You may want to set up a discretionary trust to operate your business or manage your family’s assets. A trust is attractive for business or family investments because of tax planning flexibility. It is therefore important to understand the taxes your trust needs to pay and whether managing tax liability through the use of a trust makes sense for you. This article will explore:

  • what it means to set up a discretionary trust; and
  • the tax implications of managing and operating a discretionary trust.

What is a Trust?

A trust exists when a holder of assets (the trustee) who has an interest in certain property and assets, holds those interests and assets for the benefit of others (the beneficiaries).

A discretionary trust means that the beneficiaries do not have a fixed entitlement or interest to the income or capital of the trust. Rather, the trustee has discretion in deciding if and to whom they will distribute income and capital of the trust from year-to-year.

Who Are the Parties to a Trust?

There are four main participants in a trust:

  1. trustee: The person or entity responsible for managing and administering the trust and making distributions of income and/or capital;
  2. beneficiaries: The people who the trustee considers the recipients of income and/or capital distributions from the trust;
  3. appointor: The person who can appoint and remove trustees in accordance with the trust deed; and
  4. settlor: The person who transfers the settlement sum to the trustee. This, combined with the execution of the trust deed, establishes the trust.

What Governs a Trust?

A trust deed governs a discretionary trust. The trust deed sets out how the trust should be managed and what the trustee’s powers are.

The trustee must comply with the terms of the trust deed, as well as any relevant state or territory laws.

You establish a trust when you execute the trust deed and the settlor settles the trust. Additionally, depending on the state or territory where you establish the trust, you may be required to have the trust deed stamped and make payment of stamp duty.

Taxation of a Trust

Tax Liability of the Beneficiaries

Discretionary trusts are ‘flow through’ vehicles. This means that they are not generally subject to tax. Additionally, trust income is primarily taxed in the hands of beneficiaries.

Beneficiaries will pay tax on the share of the trust income to which they are ‘presently entitled’ or ‘specifically entitled’. This does not necessarily mean the trust income which is actually distributed to them. Therefore, you need to exercise great care in this regard. The amount of tax you need to pay will, therefore, depend on the tax rates applicable to the relevant beneficiary (such as an individual or a company). For example, income distributed to beneficiaries under 18 could be taxed up to 66%.

There is tax planning flexibility available through a trust because you can distribute income to beneficiaries as tax-effectively as possible from year-to-year.

Trusts cannot distribute losses to beneficiaries. Rather, losses are ‘trapped’ in the trust and cannot be offset against the beneficiaries’ incomes.

Other Taxation of the Trust

Although beneficiaries are generally taxed on trust income, a trust still needs to lodge a tax return.

A trust’s tax return is a data-matching tool for the Australian Taxation Office (ATO). The ATO can cross-check the amounts distributed by the trust against the tax returns of the relevant beneficiaries.

Additionally, there are circumstances in which the trustee is liable to pay tax on behalf of the trust. For example, a trustee is liable to pay tax on:

  • the net income of the trust that has not been assessed to a beneficiary (i.e. undistributed trust income will still be taxed, and at the highest marginal rate); and
  • distributions to non-resident foreign beneficiaries.

If the trustee of your discretionary trust is a company and that company has no other business than to act as the corporate trustee of the trust, that company does not require an Australian Business Number (ABN) or tax file number (TFN) and does not need to lodge tax returns.

Capital Gains Tax (CGT)

As well as income tax, there may also be tax you have to pay on gains relating to capital assets held by the trust. For example, CGT consequences may apply where you sell an asset of the trust.

Is My Trust Eligible for the 50% CGT Discount?

Subject to meeting various conditions, certain taxpayers may halve their capital gain before including it in their assessable income. That is, they take the first half completely tax-free and only pay tax on the remaining half.

Trusts are eligible to access the 50% CGT discount. However, as trusts are generally flow-through vehicles, eligibility for the discount depends on the beneficiary receiving that discount. For example, the 50% CGT discount could apply flowing out to an individual beneficiary but would be reversed out to a corporate beneficiary (since companies are ineligible for the 50% CGT discount).

What Small Business Concessions Apply to my Trust?

A ‘small business entity’ includes businesses which you run through a trust.

Running a small business entity through a trust means the trust carries on business with aggregated turnover of less than $2 million. Alternatively, a small business entity trust (or connected or affiliated entities) has CGT assets that have a total net value of less than $6 million. If your trust meets either of these requirements, you may be able to access the small business CGT concessions.

The small business CGT concessions allow you to disregard or defer some or all of the capital gains made from an active asset (an asset you use in the course of carrying on a business or an asset inherently connected with the business), in certain circumstances:

  • where you sell an active asset and your business has continuously owned it for 15 years, you’re aged 55 or over and are retiring or permanently incapacitated, you can:
    • reduce the capital gain on that asset by 50% (in addition to the abovementioned 50% CGT discount); or
    • use the small business retirement exemption to shelter up to $500,000 from tax. However, if you are under 55 years of age, you must contribute the amount to a complying superannuation fund; and/or
  • you can defer all, or part, of the capital gain for two years or longer. This is the case if you acquire a replacement active asset or incur expenditure on making capital improvements on that active asset.

Key Takeaways

Operating a trust requires you to lodge a tax return for the trust when it’s making income.

Beneficiaries also need to be aware that their tax liability for income distributed to them from the trust depends on their personal tax rates. Additionally, trustees must consider the circumstances in which they will be liable to pay tax on behalf of the trust.

Furthermore, the eligibility of trusts for the 50% CGT discount can be very useful. If you want tax advice on a discretionary trust or help setting one up, contact LegalVision’s taxation lawyers on 1300 544 755 or fill out the form on this page.

Sophie Mao
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