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What do we mean by a “trust”?
A trust is a legal device used to manage real or personal property, established by one person (the grantor or Settlor) for the benefit of another (the beneficiary). A third person (the trustee) or the grantor manages the trust.
Trusts go back to the days of the Holy Crusades in the 11th and 12th centuries. Knights were forced to go and fight in the Middle East, if however they were killed on the journey or in battle, their assets would go to the King. The Monks came up with the idea that the Knight’s assets should be held in trust for the benefit of the Knight and his family, whilst not actually being owned by the Knight himself. This in effect allowed the Knight’s assets to pass to his family if anything was to happen while he was away.
Why Do I Have A Company Involved and What Is A Corporate Trustee?
The trustee is the person or company responsible for making the day to day decisions on behalf of the trust. The trustee can be either one individual; joint individuals; or a company. If it is a company, then you control the company by being the shareholder and director.
The reason why many trusts have a corporate trustee is for assets protection purposes. Where the trustee of the trust is subject to litigation – such as personal liability action in relation to one of the trust’s properties if a trust has individuals as trustees of the trust, they will be jointly and severally liable for any such action.
In contrast, where there is a corporate trustee any action undertaken will be limited to the assets of the company not those of the underlying directors.
The corporate trustee is a Pty Ltd company which is usually setup at the same time in conjunction with the trust. Depending on the type of assets that the trust will be holding it may be beneficial to have one director or many directors and this can be advised upon at the time of creation.
How Does A Trust Protect My Assets?
The main, and the original reason, trusts are used is for their ability to protect assets. The reason why trusts are able to protect your assets is that in the case of the trust being sued the entity that the action is taken against in the trustee. As explained above the trustee is a Pty Ltd company and as many people will know companies have limited liability, which protects their shareholders.
If the trust was to be sued the appointor/guardian (controller of the trust) sacks the trustee who is being sued and appoints a new one. If the lawsuit then continues against this company it owns nothing more than $2 in shares and no assets. In this case the person suing you would walk away with little or nothing or would most likely give up suing you altogether.
Appointors must be reminded that there are laws which prevent the movement of assets to defraud creditors. However at a very minimum the trust will protect assets held outside the trust if the trust was to be involved in litigation.
For more information see our brochure “Are your Assets Protected”?
How Does A Trust Help Me Save Tax?
Trusts save you tax in two ways:
Distributions To Beneficiaries
As stated above the trust (unlike companies) has no tax rate. Instead the beneficiaries of the trust are taxed at their marginal tax rate dependant on the amount of taxable income they have been distributed from the trust. As many people would know your PAYG income cannot be distributed between family members and/or even spouses. This is where a trust differs and where careful tax planning can take place to gain the maximum tax benefit.
[su_note note_color="#FDE36D"]Sandy came to see us. Her husband had just died. Her husband’s sole asset (apart from a small amount Example: Let us assume that John sets up a family discretionary trust (as the settlor) with Smith Pty Ltd as the trustee (Fred Smith and Mary Smith control the company). Mary Smith is the appointor. The trust is set up to hold assets and invest monies to generate profits and distribute the profits at their discretion to the beneficiaries (which are their children, James, Jack and Jenny, relatives and favourite charities). Let us further assume that Fred and Mary make $100,000 profits from their investing and other business activities in the 2006/07 income year. Fred and Mary can distribute the money each year to whoever they want to and in the proportion they wish. And the beauty is – whoever gets the money pays the tax. They can give it all to their 3 children. They can give 70% to James, 10% to Jack, and 20% to Jenny. They can give 30% each to themselves, 20% to each of their children and the remaining 10% to their favourite charity or local church. To be more specific, in distributing the $100,000, let us assume that Fred is earning $80,000 per annum. Fred will pay tax at the highest marginal rate of 45% (plus 1.5% medicare levy). Fred and Mary may decide to distribute no money to Fred, $60,000 to Mary (as Mary pays no tax but stays at home so the tax on $60,000 will only be $13,350), $30,000 to their family company (which pays tax at 30%, so tax will be $9,000) and the remaining $10,000 to their local church (which pays no tax at all). So the total tax will be $22,350 ($13,350 + $9,000). Yet if Fred had done everything through his company, he would have paid tax of $30,000 on the $100,000 and if it had been in his own name, he would have paid 46.5% tax. Worse still, any money he had given to his local church would have come out of his after-tax income. Yet by using a trust, it comes out of the pre-tax income.[/su_note]
As can be seen from the above example the ability to spread the income between different parties can save thousands of dollars of tax every year. In addition to this unlike PAYG income, where tax is removed every pay cycle, in a trust tax is only payable on distributions made at the end of the financial year. This could effectively mean you can invest your money for 12-18 months longer without having to withdraw the tax. This could have great compounding effects on your investments.
