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Discretionary Family Trust

Let's look at what is a "Discretionary Family Trust"

A Discretionary Family Trust is one of the most common small business structures in Australia. Unlike, say a Unit Trust, you establish a Discretionary Family Trust to benefit the members of a family. Discretionary Family Trusts provide families with a great deal of flexibility in sharing the tax burden among family members and protecting family assets.

The Discretionary Family Trust structure is useful if your family holds capital growth or income-generating assets. Some of the key attributes of the Discretionary Family Trust are:

  • It offers some protection from bankruptcy and insolvency
  • It is a relatively low cost and simple structure to use
  • It allows you to distribute income to family members who are on low tax rates
  • It allows you to "stream" income: you can distribute one type of income to one person and another type of income to another person

A Discretionary Family Trust can operate for up to 80 years.

Now, let's look at why the Discretionary Family Trust needs to be "CGT Complying"

In August 2002 all Family Trusts had to be amended. Otherwise you would automatically NOT be able to get the Capital Gains Tax Small Business Rollover relief. The relief reduces the CGT that your Discretionary Family Trust has to pay when it sells its business.

As Benjamin Franklin said hundreds of years ago, nothing is as certain as death and taxes. Even he could not have foreseen the amount of change that occurs in the tax system each financial year.

A company pays 30% tax. After $60,000 you pay tax at 48.5%. However, if you realise a capital gain then your highest rate may drop by half to 24.25% and then half again to 12.12%. Given CGT roll over relief, you may be able to get that rate down to zero. Super pays tax at 15% (10% when it sells CGT assets). This rate distortion in the tax system means that you have to plan ahead. Perhaps 2 generations ahead of yourself.

If you plan now with your Accountant, Adviser and Tax Lawyer then you choose your tax rate. If you purchase a family home, rental property or shares then make sure you discuss the purchase with your professionals.

The government is already aware that you want to change income into capital. Watch out for Part IV A of the Income Tax Assessment Act 1936 and amendments.

Business Vehicles

Be careful in which "vehicle" you buy a business or asset. You can run your business as a sole trader, partnership or through a company via a Discretionary Family Trust or Unit Trust or a combination of all the above.

You may buy a business in your own name. As things go well you may want to share the profits with your spouse to reduce tax. Later you may want to take on partners or gain the benefit of a family, unit and service trust.

Every time there is a change in the ownership the taxman will want to take his cut.

If you started your business from scratch then your "cost base" could well be nil. If you later sell or transfer the business, to say, a Discretionary Family Trust then you may pay capital gains tax on 100% of the value of the business. This can have devastating results.

Therefore, decisions made now could well affect the future value and flexibility of your business. One structure that you should discuss with your Accountant, Risk Adviser and Financial Planner is a Discretionary Family Trust.

Consider:

  • Discretionary Family Trusts
  • Superannuation and Self Managed Super Funds
  • Companies
  • Employee Share Plans
  • Owning assets in Partnerships and in your own name

How does a Discretionary Family Trust work?

Discretionary Family Trusts provide your Financial Planner, Risk Adviser and Accountant with a great deal of scope in sharing the tax burden around your family.

Consider Charles and Gianna

Charles and Gianna control (through a Discretionary Family Trust) a corner deli. They give themselves annual wages of $60,000 each. At the end of the year their accountant tells them the good news that in excess of wages they have made an additional $40,000. If either Charles or Gianna receives this as income they will have to pay tax on the $40,000 on the highest tax rate - not much fun for all that hard work.

Because they are in a Discretionary Family Trust they are able to distribute $20,000 to their 18-year-old son who is at school. The son gets all the tax benefits of an adult and pays tax at the lower tax rates. The remaining $20,000 Charles and Gianna can either distribute to their company (or from July 2001 keep in their Discretionary Family Trust). The company (and from July 2001 the Discretionary Family Trust) pays less tax than they pay themselves.

Who are the people you need to create a Discretionary Family Trust

You need:

  • the legal (in name only) owner - trustee
  • the person who hires and fires the trustee - Appointor or guardian
  • the assets (business or other assets, such as a home) - trust fund
  • the group of people who can benefit - beneficiaries

The trustee can be you and your spouse, just you or your company.

The power to appoint and dismiss the trustee is given to the Appointor (sometimes called guardian) of the trust. You can also appoint both yourself and your spouse as Appointors.

This is what a Discretionary Family Trust looks like:

  Trustee - yourself & spouse or your company  
Appointor - this person can sack the trustee on a whim. (If it was my Discretionary Family Trust I would be Appointor!)   Settlor this person gives you the first $10 to start the trust off. You never hear from the Settlor again. (Make the Settlor your Lawyer!)
  Trust Fund - the original $10 and every other asset you or other members put in the Discretionary Family Trust from time to time  
Beneficiaries or members Mum, Dad, children Uncle Harry, Mother in law Companies Other persons or classes of persons

But I don't want my mother-in-law or Uncle Harry to have any of my assets...

