What is a Discretionary Trust?

A Discretionary Trust, sometimes called a Family Trust, is established by a Deed between the person who sets up the trust (settlor) and a Trustee. In a discretionary, or family trust, the Trustee has the power to choose at his or her own discretion whether any sum is to be paid to beneficiaries, and if so, how much.

The term Family Trust refers to a Discretionary Trust set up to hold a family's assets or to conduct a family business. Generally, they are established for asset protection or tax purposes.

The trustee is given the discretion to distribute trust income and capital among a nominated class of beneficiaries. The heads of a family are usually appointed as a trustee company's directors and in this way they are able to control the exercise of the trustee's discretionary powers.

Click here to view a diagram of a Discretionary Trust.

A Discretionary/Family Trust:

  • Is generally established by a family member for the benefit of members of the 'family group'
  • Can be the subject of a family trust election which provides it with certain tax advantages, provided that the trust passes the family control test and makes distributions of trust income only to beneficiaries of the trust who are within the 'family group'
  • Can assist in protecting the family group's assets from the liabilities of one or more of the family members (for instance, in the event of a family member's bankruptcy or insolvency)
  • Provides a mechanism to pass family assets to future generations
  • Can provide a means of accessing favourable taxation treatment by ensuring all family members use their income tax "tax-free thresholds".

A trust arises when the settlor gives/gifts property to the trustee to hold or invest on behalf of the beneficiaries.

  • A trust is not a legal entity and is recognised as a separate and distinct entity from its constituents
  • A Trust commonly involves three parties; the settlor, the trustee and the beneficiaries
  • The trust cannot sue or be sued
  • The trustee holds the legal title to trust property on behalf of the beneficiaries who hold the equitable interest
  • A trust is not permitted to continue indefinitely (generally have a life span of 80 years)
  • The death of a beneficiary does not affect the existence of the trust
  • Beneficiaries may assign their interest in the trust dependant on the settlor provisions

Benefits of Family Trusts

One of the key benefits of a family trust is that the trustee can distribute income earned by the trust (from the trust property) in any way they see fit, provided distributions are made to people who qualify as beneficiaries. They do not have to make trust distributions in any particular proportion or in the same proportions as they did in previous years.

A trust does not have to pay income tax on income that is distributed to the beneficiaries, but does have to pay tax on undistributed income. The trustee is free to distribute trust income to as many beneficiaries as possible, and in proportions that take best advantage of those beneficiaries' personal marginal tax rates. The beneficiaries then pay the tax on distributions made to them.

For example, if an adult beneficiary of the trust only receives income from a trust and has the benefit of the tax-free threshold (currently $6,000) for the year, the trustee could distribute part of the family trust's income to this person. The result is that the beneficiary will receive some income but may not have to pay tax if that amount is less than $6,000. If the distribution to the beneficiary exceeds his or her tax-free threshold, the excess amount will be taxed at the beneficiary's personal marginal tax rate.

Distributions received from a trust are not a special form of income, but instead forms part of a beneficiary's assessable income. If the beneficiary receives income from other sources in addition to distributions from the trust, all of the income will be taxed together.

Even if the beneficiary's income does exceed the tax-free threshold for a particular year, the rate of tax applied to the amount of the excess income over the tax-free threshold may be lower than for other beneficiaries because of the total income that these other beneficiaries already receive.

Undistributed income is taxed in the hands of the trustee at the top marginal tax rate for that taxation year, giving a strong incentive to family trusts to fully distribute the trust's income before the end of each financial year.

The trustee should also take care in relation to which beneficiaries are chosen to receive distributions, as penalty tax rates can apply to distributions made to minors.

A family trust has many other potential benefits, including avoiding issues such as challenges to the will following a death of a senior member of the family.

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