What Are The Benefits Of Setting Up A Trust?

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DISCLAIMER: This information is for general purposes only. Do not rely on this information without seeking further professional advice from us or another firm of accountants or solicitors.

What is a trust?

In its simplest form, a trust is where one party holds assets on behalf of another. The main trust parties are the settlor, trustee, and beneficiaries.

Settlor: The settlor sets up the trust, with a nominal sum (often $5 or $10). This is usually an unrelated person, eg. an accountant, a lawyer. This is done to avoid stamp duty and nasty income tax consequences. You never want a family member to be the trust settlor.

Trustee: The trustee manages the trust property (investments, assets, etc.) and pays out the trust profit for the benefit of the beneficiaries. The trustee can be an individual or a company (in most cases, the trustee is a company).

Let’s give a simple example of a trust. John gives Anne $1000 to give to John’s sister in 2 days time. They sign an agreement in writing to this effect. That is a trust. John is the settlor (as John created the trust), Anne is the trustee (as Anne is holding the $1,000 on trust for John’s sister) and John’s sister is the beneficiary (as she is beneficially entitled to that $1,000, and would have a claim against Anne as the trustee if Anne was naughty and decided not to pay up). Even if it was not in writing, but it was done verbally, it would still be a trust.

To give another example, John gives Anne $10,000 to invest and pay any income earned on that $10,000 to Derek. John is the settlor (as John gave you the $10,000), Anne is the trustee (as Anne is holding the $10,000 on trust, and is investing it to produce income), and Derek is the beneficiary (as Derek is entitled to the income from the $10,000 and the $10,000 itself unless stated otherwise).

What are the different types of trusts?

There are many types of trusts. There are 42 types of trust to be precise! However, the two main types are unit trusts (fixed trusts) and discretionary trusts.

Unit trusts are similar to companies. They have a fixed entitlement to the trust assets and profits. The parties are a settlor, a trustee and beneficiaries (with the beneficiaries being known as “unitholders”, as opposed to companies, where the holders of interests are called “shareholders”).

For example, if John sets up a trust, and wants to give Anne and Derek a 50% entitlement each to the trust capital and profits, and make Mary the trustee of that trust, John may use a unit trust, and give Anne 50% of the units in the trust, and Derek 50% of the units in the trust. John is the settler, Mary is the trustee and Anne and Derek are the unitholders.

Discretionary trusts are a completely different entity. They are highly popular structures for tax planning and asset protection. The discretionary trust has a settlor, a trustee, and beneficiaries.

But it also has an appointor. The trustee manages the trust property and investments, and pays out the net income for the benefit of the beneficiaries. The appointor ultimately controls the trust. The appointor has the right to hire and fire the trustee (and is the true controller of the trust).

Some discretionary trusts also have a guardian who is the ultimate controller behind the appointor.

The beauty of a family discretionary trust is the beneficiaries are a wide class of people. Any one of them can receive the income as the trustee has a discretion to pay the income out in whatever proportion he or she pleases to the beneficiaries. There is no restriction.

For tax planning purposes, and asset protection, this is a wonderful benefit.

Can you give me an example of how a family discretionary trust can help me?

Most certainly.

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. 70% to James, 10% to Jack, and 20% to Jenny. 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.

As you can see, this gives incredible tax planning flexibility and savings.

This describes a classic family trust. In our view, a family trust is still one of the best structures available in Australia to protect assets and reduce income tax.

What are the benefits of a family discretionary trust?

Trusts are wonderful for a number of reasons:

  1. Compliance costs. They have low compliance costs unlike companies (ie. they cost almost nothing to set up and involve less accounting work).
  2. Taxation of trust income. Trust income is taxed in the hands of the beneficiaries, not the trustee. This is very important and is the key feature of trusts which makes them so attractive. Therefore, as the trustee has discretion in making their distributions of profit, they can distribute the profit to the beneficiaries with the lowest tax rates; they can even distribute to exempt charities (meaning they are effectively distributing to them from pre-tax income)
  3. Asset protection. For asset protection purposes, family trusts are very difficult to penetrate (although in some circumstances the Bankruptcy Act and the Family Court Act allow the Trustee in Bankruptcy and the Family Court to look through the trust; Centrelink also have such powers in relation to family tax benefits)

Are there any drawbacks with trusts?