Expenses Out Of Pre-Tax Income
Under the Australian tax system most things we purchase (apart from some small items that we can salary sacrifice) come out of our post-tax income. For example if you are on the top marginal tax rate of 46.5% in Australia something that costs you $30, really cost you $56. Over time this can really add up.
However as the trust is treated like a business, the trust can pay for items related to that business out of pre-tax income. In the case of the $30 you have effectively saved yourself $26 which can be reinvested. Like the above distributions this can have amazing compounding effects over time.
As an appendix to this booklet I have attached all the potential tax deductions that can be made in relation to your trust. This list although wide ranging is still not complete and gives only a basis of what can be claimed. Depending on what you are doing in your trust you will be able to claim different items.
[su_note note_color="#FDE36D"] Did you know that if you had a trust setup before you came to this seminar you would be able to claim all your expenses while you are here? However this is unlikely to be claimable in your own name.[/su_note]
How Do I Get Money Out And Put Money Into My Trust?
As stated above getting money out of your trust is done simply by making a distribution. This distribution can be made as easily as a bank transfer from the trust account to your own personal account. It is important to remember at this stage however that any payments made from your trust to yourself are included in your taxable income and therefore stringent records should be kept so these amounts can be included in your tax return (there is a specific section in your tax return for distributions from trusts).
It is also not just money that can be distributed out of your trust. Capital gains and franking credits can also be passed out of your trust to the most beneficial beneficiary to reduce the total tax payable.
Putting money into your trust to invest with can be done in two forms:
Many people will tell you that the only way to put money into your trust is via a loan and the failure to draw up a loan agreement will lead to the money gifted in being taxed twice or penalties being enforced. This however is not the case when money is being gifted from a beneficiary to the trust. Clear documentation should however be kept in the case of a gift to make sure that the monies which are gifted in are not included in the trusts taxable income for that year.
Even though as explained above a loan agreement is not necessary, many people still decide to draw up such an agreement due to the effects such an agreement may have. By putting in place a loan agreement with a rate of interest (at market rates) the interest paid will become a deduction in the trust and income to the person loaning the money. Such agreements can be used effectively to improve the tax effects for either the trust or the individual loaning the money.
When a trust is setup we will be more than happy to advise which method will work most effectively for you and what possible benefits may be available in your own personal situation if a loan agreement is drawn up.
Why Can’t I Just Leave The Money In My Trust And Not Distribute It?
A question we often get asked by many of our clients is “why don’t I just not distribute the money to anyone and therefore no one will have to pay tax on it?” Unfortunately this is not the case.
If the trust does not distribute all of its income (profit) every year to one of a number of the beneficiaries that income will be taxed at 46.5% (the top marginal tax rate). This will not normally happen though as the trust will distribute its income to a number of the various beneficiaries who will pay at their respective tax rates.
[su_note note_color="#FDE36D"] If you are looking at holding money in your trust for long periods of time you should look at a bucket company, which will be explained later, to reduce the amount of tax payable each financial year.[/su_note]
Do I Have To Give The Money To The People I Distribute To?