Don't worry. None of the beneficiaries can demand anything from the Discretionary Family Trust. It is the Trustee (acting under the advice of the Appointor) who decides who gets what. Therefore, your class of beneficiaries should be as wide as possible.

The beneficiaries presently are divided into 2 classes:

  • if you fail to work out who gets the income from the Trust in any financial year then the default beneficiaries get the income;
  • the remaining class of beneficiaries ("general" beneficiaries) receive income and capital amounts only as the trustee so directs.

It is proposed that after July 2001 that any income retained within the Discretionary Family Trust is taxed at the corporate rate of 30%. Any Discretionary Family Trust deed you contemplate should therefore contain the power to accumulate income and not distribute to the default beneficiaries.

Who can be the Settlor of the Discretionary Family Trust?

The Settlor should be your Financial Adviser, Accountant, Risk Adviser or Lawyer who starts the trust by putting an asset into it (usually $10). After the Discretionary Family Trust is set up, you transfer assets or funds to purchase assets into the trust.

A Settlor should never be a beneficiary; Income Tax Assessment Act (1936) section 102(1).

What happens if the Discretionary Family Trust goes broke?

The trustee of the trust is indemnified out of the assets of the trust. The beneficiaries of a trust are likewise personally indemnified. This means that should the family business find itself in difficulty with creditors, provided you have followed the advice from your Accountant, Adviser and Lawyer and you have signed no personal guarantees then it is possible that the only assets that can be called upon to pay these debts are those owned by the Discretionary Family Trust.

The trust can also limit the personal liabilities of individual members of the trust’s business. Properly set up, the business is not owned by the individuals, as in the case of a partnership; the business is owned by the trust for the benefit of it’s beneficiaries.

How long can a Discretionary Family Trust exist?

Like a company, a trust offers a greater degree of stability than a partnership because it is not dissolved on the death of a beneficiary or trustee. A trust can operate up to 80 years in Australia.

Can Discretionary Family Trusts avoid the death taxes such as Capital Gains Tax and Stamp Duty?

Scope exists to avoid or generation skip these death taxes. You do not own the Trust Fund. You only control the Trust Fund. When you die, the Trust Fund does not form part of your Estate under your Will. A person could have $800 000 worth of assets in their Discretionary Family Trust and yet die a pauper.

You have to be very certain about who you want to be in control of your Discretionary Family Trust after you and your children die. This Estate Planning is best carried out with your Financial Planner, Accountant, Risk Adviser and Lawyer working together with you.

Keeping income separate and updating the Discretionary Family Trust

Most pre 1992 Discretionary Family Trusts need to be amended to include "streaming provisions". This allows you to distribute one type of income to one person and another type of income to someone else. The income is distributed with reference to its source.

For example, you may want to distribute dividends with franked credits to a high income earning beneficiary. Similarly, you may want to distribute income subject to capital gains tax to a lower income earner.

In addition, many Discretionary Family Trusts need to be amended to include the power to accumulate income in line with the proposed July 2001 changes to the taxation of non-fixed trusts.

All trusts must be reviewed from time to time to make sure they are still up to date. If your circumstances change (for example, if you divorce) you should review all trust documents immediately.

How much stamp duty is paid on a Discretionary Family Trust?

Stamp duty is calculated on the original money settled. Usually $10 is given to the trustee by the Settlor. The stamp duty on $10 is $2.00 (for WA). (Each copy of the Discretionary Family Trust is an additional $2.00.) You usually get 2 copies of a Discretionary Family Trust deed: one for your professional adviser and one for yourself.

How do I obtain a Discretionary Family Trust for my family?

You can get a Discretionary Family Trust in 3 ways:

  1. Your Adviser, Accountant or Lawyer orders one for you through the Civic Legal FastTrack service.
  2. You order one online yourself through www.LawCentral.com.au
  3. Your Adviser, Accountant or Lawyer refers you for an appointment with one of our tax lawyers for advice. Our hourly rate is $440/hr (including GST).

Other ways to hold assets:

Hybrid Discretionary Trusts

Hybrid Discretionary Trusts combine many of the good features of both a Discretionary Family Trust and a Unit Trust.

Unit Trusts

Unit Trusts are similar to Discretionary Family Trusts but the income and capital are distributed exactly according to the units you hold in the Unit Trust.

Testamentary Trusts

Testamentary Trusts are more tax effective than any other entity. However, you have to die to get one - a bit of a sacrifice! The Three Generation Trust is generally the most advanced.

Self Managed Superannuation Funds

Check with your Adviser first. You generally need $250,000 - $300,000 in Super to make these pay their way.

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