Sometimes discretionary or family trusts are included in a founder's personal tax situation to enhance tax planning & asset protection.
A discretionary trust gives the Trustee broad discretion. Aside from the Trustee, there are several other roles within a Trust that must be understood.
What exactly is a discretionary trust?
An express trust is a type of discretionary trust (i.e. it is written rather than arising from conduct or a verbal declaration). It is referred to as a 'discretionary' trust because the Trustee has broad discretion to benefit any person who, from time to time, falls within the class of 'Beneficiaries' as defined in the deed, as well as additional discretion over the amount of income or capital that each person will receive when the trustee exercises its discretion.
A 'trust' is a legal relationship in which one party (the Trustee) holds trust property for the benefit of others (beneficiaries). Certain rights, obligations, and powers are attached to the trust property and can only be exercised for the ultimate benefit of the beneficiaries. Trust law evolved from feudal England, where trusts known as "uses" were commonly used to reduce royal taxation on agricultural land while also ensuring succession and control over land through successive generations.
As a result, a 'trust' is not a separate legal entity. Rather, it is a relationship, and the Trustee is the person or persons who enter into transactions with other parties and manage the trust property.
The Trustee holds the legal title to the trust's cash and other assets, as with any trust estate. The trust can only function through the trustee, who can be one or more natural persons or a company that has agreed to serve as trustee of the trust.
Settlor's Roles in a Discretionary Trust
The 'settlor' is the party who transfers the settled sum (typically $10, $20, or $50) to the Trustee in exchange for the trust powers and obligations outlined in the trust deed. There is no initial trust property and no trust estate without the settled sum. The settlor is not a beneficiary under this trust deed (see the deed's definitions of 'Beneficiaries' and 'Excluded Persons'). The main risk of a relative acting as settlor rather than an independent person such as your accountant or financial planner is that distributions may be made to a related trust or company in which the Trustee assumes the settlor has no interest (see definitions of 'Eligible Corporation' and 'Eligible Trustee,' but more importantly paragraph (d) of the definition of 'Excluded Persons'). In fact, if the settlor has an interest in the related trust or company, the trustee's distribution will be invalid. The Australian Taxation Office ('ATO') may treat an invalid distribution (i.e. one that violates the terms of the trust deed) as a distribution of income to which no beneficiary was 'presently entitled'. In that case, the ATO would assess the Trustee as liable to taxation on the distribution amount at the penal tax rate of 45% under section.99A of the ITAA 1936.
It is recommended that the settlor be an independent person, such as an accountant, financial planner, or family friend, to avoid any accidental distributions.
Trustee
The trustee is the person who is legally responsible for following the terms of the trust deed, investing trust property or running a business, distributing income or capital to beneficiaries, and otherwise administering the trust (e.g. taxation returns, financial statements, entering into transactions such as leases or contracts to borrow or acquire property). The trustee can be either an individual or a corporation.
Although any conduct of the trustee that is authorized by the trust deed will lawfully allow the trustee to be indemnified out of trust property, any conduct that is fraudulent or intentionally undertaken in bad faith may result in damages being payable by the trustee in favor of beneficiaries (see clauses 7.10, 7.11, 7.12 and 7.13). Furthermore, a natural person trustee or trustees who conduct a business may be liable for any shortfall arising from a legal claim against the trustee (for example, a default judgment for $10,000 but the trust's assets are only $8,000, leaving a shortfall of $2,000 after indemnification of the trustee).
If you are particularly concerned about liability, you should consider using a corporate trustee, especially if the trust is to conduct business or enter into major transactions, such as borrowing large sums from a bank to make investments or acquire real estate. As a general rule, the company acting as trustee will be liable for any shortfall, and if the company has no other assets, the personal assets of the directors cannot be resorted to by the trust's creditor (provided the corporate trustee acted within its powers and there is no fraud or breach of trust involved) (see s.197 of the Corporations Act 2001).
A personal trustee is simpler in nature, requiring only a tax return for the trust itself, whereas a corporate trustee will require you to complete a tax return for the trust as well as a tax return and ASIC returns for the company trustee.
