A very common feature of many private family groups is a discretionary trust, commonly known as a ‘family trust’. A family trust allows a pool of assets, including cash, shares and loans, to be held in a trust capacity by a trustee for the benefit of a group of beneficiaries within a family group. A family trust can earn income from its trust assets including a business, and distribute to persons or entities as the trustee may decide in each income year (with some limitations). All income distributed to beneficiaries are taxed in the hands of the beneficiaries, with the exception of any minors or some overseas beneficiaries for whom the trustee must withhold and pay tax on behalf of.
The principal attraction of a family trust structure is for asset protection and estate planning reasons. This is because assets held in trust by a trustee of the family trust is not considered assets of any individual family member, until such time that person is made presently entitled to the income or assets by way of a trustee resolution of income distribution. This is an extremely useful strategy because it allows an “at-risk” individual, e.g. a professional practitioner or a company director, to keep family assets out of reach of potential creditors in a litigation event. It also allows family estate planning by ensuring only those family members that are nominated and made presently entitled by the trustee will receive the income or assets out of the trust.
Corporate or individual trustee?
When setting up a trust, you should first decide whether you want a corporate or non-corporate trustee for your family trust. A corporate trustee just means a company will act in the trustee capacity in “managing” the family trust’s operations and decision-making. The alternative is one or more individual persons will act in the trustee capacity (jointly where multiple trustees).
At Prosperity, we strongly recommend a corporate trustee for legal liability reasons. This is because a trustee is liable for trust debts. While a trustee generally has right of indemnity against trust assets for trust debts, if the trust has insufficient assets to cover the trust debts, the trustee will become personally liable for the shortfall. Where you have an individual trustee in place, the individual trustee’s personal asset pool will be exposed to the liability, or where there are multiple joint trustees, each trustee is jointly and severally liable for the debt. This is where a corporate trustee will see greatest protection, as a limited liability company can only be held liable to the extent of its assets, which for a corporate trustee will only be a nominal amount of share capital.
If your family arrangements are more complex, such as having a shareholder or director guarantee/indemnity in favour of a creditor (common scenario where unsecured loan has been taken out in the name of the trust), you should seek proper legal advice to make sure the structure is right for your personal circumstances.
How to set up a family trust?
A trust is assigned over a pool of assets to be “managed” by the appointed trustee who is governed by a set of rules in a trust deed. As trust laws are based at the state/territory level, the trust deed is governed by the state/territory trust legislative requirements and therefore the declaration of trust must be made under the laws of a nominated state/territory – usually the one the family resides in or where any real properties are located in. We also note that a declaration of trust may be a dutiable event in some states such as NSW ($500 stamping fee is applicable) but exempt in other states such as VIC.
A family trust generally has four defined roles, for which you must decide on the persons/entities that will be in the role.
- Settlor – This is the person that sets up or ‘settles’ the trust on behalf of all parties to the trust. The Settlor is generally excluded from obtaining any benefit from the trust but also has no ongoing role in the operations of the trust. The role of Settlor is normally the accountant or lawyer that sets up the trust.
- Appointor – A person that has the power to appoint and remove trustees, in accordance with power to do so as conferred in the trust deed.
- Trustee – A person or company that is appointed by the appointor to make decisions on whether to do anything in respect of the trust and to act in the interests of the beneficiary in accordance with the terms of the trust.
- Beneficiary – One or several persons or entities that may be either defined in the trust deed (including classes of persons or entities), or nominated by the trustee, to receive a benefit from the trust by way of an entitlement to a distribution of trust income or assets.
Once you have decided on the above roles, contact one of our Prosperity team members for our trust formation service which includes discussions with you to ensure fit-for-purpose and the drafting of a formal legal trust deed with optional amendments depending on your family circumstances. We will also incorporate a corporate trustee if one is required.
Common uses of family trusts
Now that you understand the basics of a family trust, how is it commonly used in a family business setting to achieve asset protection and estate planning goals? We describe two common structures for a family business using a family trust.
Family trust business
Many small owner-operator businesses are commonly run directly from the family trust. The advantage of this structure is the profits of the business can be distributed directly to family members instead of paying wages, especially where the owner-operator of the business relies on all the earnings from the business to meet their family needs. This arrangement greatly simplifies the tax obligations as there only needs to be one tax return prepared for the family trust, plus individual tax returns for the family members whom receives trust distributions. There are also little complex tax rules to manage (e.g. Division 7A) with all profits simply distributed and taxed in the hands of the beneficiaries.
However, one big disadvantage of this structure is the inflexibility to grow and expand the business structure plus limited options to sell the business. This is because once a business is operating in the family trust environment, the ‘business’ becomes an asset of the trust. As family trusts has no formal ownership structure, the only option to change ownership of the business is to sell the business assets out of the family trust, which will trigger capital gains tax with only limited scope for relief or exemption. Where the value of the business is in the form of an intangible goodwill, this may also involve a complex business valuation exercise especially if the business is transferred between related parties.
One quirk of family trusts is that they can only be maintained for a maximum period of 80 years, meaning a business in a family trust is difficult to pass down to the next generation.
Family trust shareholding
Another common use of a family trust is to hold the shares in your operating company of the business group. This is a feature of many SMEs and provides a wide range of benefits.
This type of shareholding structure takes advantage of the flexible tax options a family trust provides by allowing dividends and capital gains derived by the company shareholder (the family trust) to be distributed amongst some or all the members of the family group, while also give the tax and legal advantages of operating a business in a company structure. This arrangement effectively allows you to pay out profits of the company via dividends to any member of your family group without having to deal with different classes of shareholders and accompanying complex legal agreements.
The main drawback of this type of use is the higher complexity and compliance costs, as you will be required to maintain at least two different tax entities (a company plus a trust) in addition to your personal tax affairs.
Update
The taxation of trusts has recently been revised by the ATO (or rather, their views of) and this will have very significant tax implications on how families will need to consider their family trust arrangements. Read our article on this topic for our explanation on these changes and our views on what can be done to prepare.
We discuss in the next section about How should you manage the business’s taxes?
Thinking about other legal structures? Go back to our topic on Best structures for your business.
To discuss any taxation concerns you have regarding family trusts, please contact Director of Taxation, Paula Tallon at ptallon@prosperity.com.au or Manager of Taxation, Charles Yuan at cyuan@prosperity.com.au.
