Discretionary trusts are a type of structure commonly used as an effective way to share business or investment profits among family members, to minimise tax liabilities and to protect a family’s assets.
A discretionary trust can be further classified as a “family trust” for tax purposes. This occurs when the trust makes a Family Trust Election on it’s tax return. So why use a family trust?
There are three main circumstances where a trust could benefit by making a family trust election:
- The trust receives franked dividends
The election bypasses restrictions in distributing franking credits, which can usually only be passed to beneficiaries if the individual receives less than $5,000 in franking credits.
- The trust has losses
Ordinarily trusts are subject to complex measures before being allowed to deduct prior year losses from current year taxable income. However where an election has been made, the trust only needs to pass one test – known as the income injection test rather than face the four regular complex tests to recoup the loss.
- The trust owns shares in a company that has losses.
The election allows for a more concessional treatment of the company loss recoupment rules, and may permit the offset of company losses in circumstances where a non-family trust would not.
The election must specify one person – the test individual, who forms the point of reference for defining the family group. The family group sets the maximum range of beneficiaries to whom the trustee can distribute income or capital of the trust to.
The family group includes:
- The test individual and their spouse
- Any parent, grandparent, brother or sister of the test individual or of their spouse
- Any nephew, niece, or child of the test individual or of their spouse and any lineal descendant of these individuals
- The spouse of anyone mentioned above
To make a valid election the trust must pass the Family Control Test, which ensures that only a trust controlled by that family can make a valid election.
Control mainly looks at who can control the application of income or capital of the trust. To pass the test the trust needs to be controlled by a group consisting of the test individual, their family, or their legal/financial advisors.
An Interposed Entity Election is used to make an entity, such as another family trust, a member of the family group. This election must specify the same test individual as in the family trust election.
- Distributing income among beneficiaries who are on lower marginal tax rates can reduce the effective tax rate on a trust.
- As a consequence of making the family trust election you are restricting the people to which income can be distributed, and distributions to anyone outside the family group trigger tax at the highest rate (currently 47%).
- It is important to understand when the election may be required, as the absence of the above scenarios may mean there is no benefit in doing so.
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Author: Danielle Pomersbach