Why you should set up a family trust.

Understanding Family Trusts: A Comprehensive Guide to Their Benefits and Drawbacks

Popularity of Family Trusts

In Australia today, the most common type is the discretionary trust, often referred to as a family trust. These trusts have become a popular tool for wealth management and investment within families.

According to the Australian Taxation Office (ATO), there are currently about 1 million family trusts in the Australian tax system, collectively managing an estimated $3 trillion in wealth. This means roughly 1 in 25 Australians has a family trust.

Who Needs a Family Trust?

A common misconception is that only the wealthy need family trusts. In reality, you don't need to be extremely rich to benefit from one. Family trusts are flexible structures that offer many advantages for families with varied financial circumstances, whether you're a high earner or simply looking for a way to protect and manage family assets.

How a Family Trust Works

A family trust is not considered a separate legal entity under common law but is treated as one for tax purposes. It operates as a relationship between the trustee — the person or company responsible for managing the assets—and the beneficiaries, who benefit from the trust.

1. The Trustee:

- Administers the trust, including deciding how and when to distribute income.

- Is liable for the debts of the trust, making the choice of a corporate trustee (a company) a wise decision to limit personal liability.

2. The Beneficiaries:

- Are the individuals or entities that receive distributions from the trust.

- In a family trust, beneficiaries are typically immediate family members like spouses, children, or grandchildren but can also be a bucket company.

The relationship between the trustee and the beneficiaries is documented in a trust deed, which outlines the rules and obligations of the trust. It’s important to work with an accountant or solicitor to ensure the trust deed is drafted correctly to fit your needs.

Taxation of Family Trusts

One of the key benefits of a family trust is its taxation structure. Family trusts are considered "flow-through" vehicles, meaning they generally don’t pay tax at the trust level. Instead, the income flows to the beneficiaries, who are taxed at their individual marginal rates.

This system allows for tax-efficient distribution of income within a family. However, trustees need to make formal decisions about income distribution before the end of the financial year (June 30). Failure to do so could result in the trust's income being taxed at the highest marginal tax rate, currently 45%, plus a 2% Medicare levy.

Tax Planning Opportunities: Income Splitting and Streaming

Family trusts offer two key tax strategies: income splitting and income streaming:

1. Income Splitting:

Trustees can allocate income among beneficiaries in a way that minimizes the overall family tax burden. For example, distributing more income to a family member in a lower tax bracket reduces the overall tax paid by the family.

2. Income Streaming:

Different types of income can be distributed to different beneficiaries. For example, if one beneficiary has capital losses, it may be beneficial to allocate capital gains from the trust to that beneficiary, thus reducing the overall capital gains tax liability.

However, it’s crucial to consult the trust deed to ensure that income splitting and streaming are permissible. Not all trust deeds allow these strategies.

The Advantages of Family Trusts

Family trusts provide several benefits, particularly for tax efficiency, asset protection, and estate planning:

1. Tax Flexibility:

Trustees have the flexibility to distribute income according to the tax circumstances of each beneficiary, allowing for more effective tax planning within the family group.

2. Asset Protection:

Family trusts offer a degree of protection from creditors, as the assets are legally owned by the trust rather than by the beneficiaries. This means that if a beneficiary faces financial or legal challenges, their creditors may not be able to access the trust’s assets.

3. Estate and Succession Planning:

Family trusts allow parents to pass on control of the trust, and therefore the assets, to future generations without triggering capital gains tax (CGT) or stamp duty. This enables beneficiaries to continue benefiting from the trust's income after the original trustee's passing.

4. Capital Gains Tax Benefits:

If assets held by the trust, such as an investment property, are sold after being held for more than 12 months, the trust may be eligible for a 50% capital gains tax discount. This capital gain can be distributed to the most tax-efficient beneficiary.

Drawbacks of Family Trusts

Despite the benefits, family trusts have some notable drawbacks that need to be considered:

1. Expiration Date:

Most trusts in Australia, except those in South Australia, have a maximum lifespan of 80 years. After this period, the trust must "vest," meaning its assets are distributed to beneficiaries, potentially triggering capital gains tax.

2. Tax on Undistributed Income:

If a trust fails to distribute its income by the end of the financial year, the undistributed income is taxed at the highest marginal rate. Additionally, distributions to minors (under 18) attract high tax rates, up to 66%.

3. Losses are Trapped:

Any losses, such as capital losses, cannot be distributed to beneficiaries. These losses must remain within the trust and can only be used to offset future trust income.

When is the Right Time to Set Up a Family Trust?

A family trust may be particularly beneficial if you:

- Run a profitable family business.

- Are expanding your business and looking for tax efficiency.

- Want to hold investments in a tax-effective structure.

It’s also an ideal structure for estate and succession planning, allowing you to pass wealth to future generations while minimizing tax liabilities.

Closing Thoughts: Consult an Expert

Before setting up a family trust, it’s important to understand both the advantages and disadvantages based on your personal financial and family situation. Trusts offer significant tax planning opportunities, but they come with complexities and potential risks.

With the ATO closely scrutinizing trusts, particularly around distributions to adult children, it’s more important than ever to consult a tax specialist or financial advisor. If properly managed, a family trust can be a powerful tool for protecting family wealth and minimizing tax, but it’s essential to get expert guidance to avoid pitfalls.

If you're considering a family trust, reach out to us for a free consultation, to help you make the best decision for your financial future.

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This article outlines the mechanics of family trusts, their benefits and drawbacks, and when it may be the right time to consider one. Consult a professional to ensure that a trust structure aligns with your goals and financial needs.