Things to know about your Trust
Sally Preston
Many business structures include trusts in them - discretionary trusts, unit trusts, maybe even a hybrid trust or bare trust.
But what is a trust, how does it work, and what do you need to know about your trust?
So, what is a trust?
A trust is a relationship or obligation imposed on a person or other entity (called a trustee) to hold property (the property of the trust) for the benefit of another person or entity (called the beneficiaries). The reason I refer to it as an obligation is because the trustee is bound by the terms of the trust not to use the trust property for their own benefit but rather for the benefit of the beneficiaries.
Sometimes there is more than one trustee. Often there are many beneficiaries.
For legal purposes a trust is a relationship, not a legal entity so it is the trustee that legally owns any of the assets of the trust.
For tax purposes though, trusts are treated as taxpayer for the purposes of tax administration.
Types of trusts
There are many types of trusts. The type of trust you may have in your business group can be determined by looking at the characteristics of the trust. We discuss two key types below.
Key elements to understand
Control over a trust - A trust is controlled by its trustee and appointor. The trustee manages the day-to-day operations of the trust and the appointor has the ability to remove the trustee.
Trustee – the legal owner of the property ofthe trust and is responsible for the day to day operation of the trust. Their duties and powers are specified under the trust deed, the Trustees Act in the relevant state, and under common (case) law. If the trustee is a company, it is necessary to review the identity of its directors and shareholders to determine who needs to make the decisions as trustee.
Appointor – a named person (or more than one) who has the power to remove the trustee and appoint a replacement trustee in a discretionary trust.
Trust deed – this is the key document that sets out the terms of the trust. It is needed to make sure the trust exists and will set out (amongst other things)
Who the beneficiaries are
Who the trustee is
The trust property
What powers the trustee has to deal with the property
What rights the trustee and beneficiaries have in relation to the trust property and in relation to each other
Who the appointor is
How income is defined or to be determined
How distributions of income or capital may be made
Beneficiary – these are the entities or people who may benefit under the trust. For a fixed trust this would be specifically identified. For a discretionary trust, one or more individuals will generally be identified and then classes of beneficiaries will be included.
Operation of a discretionary trust
Some of the key things you need to understand about your discretionary trust are:
A trust is a “flow through” entity for tax purposes. This means that the trust does not pay tax on the income it makes/receives. Instead, it distributes it to the beneficiaries who pay tax on the amounts. It also means that when income flows through the trust, it keeps the same form/nature in the hands of the beneficiary. For example, if the trust receives a franked dividend, the beneficiary that is distributed this income, will treat it similarly – as a franked distribution from a trust. If the trust instead makes a business profit, then the net taxable profit will be taxed in the hands of the beneficiary receiving the distribution that year.
At the end of the year, any intended distribution of the income or profits of the trust needs to be “resolved” i.e. documented. This document is called a trust resolution and needs to specify:
o Who - is to receive a distribution;
o What - If the trust deed allows those different types (classes) of income be specifically names and distributed, then what each beneficiary is to receive can be stipulated;
o How much – how much will each beneficiary receive (overall and/or per category of income)
It may also need to have other details like how “income” is to be defined for the resolution purpose but this is something your adviser needs to help you with.
Failure to make a distribution of an amount in any year, may mean the trustee pays tax on the income instead. The trustee will however pay tax at the top marginal rate in most cases. This may be significantly more tax than may have been paid had the amount been distributed.
As trustee and/or appointor you need to understand your responsibilities.
o This may mean having your trust deed explained to you and making sure the way you operate the trust is only in accordance with what the deed allows; and
o Ensuring tax lodgements are made.
Operation of a fixed trust
Some of the key things you need to understand about a fixed trust are:
The interest (sometimes this may be units in a unit trust) is a set entitlement and is a transferrable asset. However, a fixed entitlement does not provide a right to a specific asset held by the trust. Just a percentage of the income and/or capital.
The interest is transferrable – within the restrictions of any agreements in place. So, like a share in a company can be sold or acquired.
The trust is a “flow-through” entity for tax purposes.
Failure to make a distribution of an amount in any year, may mean the trustee pays tax on the income instead.
At the end of the year, any intended distribution of the income or profits of the trust needs to be “resolved” i.e. documented. The terms of the trust deed may make this fairly straightforward depending on each person/entity's entitlement specified under the deed. There may be still some element of flexibility between the fixed entitlement holders, so the resolution should still set out the relevant distributions. It may also need to have other details like how “income” is to be defined for resolution purposes.
Failure to make a distribution of an amount in any year, may mean the trustee pays tax on the income instead. The trustee will however pay tax at the top marginal rate in most cases.
