed units. Property and cash management trusts are examples of unit trusts. Distribution of income from a unit trust depends upon the number and/or classes of units held. A unit trust entitlement can be fixed or at the trustee's discretion.
Deceased Estate Trusts - A Deceased Estate trust arises from the death of the taxpayer. It exists until all the assets are distributed and liabilities met.
Family Trusts - A trustee of a discretionary trust can, at any time, elect for that trust to be a family trust. Distributions must be made to a defined group of family members and associated entities, otherwise tax at the highest margin rate will apply.
A Discretionary Family Trust (also known as a family trust) is one of the most common small business structures in Australia. Discretionary Family Trusts provide families with a great deal of flexibility in sharing the tax burden among family members and protecting family assets. This type of trust can operate for up to 80 years.
The Discretionary Family Trust structure is useful if a family holds capital growth or income-generating assets. Some of the key attributes of the Discretionary Family Trust are that it:
- Offers some protection from bankruptcy and insolvency
- Is a relatively low cost and simple structure to use
- Allows income to be distributed to family members who are on low tax rates
- Allows the trustee to "stream" income (i.e. can distribute one type of income to one person and another type of income to another person).
An Australian family trust:
- Is generally established by a family member for the benefit of members of the "family group"
- Can be the subject of a family trust election which provides it with certain tax advantages, provided the trust passes the family control test and make distributions of trust income only to beneficiaries of the trust who are within the "family group".
- Can assist in protecting the family group's assets from the liabilities of one or more of the family members (for instance, in the event of a family member's bankruptcy or insolvency)
- Provides a mechanism to pass family assets to future generations; and,
- Can provide a means of accessing favourable taxation treatment by ensuring all family members use their income tax "tax-free thresholds".
A Discretionary Family Trust has many other potential benefits, including avoiding issues such as challenges to the will following the death of a senior member of the family.
Family Trust Income - One of the key benefits of a family trust is that the trustee can distribute income earned by the trust (from the trust property) in any way they see fit, provided distributions are made to the people who qualify as beneficiaries. They do not have to make trust distributions in any particular proportion or in the same proportions as they did in previous years.
A trust does not have to pay income tax on income that is distributed to beneficiaries (with some exceptions) but does have to pay tax on undistributed income. The trustee is free to distribute income to as many beneficiaries as possible, in proportions that take best advantage of those beneficiaries' personal marginal tax rates. The beneficiaries then pay the tax on distributions made to them.
Bare Trusts - Where there is only one trustee, one legally competent beneficiary and no specified obligations, the beneficiary has complete control of the trustee (or “nominee”) and this is known as a bare trust. A common example of a bare trust is a nominee shareholding – where the shareowner holds shares on behalf of someone else who does not want to be identified.
Hybrid Trusts - These are trusts which have both discretionary and fixed characteristics. The fixed entitlements to capital or income are dealt with via “special units” which the trustee has power to issue.
Testamentary Trusts - A testamentary trust is a trust established under a will. It does not come into effect until after the death of the person making the will. At that point in time, specified deceased estate property is transferred to a trustee who holds the assets on trust for the benefit of the beneficiaries. A testamentary trust is not the same trust type as a deceased estate. A testamentary trust may last for many years after the deceased estate has been fully administered. It arises where an executor pays a distribution into a trust, where permitted in the will.
Trust losses are retained in the trust - there is no amount of net income available for distribution. They are not distributed to the beneficiaries and, therefore, cannot be offset against income which the beneficiary may derive from other sources. Thus, if a trust incurs a tax loss that loss must be carried forward and used to reduce future trust income.
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