Beneficiaries
The range of people who the Trustee may decide to benefit is referenced in the trust deed around the identity of the 'Primary Beneficiaries.' The Primary Beneficiaries are the people named in Schedule 1 of the deed, who are usually the parents and their children. The definition of 'Beneficiaries' then broadens the class to include relatives of the Primary Beneficiaries, legal personal representatives of deceased beneficiaries or trustees of trusts established under a deceased beneficiary's Will, eligible corporations, eligible trustees, income tax-exempt charities, deductible gift recipients, and any person added to the class by the Trustee with the Appointor's consent.
Appointor/s
The appointees are those named in Schedule 1. (or them plus their nominated successors or otherwise any person who they pass the role of appointor onto via a deed of succession of appointor). Because they have the authority to remove the trustee and appoint a new trustee, the appointor has complete control over the trust estate. Certain acts of the Trustee, such as advancing trust property to a beneficiary prior to the termination of the trust and varying the trust deed by a deed of variation, also require the appointor's consent.
Appointors are usually also Primary Beneficiaries, but for strategic reasons, an independent appointor such as your accountant, solicitor, or a family friend may also be an appointor. When there is more than one appointor, the deed requires that decisions be made by majority (for an odd number of appointors) or unanimously (for an even number of appointors). If a dispute arises, the deed includes a dispute resolution process (see clause 9.11 of the deed).
Why Should You Use a Discretionary Trust?
Using a discretionary trust has tax advantages, family succession advantages, and asset protection advantages. Discretionary trusts are frequently used to hold significant family assets, such as a family farm, to hold investment assets that generate consistent income streams, and to run a business.
The tax advantages are that overall income taxation (e.g., dividends, interest, rent, or business income) can be reduced by distributing trust income among family members who have lower marginal tax rates than, say, a high net wealth Primary Beneficiary. This is due to the fact that, under Division 6 of the Income Tax Assessment Act 1936 (Clth) ('ITAA 1936'), net income is taxed to the specific beneficiaries who become 'presently entitled' through the trustee's exercise of discretion and at their own marginal tax rates. Only if the Trustee fails to exercise its discretion or exercises it incorrectly will the Trustee be subject to tax at the penalty tax rate of 45% under section.99A of the ITAA 1936.
Furthermore, a discretionary trust structure can be used to take advantage of the 50% general capital gains tax discount and the four types of small business capital gains tax reliefs (subject to careful planning and passing certain tests set out in Division 152 of the Income Tax Assessment Act 1997). (Clth).
Because of the nature of a trust at law, asset protection and succession advantages arise. Assets held in a purely discretionary trust are not beneficially owned by any specific beneficiary (unless that beneficiary has been made presently entitled to an amount of trust income or a specific asset has been vested absolutely in that beneficiary's name). A member of the beneficiary class has only equitable rights to ensure that the trust is operated properly in accordance with its terms and to be considered as an object for distribution by the trustee. As a general rule, a beneficiary who is sued by a third party and is nothing more than a whim of the trustee will not jeopardize the trust's assets. Furthermore, discretionary trust assets are not part of your personal estate when you die, and the trust's assets cannot be dealt with in your will (although your will may pass ownership of shares held in a corporate trustee). This may make putting key family assets into a discretionary trust prudent if you anticipate a testator's family maintenance claim after your death (although note that NSW has anti-avoidance rules designed to catch this strategy). More broadly, passing the role of appointor to your adult children can easily achieve family succession with some appropriate safeguards (such as having an independent appointor involved to ensure that your adult children operate the discretionary trust appropriately).
However, it should be noted that in family law proceedings, the court will generally disregard the above trust principles and will make a commonsense judgment as to whether a spouse controls the trust's assets (e.g., a family court may determine that a husband has control over the trust's assets and that the trust's assets should therefore be considered as a financial resource of the husband).
The Trust's Administration
A trust with natural person trustees must arrange for financial statements to be prepared each year, a trust tax return to be prepared and lodged with the ATO, various investment decisions to be made, and a determination of which beneficiaries are to receive income in each fiscal year.