Family trusts remain popular for several reasons including potential tax savings, asset protection and succession planning. These benefits could see a family trust play an important role in your wealth creation plans. We look at how trusts work, and review the pros and cons.
The term ‘trust' may sound complex however family trusts (also known as ‘discretionary' trusts) are simply an arrangement where a trustee agrees to hold assets for the benefit of the beneficiaries. The trustee can be a real person – often a husband or wife, or a small private company, and the beneficiaries can include children, grandparents, parents, and a partner or spouse.
The trust assets, which may encompass a small business or investments like a rental property, are managed by the trustee in line with a trust deed. The income these assets generate are distributed among beneficiaries. And this is where trusts may become interesting, depending on your situation.
Taking advantage of lower personal tax rates
As a rule, the trustee has the power to distribute income from the trust as they see fit (hence the term discretionary trust). This means income can be spread across different beneficiaries in a way that quite legitimately minimises tax.
A beneficiary who is a low income earner for instance, may be allocated a larger share of trust income than a beneficiary who is a high income earner. In this way, the trust can be used to split income across beneficiaries to take advantage of low personal marginal tax rates. It's a practice sometimes referred to as ‘tax rate arbitrage', and it makes family trusts a key tool in tax management.
On one hand, it's easy to assume this would make trusts an ideal way for families to reduce their overall tax bill by splitting income among younger children. The downside is that ‘unearned income' received by minors can be subject to very high tax rates. So the income splitting benefits of a trust may be better suited in situations where children are close to 18 and planning to study. If interested in learning more, we can explain the best way to use a family trust might be appropriate for your situation.
Be aware, a key drawback of a trust is that it cannot distribute either capital losses or revenue losses to the beneficiaries. So, if a trust makes a loss in a financial year, the losses can't be distributed among beneficiaries to offset against any other assessable income they may have earned.
An overriding issue is to ensure any trust distributions strictly follow the trust deed – and the letter of the law, to avoid any potential problems with the tax man.
Family trusts can do far more than trim the tax office's take. They can also protect family assets, and in an increasingly litigious world, asset protection is a key aspect of wealth management.
Unlike assets held in personal names, assets held in a family trust can be protected from the creditors of a beneficiary who is declared bankrupt, and even from the asset-splitting effects of divorce.
These are worst case scenarios, but a family trust can also allow parents to pass down their personal and business assets to future generations.
While this aspect of a trust may sound promising, there are downsides. Assets transferred to, or purchased by, a discretionary trust are not owned by an individual person – and therefore can't be controlled by an individual. This makes it critical to think very carefully about which assets are suitable to be held in a trust, and it's an area where our expert advice is essential.
The benefits of flexibility
Unlike a super fund, assets held within a trust don't have to be locked away for years. There are no restrictions on how much can be contributed to, or held in, a family trust, and there are none of the extensive compliance requirements faced by super funds. Trust paperwork focuses chiefly on documenting annual distributions to beneficiaries, preparing annual financial accounts and lodging tax returns.
Impact on estate planning
As we've noted already, a trust can be used to pass assets down from generation to generation. But that doesn't mean a trust can be used in lieu of a current (and valid) will. On the contrary, a trust and your will should be as consistent as possible – both with each other, and your wishes in general.
We can help you work out if a family trust is suitable to your situation, and which assets might be best suited to be held in a trust. Please call Mortgage Choice to arrange a meeting if you would like to discuss whether a trust is appropriate for your family structure.