Anyone can be named as a beneficiary on your trust however it is usually limited to family members and associated trusts and companies. There is no requirement for these people to be informed that they have been made a beneficiary of the trust when it is first drawn up.
If you plan on making a distribution to a particular person they must be informed due to the reason that this income must be included in their tax return for that financial year. This money will then be taxed at their marginal tax rate which if lower than your own can be an effective way of minimizing the trust’s taxable income.
Once this money has been paid tax on it is effectively the income of that person. However what happens in practice is that many agreements are put in place so that although one person may pay the tax on that income and receive a nominal amount for doing so, the original controller of the trust will end up with the income. As stated above the most important aspect of distributing to people other than yourself is informing them of the distribution before it happens so that they may seek advice as to how this will effect their taxable income for that year. It must also be noted that such payments may also effect government payments if these payments break thresholds.
What Is A “Bucket Company”? And How Does That Help Me In My Trust?
The term “bucket company” is used to describe a company which is setup as a beneficiary of your trust to accumulate money. The reason the term ‘bucket’ (sometimes also called ‘slosh’ or ‘holding’) is used is due to the fact that it sits below your trust and is used to pour money into to reduce tax.
The reason why ‘bucket companies’ can be effective is that they have a flat taxation rate of 30%. For this reason companies can be effective where all of your beneficiaries have marginal tax rates of 30% or more.
[su_note note_color="#FDE36D"]The Smith Family Trust has $100,000 of profit to distribute and all current beneficiaries are on the highest marginal tax rate of 46.5%. The members of the Trust would like to reinvest this $100,000 into a new investment which starts in the new financial year. They want as much money as possible to put into the investment. If this $100,000 was distributed to the current beneficiaries the tax payable would be $46,500. If however the money is distributed to Smith Pty Ltd (a bucket company) only $30,000 tax would be payable. This would enable $16,500 extra to be invested. With compounding effects over 10 years at 7% interest this would lead to an extra $280,000 for the trust.[/su_note]
As this money will be taxed at the company tax rate it can then be loaned back to the trust which can then reinvest the money. If this money this wants to be distributed at a later date it can then be paid in the form of a fully franked dividend where the person who receives this distribution will be able to full utilize the franking credits to reduce their income. For this reason this can be an effective way of reinvesting money at a lower tax rate and wait for a time when your marginal tax rate is lower before paying it out to yourself or to another beneficiary.
Can I Just Give All The Money To My Children?
When the term ‘family trust’ the first thought that comes to many people is ‘can I give all the money to my children to save tax?’ Although this would be a wonderful thing it if were true unfortunately this is not the case. When it comes to children there are a number of different rules depending on their age and what role they play in the trust.
In relation to distributions being made to children there are 3 important age groups:
Each of the above ages has different distribution rules and different tax rates. For children 0-14 they can be distributed up to $1325 tax free each year. Any amount over this will be taxed at 46.5% and therefore would not be beneficial to distribute any amount above this. When distributing to children care should be taken to make sure they have not received any other income such as bank interest which would push their total income above $1325 for the year.
Once a child reaches the legal working age in Australia (which varies between the States – See table below) they can then be employed in the trust so long as they are completing work related to the trust’s dealings. At this stage the child will be able to be paid from the trust at their marginal tax rate. (for example they will receive they first $6000 tax free). It is important to discuss with us before making such a decision as such considerations as superannuation must be considered and rates differ from year to year.