Yes. There are two problems with trusts in Australia.

  1. Accumulation of income. Trusts cannot accumulate the income. The trustee must distribute the income to the beneficiaries each year. You can accumulate income with companies but not with trusts. If a trust accumulates income, the trust pays 48.5%. (This does not mean the trust must pay out the income every year; it can distribute the money on paper but can avoid paying it out indefinitely if it so desires.) So if you want to accumulate income, you are best to set up a family company and distribute the money you wish to accumulate from the trust into the family company.
  1. Buying negatively geared property. If you are buying negatively geared property in a trust, the losses cannot be taken out of the trust. That means you cannot easily offset the negative gearing losses against your personal income. They get stuck in the trust. To avoid this result, you may need to consider a hybrid trust, or alternatively, a loan agreement with the trust. Please contact us to discuss this further.

Can you give me another Example?

Yes. Let’s give a further example to show how wonderful trusts are for business people. We will use the Smith Family Trust from the above example.

Fred goes to an options trading seminar and learns how to trade options. Fred opens up a brokerage account with an options broker in the name of the Smith Family Trust.

To date, Fred has been working, making an income of $80,000 per year, while Mary has earned no income, preferring to stay home and look after their 3 children James, Jack and Jenny. She has no interest in options trading. Fred goes to church and pays 10% to his church each week from his after tax income.

Fred makes $60,000 in net profits before tax from his options trading. On his accountant’s advice, for the 30 June 2007 tax year, Fred resolves to distribute $5,000 to Fred, $35,000 to Mary, $5,000 to Fred’s church, $500 to James and Jack (aged 10 and 14 who earn no income) and $4,000 to Jenny (his 18 year old daughter who earns $10,000 per annum and is not options trading at this stage). The remaining $10,000 he distributes to his family company “Smith Investments Pty Ltd”.

So what happens for tax purposes?

As profits are taxed in the hands of the beneficiaries, Fred will be taxed on his normal day job income plus his $5,000 distribution at 48.5% ($2,425). Mary pays tax of $7,054 on her $35,000 distribution (about 20%). John and Jack will pay no tax on their money as they are earning no income. Jenny pays tax of $650 on her $4,000 (17% tax as she is in the lowest marginal bracket as she only earns $10,000 per annum). And with the $5,000 paid to his church, not only will there be no tax to the church, but Fred can distribute it out of his pre-tax trust income. If he was giving it from his day job income, it would come from his after-tax income. Pretty neat eh?

The company, Smith Investments Pty Ltd, will pay tax at 30% on its $10,000 distribution ($3,000).

As you can see there are considerable tax savings available to Fred. If he had earned all of his profits in his own name, he would have paid tax of $29,100. By doing it this way, he pays tax of $13,479, more than 50% less. This is a saving of nearly $16,000. Fantastic!

It gets better. Let’s say Fred’s 18 year old daughter got a job paying $60,000 per annum next year, while Fred quits work to be a full time options trader. Fred can simply distribute more income to himself and less to his daughter.

And there are other wonderful things you can do with trusts.

In the above example, you might ask: why wouldn’t Fred distribute more to his 10 and 14 year old sons? Surely with the $6,000 tax free thresholds, he could save a fortune in tax!

The problem is there are penalty tax rules in Division 6AA of the Tax Act if you distribute profits from a trust to children under 18. Unless the amount is less than $1,372, or falls within certain exemptions, it is taxed at the top marginal rate of 48.5%.

2 responses to “What Are The Benefits Of Setting Up A Trust?”

  1. Melanie Day says:

    Excellent article. Thankyou