Ultimate control over the trust rests with the unit holders rather than the appointor. It is for the unit holders to decide to remove the trustee.
As trustee you need to understand your responsibilities.
o This may mean having your trust deed explained to you and making sure the way you operate the trust is only in accordance with what the deed allows;
o For a fixed trust, keeping a register of the unit holders (if applicable); and
o Ensuring tax lodgements are made.
Advantages and disadvantages of each
Advantages of a discretionary trust
Provides significant flexibility in the distribution of income, capital and termination of the trust.
Subject to the terms of the deed, the trustee has control over who receives different types of income such as capital gains and franked dividends.
Trusts are entitled to apply the 50% general discount.
Asset protection may be achieved for the potential beneficiaries.
Disadvantages of discretionary trusts
The main disadvantage of a trust structure is the need to distribute all income on an annual basis.
Beneficiaries do not have a fixed interest so cannot sell their “interests” or leave these in a will/estate.
Hard for the business owner to really understand them!
Unit trust advantages
‘Fixed entitlement’ to income and capital.
The interest is generally transferrable and is an asset itself, so can be left in a will/estate.
Has the advantage over a company that it can still access the general 50% CGT discount.
Allows unrelated parties to invest together by holding interests in the trust.
Unit trust disadvantages
Like the discretionary trust, all income needs to be distributed each year or face the highest marginal rate of tax to the trustee.
A unit trust has a specific CGT event that arises when the unit holder receives more accounting distribution than tax distribution.
Examples
We provide two examples of how a trust may be used in your business group.
Example 1: A discretionary trust as a shareholder of your trading company
We often recommend business owners hold the shares in their company through a discretionary trust because:
When dividends are received from the company, there is flexibility in distributing the profits.
Should the shares in the company be sold, a discretionary trust has access to the 50% general CGT discount.
This may work as follows:
Ms White has three children and is the sole partner in her architecture firm. The business turns over $2m per year and she has multiple clients and 6 employees. The business is operated through a company, Biz Architects Pty Ltd and Ms White is the director of the company.
The shareholder of the company is White Pty Ltd as trustee for the White Family Trust – a discretionary trust. Ms White, her children, their spouses, other family members, and related entities are all beneficiaries of the trust. A family trust election is in place for tax purposes.
Each year Ms White receives a salary from the company, and at the end of the year, as the director of the company, she decides whether to pay a dividend out of the company profits. On 30 June 2023, Biz Architects Pty Ltd declared a fully franked dividend.
White Pty Ltd as trustee for the White Family Trust, received the dividend and resolved on 30 June 2023 to distribute 100% of the income of the trust to Ms White. As 100% of the income was distributed to an eligible beneficiary, the trustee is not liable to pay any tax. The trust will lodge an income tax return, showing the income and expenses of the trust, as well as disclosing who the beneficiary of the trust was and what they received.
Ms White will then include the franked distribution she received in her personal income tax return.
Example 2: Owning units in a unit trust to acquire multiple properties
A unit structure may be used where there are parties who want a fixed interest in assets. For example:
Mr Black, Ms White and Mr Grey wish to acquire several commercial buildings for long-term renting. Given the number of parties, and that they may wish to acquire more assets in the future and/or one or more parties may change over time, they are recommended to consider investing through a unit trust with a company as the trustee.
This structure will provide the following:
Each party can have a fixed entitlement to income and capital distributions of the trust.
Should a property be sold, a trust has access to the 50% general CGT discount.
If a unit holder wishes to exit from the investment, they are only selling units in the trust rather than selling each asset (if they owned them in their own names rather than through a trust).
However, the trust has the disadvantage that, should it instead make a loss in the year, the unit holders cannot access the loss to offset other sources of income. The losses are trapped in the trust and may be utilised when a profit is made by the trust.
The income and capital gains made each year by the trust will be distributed to each unit holder following the trust deed (which sets out the entitlements) and the trustee resolution. The unit trust will lodge an income tax return disclosing the income and expenses and gains of the trust and the distributions made to beneficiaries.
The unit holders will then include the trust distribution in their own income tax returns.
The above are simple examples. In reality, the unit holders of the unit trust may actually be each person's discretionary trust. In this way, Mr Black, Ms White and Mr Grey have the advantages of a discretionary trust when the distributions from the unit trust are received.
In Ms White’s example, it may be White Pty Ltd as trustee for the White Family Trust that holds the units. If this is the case, then the trust will report the dividends from Biz Architects Pty Ltd as well as the distributions from the unit trust.