|State||Legal Working Age|
|New South Wales, Northern Territory, South Australia, Tasmania||The minimum age for employment outside school hours is 14 years of age for casual and part time employees.|
|Victoria||the employment of children is governed by the Child Employment Act 2003 which states that the minimum age of employment is 15 years of age.|
|Queensland||With effect from 1st July 2006 employment in Queensland is governed by the Child Employment Act which requires employees who are under 16 years of age and have not yet finished year 10, to provide parental consent to commence work.Employees under 16 may only work 12 hours during a school week (38 hours a week during school holidays), with each shift being a maximum of 4 hours Monday to Friday and 8 hours Saturday and Sunday.All hours of work must be between 6am to 10pm.|
|Western Australia||With effect from 1st July 2006 employees who are under 15 years of age need to provide parental consent to commence work. For legislative reasons employees under 16 years of age may not work during school hours and those under 15 years of age may only work between the hours of 6am to 10pm.|
|Australian Capital Territory||The recommended minimum age for full time employment in ACT is school leaving age (i.e 15 years of age). It is possible to be employed below this age for a maximum of 10 hours per week. However if you wish to be employed for more than 10 hours per week, prior approval must be obtained from the Chief Executive of the Department of Housing, Disability and Community Services.|
For children over the ages above but are not ‘employed’ in the trust the $1325 limit will still apply.
Once a child reaches the age of 18 they are no longer restricted as to the amount of income they can be distributed and they will pay tax at their marginal rate. For children that turn 18 in a tax year please see the below example.
[su_note note_color="#FDE36D"]Division 6AA ($1325 limit) only applies where the child is under 18 at the end of the tax year. If the child turns 18 during the tax year then $6,000 can be distributed to the child tax free. However, care should be taken with this approach as students who cease full time education during the year may need to pro rate their tax free threshold of $6,000.[/su_note]
What About Negative Gearing And/Or Losses In A Trust?
Many people will tell you that the main disadvantage of a trust is that losses cannot be utilized. That is, you cannot claim your negative losses against your income in your personal name.
Although there is some truth in this saying, for the great part, the statement is untrue.
So long as the trust is controlled by member’s of the same family through the years losses from one year can be used to offset profits in the next year, or even in future years if they are years of running losses.
[su_note note_color="#FDE36D"]If John lost $10,000 one year and then made $12,000 profit the next, John would only have a taxable income of $2,000 in that later year, as you can offset the losses from the earlier year. Therefore the only real problem is the timing of the losses. Ultimately you will get them in most situations. It is just a question of when you get them.[/su_note]
It is for this reason that it is important that all expenses are claimed each financial year, even if you are running at a loss, due to the fact that you will be able to use these expenses in later years.
In addition to using trust losses in later years, family trust can make what is called a ‘family trust election’ so that losses from one family trust can be used to offset gains in another family trust. This is often used where one trust holds negatively geared property while they other is trading shares. The family trust election allows the losses from the property to offset the gains from the shares, in turn reducing the taxable income of the share trading trust.
What About If I Just Want To Buy Property and Have No Cashflow Means in the Trust?
Many clients come to us with the fact that they only want to buy negatively geared property for buy and hold and do not have any other positively geared investments in other trust. However these clients still want to buy their property in a trust so that they can take advantages of the asset protection and tax benefits.
In this situation it still can be possible to claim the negative gearing in your own name to offset your PAYG income, while still taking advantage of the benefits of a trust.
Two possible options are:
It is once again suggested if you are looking to invest in negatively geared property you see one of our staff who will be able to give you an insight into the options. As to the savings that can be made by investing in a trust with property see below.
[su_note note_color="#FDE36D"]Jack buys a negatively geared property in the Jack and Jill Property Trust. He earns $110,000 while Jill stays at home with the kids and earns $6,000 from selling her knitting on Ebay. Jack and Jill sell their property and have a $100,000 capital gain. As they have owned the property for longer than a year they receive a 50% discount. If Jack had to pay this himself he would have to pay $21,250 in capital gains. By distributing the capital gain all to Jill and his two children they only pay $12.575 in capital gains a saving of nearly $9,000 and the savings would increase depending on the size of the capital gain.[/su_note]
Trusts are a wonderful vehicle to protect your assets. They also are a wonderful vehicle to save a fortune in tax.
There are many myths about trusts. That it is why it is important to see your professional adviser. At the same time, however, there are many myths and assumptions as to what you can do with trusts. Without careful planning, and strategizing, you can end up with significant problems.
Come and see us for a consultation today. One of our experts would love to assist you in getting your family trust up and running, and effective.