Trusts 101: What are they, and how do they work?

One of the big motivations for considering using a trust will be to protect assets. Property and other assets can be moved into a trust for protection from creditors, to maintain an estate until a beneficiary becomes old enough to have legal possession, or isolate valuable assets from a trading company that may be more exposed to litigation, for example.

Trusts, if set up in the right way, can help you legally minimise some tax liabilities. But it is a tricky area, and the taxman is always on the lookout to close perceived loopholes or an over-enthusiastic stretching of the scope for reducing tax. Specialised advice will go a long way.

The word used to name these types of arrangements – “trust” – is appropriate. A trust is a structure that separates control and legal ownership from beneficial ownership; so that at least one person and/or company agrees to hold and manage assets or property in a way that will benefit someone else (the beneficiary). A trust therefore is a formal structure for an obligation, where “beneficiaries” place their trust (in the sense of “confidence”) in the controller or holder of assets (called the “trustee”; again appropriate, as the receiver of their trust) to manage those assets for their eventual benefit.

You could almost liken a trust to a private jet. The jet is put under the control of a pilot, who is also the owner (the trustee) to fly the jet while carrying the passengers (beneficiaries) to a destination (when the trust ends, or is “vested”) where the cargo or luggage (assets and property) is unloaded and given to the passengers again. During the flight, the luggage and cargo is maintained in the best condition possible and the passengers may occasionally be offered food and drinks if the ticket contract allows it (the beneficiaries may be paid distributions from the trust). The pilot may also off-load some cargo at stopovers along the way.

Separate control from beneficial ownership

The structure of a trust allows a business or asset to be put into the hands of a third party (trustee) who is given legal control and has a duty to operate that business or manage these assets to benefit someone else (beneficiaries). This is known as a “fiduciary duty”.

There are various types of trusts. You can have a fixed trust, discretionary trust, hybrid trust, unit trust and many more, each with unique characteristics. A deceased estate is also a trust, being property and assets that are held and managed by the executor (the trustee) for those who will inherit them. Ask this office for more complete run-downs of each trust type.

Trusts can exist even without explicit intention by the parties to create a trust – it is the existence of the necessary relationship (like the deceased estate example) that forms a trust, not formalities. Having said that, modern trusts are generally governed by written trust deeds, that spell out how it is set up and the rules for its maintenance, the rights and obligations of all parties, and also how income from the trust’s assets is “distributed”.

Distributions and tax

A trust calculates its annual taxable income under the usual tax laws and then the trustee distributes and/or retains the income. Income that is distributed to beneficiaries will be treated as though the beneficiaries earned it directly and will be taxable at their own marginal rates. On the flip side, the trustee has to pay tax (on behalf of the trust) on any taxable income that is not distributed. Undistributed income is taxed at the top rate (including Medicare levy); currently 46.5% (but will be 47% from July 1, 2014, when the Medicare levy goes up). There are some cases where the trustee pays tax on behalf of a beneficiary, such as a child or a foreign resident.

When the trustee decides whether and how much to distribute to each beneficiary, the trustee should take into account each beneficiary’s financial, taxation and personal circumstances and distribute income in the way that best serves everyone. Of course, the trustee is restricted by the terms of the trust deed.

“Ownership” conundrums

Another spur for trust use may occur if means or asset tests for government benefits are likely to figure in your financial future. Trusts can help here with the re-allocation of legal ownership without completely letting go of enjoying the asset’s benefits of the asset.

The other side of asset protection is a consideration for inheritance. If a prime asset is “owned” by a trust, like for instance a house with pristine beach front, and the trust deed is specific in terms of selling and/or maintaining the beach house, future generations of the family will be able to enjoy the same asset and not have it sold off by some initial inheriting spendthrift relative.

There are many more variations not covered here, and much more regulation and considerations than can be covered in this newsletter. The area of trusts is a complex one, and anyone considering setting up their own trust is well advised to seek expert advice.