(First published in Australian Doctor Magazine – September 2022)
Most family trusts are ‘traditional’ discretionary trusts, which are used to operate businesses or hold shares in trading companies as well as other investment assets.
The trust earns income from its trust assets and distributes the profits to such persons as the trustees may decide (with some limitations).
All income distributed is taxed in the hands of the beneficiaries, apart from any minors or some overseas beneficiaries for whom the trustee must pay tax on their behalf.
This makes trusts a useful vehicle for income splitting.
One of the other key attractions of a family trust structure is for asset protection and estate planning.
Assets held in trust by a trustee are not considered assets of any individual family member, until such time that person is made presently entitled to income or assets by the trustee.
This is an extremely useful strategy as it allows an ‘at-risk’ individual, for example, a professional medical practitioner, to separate their medical practice business from their family assets, keeping family assets out of reach of potential creditors or litigation claimants.
Do you use a family trust in your business?
A business can be run directly from the family trust, or operated in conjunction with a company.
Many medical practices are structured as a company, as a trust or a combination of the two.
The advantage of having a trust in this structure is that the practising doctor can draw a salary, but all remaining profits of the business can be distributed directly to family members instead of paying wages. This arrangement simplifies tax obligations for the business and the family members.
This is also a great structure where the value of the business is primarily in goodwill, such as a medical practice, since the sale of such businesses are almost always by way of an asset sale.
Family trust shareholding
Another common use of a family trust is to hold the shares of the operating company. This is a feature of many owner-operator businesses across a wide range of industries and provides a range of benefits, especially for businesses heavily invested in assets (physical or intangible).
This structure takes advantage of the flexible tax options family trusts provide, by allowing the operating company’s profits to be paid out as dividends and distributed among family members, while also giving the tax and legal advantages of operating a business in a limited-liability company.
The main drawback is the higher complexity and compliance costs, as there are at least two different tax entities (a company and a trust) in addition to your personal tax affairs.
Family trusts are on the ATO’s radar!
It would have been difficult to miss the uproar earlier in the year when the ATO released a taxpayer alert: TA 2022/1 Trusts: parents benefitting from the trust entitlements of their children over 18 years of age.
At the same time it also released its accompanying draft tax rulings and practical compliance guidelines, all of which are targeted at family trusts.
There was a media frenzy on the ATO’s ‘attack’ on family trusts.
Who is the ATO targeting?
To put it briefly, the ATO is trying to stamp out trust distribution arrangements where one member of the family is made entitled to a trust distribution, but the actual economic benefit goes to another family member.
The ATO views this type of arrangement as a “reimbursement arrangement” (as captured under Section 100A), which is carried out purely for the purpose of minimising or avoiding tax.
The ATO even goes so far as to call this type of arrangement a “sham” and “ineffective for trust law purposes”. However, Section 100A does not apply to arrangements that are “ordinary commercial or family dealings”.
Therein lies the problem: there is no statutory definition of what is meant by ordinary commercial or family dealings.
The suggestion in the draft ruling is that an arrangement may not be considered an ordinary dealing just because it is commonplace, but the very definition of ‘ordinary’ is something that is commonplace or standard.
The draft ruling contains nine examples representing a range of circumstances that would, or would not, constitute ‘ordinary family or commercial dealing’, but given the subjective nature of the meaning of ‘ordinary’ and that it should be construed in the context of the family group, the ATO’s examples are of limited use to most taxpayers.
Does this affect me?
If you have a family trust in your group structure, your arrangements could be affected.
Before the ATO announcements, the use of family trusts to manage and protect a family’s overall wealth was settled practice for Australian businesses and their family owners.
For decades, families managed overall finances together and this was not considered to be objectionable. That stance has changed.
These ATO announcements have certainly changed the use of family trusts as we know it, so now is the time to review your existing arrangements.
ATO reviews conducted under Section 100A have an unlimited amendment period, so the costs of ignoring the risk are likely to be high.
The ATO will be devoting compliance resources based on the risk model set out in Draft PCG 2022/D1 to review arrangements dating back as far as 1 July 2014 that are not within the ‘green zone’ or ‘white zone’ categories.
Examples of at-risk arrangements that are in the ‘red zone’, where the ATO will be directing compliance resources, include:
- Creation of a present entitlement to trust income to a person so their taxable income will not exceed certain marginal tax rate thresholds, and then making a gift of the entitlement back to the trustee, especially if it is done every year and that appears to achieve a particular tax outcome.
- A family trust earns regular income each year, and the income is distributed to an adult child who is a full-time student with no other income; however, no cash is ever paid in respect of the entitlement. The parent prepares a note each year for the adult child to waive their right to the trust entitlement so that the trustee can retain the funds in the trust, while also clearing off the unpaid present entitlement. This arrangement exists every year to date.
- The parents draw cash from the family trust throughout the year and at the end of the year, trust distributions are made to adult children or grandparents. Beneficiaries then write a letter of gift (or similar) to ‘gift’ or ‘waive’ their trust entitlement to the parents who have already benefited from the cash but are not taxed on it. This is repeated each year.
What action should I take?
The ATO are more interested in changing taxpayer behaviour than going back decades, so the first thing we recommend anyone reading this article to do is to talk to your trusted adviser. In our opinion, the ATO will use Section 100A as a tool of last resort. The more likely line of attack on trust arrangements will be on the paperwork and validity of distributions. Points you need to check include:
- Check that the trust deed includes the beneficiary that is receiving the entitlement.
- If streaming, check the deed to ensure that the trustees can stream capital gains and franked income.
- Check the trustee’s distribution powers; most deeds provide for the distribution to be made by 30 June. However, there are some trust deeds that require distributions to be made earlier, say 26 June.
- Understand what needs to happen by 30 June (or relevant date in the trust deed). Some deeds require a written determination by the trustees, other cases might provide for resolution by the trustees to whom the income will be distributed. Practically, this means that the trustees must meet and resolve by that date who is to get the income of the trust. The resolution is the decision and it is this resolution that must occur by the relevant date.
- Contemporaneous evidence should be prepared; for example, diary note, email from trustee etc.
If you haven’t already reviewed your family trust arrangements, now is the time to act!
If you have any questions regarding the above, contact Director of Taxation Paula Tallon at ptallon@prosperity.com.au.
