When and why a Discretionary Trust?
By Christine Wolfsbauer (Senior Associate) and Peter Bobbin (Managing Principal) Argyle Lawyers
What is a discretionary trust?
First and foremost it is a trust, which is a legal relationship whereby one party (the trustee) holds something (usually money, land and/or shares) for the benefit of another (the beneficiary/ies). A discretionary trust, which phrase is virtually interchangeable with the phrase family trust, is a trust where the trustee has discretion.
Discretion is the right or ability to make a judgment or decision. A discretionary trust therefore is one where the trustee, commonly a private family controlled company, enjoys the freedom to make choices over the control and allocation of assets and income, for the benefit of the beneficiaries. In Australia these conduct family businesses, hold equity interests in private enterprises and conduct private investment portfolios.
Testamentary trusts are very often discretionary trusts that have simply been created under a will and deceased estate.
Accountants, lawyers and financial planners get very excited by discretionary family trusts (testamentary or otherwise) because they see two major advantages; asset preservation and income tax distribution efficiency. Whilst undoubtedly true, the real advantage of the discretionary trust is the ability to achieve family flexible succession, it is a perfect estate planning tool.
It is prudent to consider implementing a sound asset protection strategy to accumulate and safeguard assets.
Assets owned by individuals are generally exposed to the risk of the person having a claim imposed upon them. For example, there may be personal financial exposure to creditors for having loans in their own names or having guaranteed the loan of others. Another example is exposure to legal actions being brought against them for negligence and breach of duty as company director. Assets owned by individuals can be made the subject of such claims brought against those individuals by the trustee in bankruptcy or by a plaintiff with a legal action.
A discretionary trust separates ownership from control. Ownership by the trustee for the beneficiaries of the family trust keeps assets out of harm’s way from any claims against a person. This is even where the person may, as director of the trustee company, control the trustee!
Subject to certain anti-avoidance rules, such protection is possible because beneficiaries of a discretionary trust generally have no entitlement to any of the assets of the trust nor to any income of the trust, unless the trustee exercises its discretion in their favour. This aspect of a discretionary trust makes it one of the most effective protection strategies. The way in which the trust is managed affects the extent to which asset protection is possible.
Current Australian tax laws recognise significant tax flexibility benefits for investment made through a discretionary trust structure compared with investment through a company, a traditional unit trust, or even as an individual.
A discretionary trust enables flexibility for income distribution among a defined class of beneficiaries, commonly structured around a family. Trustee income allocation decisions can have regard to tax-specific individual circumstances. Such 'income splitting' can effectively minimise overall family tax obligations if the trustee wisely chooses to distribute the trust income to the beneficiaries that have an unused tax-free threshold or a lower marginal tax rate. For instance, trust income may be paid to a wife who is on a lower tax rate or to a private company associated with the spouse. The way a trustee distributes income can be changed from year to year to reflect marginal rates for that year.
The discretionary trust flexibility commonly also allows distributing different classes of income to different beneficiaries (often called 'income streaming') to ensure that different tax treatment applied to different classes of income is best utilised, again, having regard to specific circumstances of the beneficiaries. Income streaming allows trustees to stream trust income including interest and dividends to appropriate beneficiaries so as to enjoy any relevant tax benefits such as lower marginal tax rates and capital gains tax (CGT) discounts. For instance, foreign tax credits can be appropriately utilised by resident individual beneficiaries with relatively high marginal tax rates, whereas net capital gains can be suitably allocated to beneficiaries with capital losses.
Other tax benefits include availability of the 50% CGT concession where capital gains are distributed to natural person beneficiaries; potential for application of the CGT small business concessions; and capacity for loans to be made to beneficiaries tax-effectively and with flexibility.
For every discretionary trust it is the trust deed that is critical, this is where its rules, powers and discretions are found.
Not all discretionary trusts work effectively. A properly designed discretionary trust contains the following features:
- Well-established trust deed followed by supporting documents to record activities of the trust
- Clearly drafted clauses describing flexible and appropriate trustee discretions and appointor powers
- Special clauses that offer a significant difference to the after tax financial position of beneficiaries
- Compliance with various Australian laws dealing with income tax, capital gains tax, bankruptcy, estate planning, companies and stamp duty
- Tailored to meet both short-term and long-term objectives
There are a number of choices to make when managing assets via a discretionary trust. Critical among these is proper trustee management and control. Having assets in a (family) discretionary trust (testamentary or otherwise) is just the beginning. Care and trust respect is needed otherwise the trust structure and the intended objectives will fail.
Future articles will look at the most common trust fails and how to fix these. Until then, trust the trust.
Originally published in EQUITY JUNE 2017