Trusts: Their use and their structure
A major motivation for the setting up of trusts is asset protection. Valuable property and other assets can be moved into a trust to isolate them from being exposed to litigation, for example, for protection from creditors, or to maintain an estate until a beneficiary becomes old enough to have legal possession.
The use of a trust to protect assets will allow you to:
- protect your financial interests as well as that of your spouse, children, siblings and other beneficiaries from unforseen risks and liabilities
- significantly reduce taxes by strategically planning the distribution of income, capital gains and assets to your beneficiaries
- manage your assets more effectively during your lifetime, and
- create a legacy when you’re no longer around and ensure your assets are passed on while minimising taxes and duties.
Separate control from beneficial ownership
A trust is simply an agreement whereby a person or company agrees to hold an asset for the benefit of others. The person who legally owns and controls the asset is known as the “trustee” and those who benefit are called the “beneficiaries”. The assets held in a trust can vary – from property, shares, a business and business premises to works of art and so on. The person who creates the trust sets out the specific terms about how these assets are to be managed and controlled in a document called the “trust deed”.
Assets that are transferred to, or bought for, a trust are not owned by the person concerned, but are owned by the trust and legally controlled by the trustee. However, one can control, via the wording of the trust deed, exactly how the assets are managed and how the investment earnings are dealt with and distributed among the beneficiaries. So regardless of what happens in one’s circumstances outside of the trust, these assets can usually be protected.
Another prompt to consider a trust structure 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 benefits of the asset.
Securing assets for inheritance purposes may also be a consideration when people think about setting up trusts. If a prime asset is owned by a trust, for example a house with pristine beachfront, 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 without fear of having to sell it off due to some spendthrift relative.
There are pitfalls and challenges in getting the trust structure right. Asset safety and taxation can sometimes be competing interests, and other trade-offs made to take advantage of a trust structure need to be considered. For instance, when selling your primary residence, one of the main requirements for this sale to be tax free is that it is held in your own name. This means trusts cannot generally sell a primary residence tax free.
But trusts can, if set up in the right way, help you legally minimise tax liabilities. 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 be invaluable.
Types of trusts
Trusts come in many shapes and sizes, and there is no “one size fits all”. The type of trust that will suit your purpose will depend on many factors particular to one’s circumstances. There are various types of trusts, such as a discretionary trust, hybrid trust, unit trust, a fixed 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.
However the three most common types of trusts are:
- discretionary trusts
- unit trusts, and
- hybrid trusts.
A discretionary trust is the most common type of trust used by families, small to medium size business owners, investors and many professional practitioners in Australia, mainly due to the flexibility they offer. Income can be allocated to beneficiaries at the trustee’s discretion — hence the name. They are generally set up to hold assets and/or a business for the benefit of providing asset protection and tax planning for family members.
From a tax perspective the main advantage is that income generated by the trust from business activities and investments, including capital gains, can be distributed to beneficiaries in lower tax brackets to significantly reduce taxes. And the distribution is discretionary, which means no beneficiary is automatically “entitled” to receive income or capital. So if, for example, one beneficiary is sued, the trustee can decide not to distribute income to that beneficiary. Assets can also be transferred from generation to generation duty free and with greatly reduced tax liabilities.
Other types of discretionary trusts are testamentary trusts, child maintenance trusts, property trusts, special disability trusts and charitable trusts.
These are trusts where the interests of beneficiaries are denominated by units, which can often be bought and sold in a way similar to trading in shares in a company. Unit trusts are used in many commercial arrangements, including managed investment schemes.
The number of units held determines one’s entitlement to a share of income, to capital gains and voting rights. Units in a unit trust can also be categorised. For example you can have income units and capital units. Also unit holders can be individuals, companies or discretionary trusts.
The taxation benefits are generally not as flexible as a discretionary trust in that any income distributions must be distributed to unit holders as per their share of units. However as a discretionary trust can be a unit holder, this arrangement can also achieve the same flow-through tax benefits.
From an asset protection point of view, unit trusts may not provide the same kind of asset protection as a discretionary trust. If a unit holder is made bankrupt, then that person’s units will be treated like any other assets and may be sold to raise funds to pay creditors.
A hybrid trust takes the best features of a discretionary trust and the best features of a unit trust and puts them into one. This means that the trustee has the discretion to distribute benefits to beneficiaries (some of whom may be on lower tax rates) as well as have unit holders who are absolutely entitled to a portion of the benefits.
A discretionary or hybrid trust can generally be a “family trust” for tax purposes if the trustee so elects, but distributions need to be restricted to members of a particular “family group” – only distributions outside this group will attract tax at the highest marginal rate (including Medicare levy).
There are a number of reasons to elect to become a family trust. Two key ones are that beneficiaries of discretionary trusts may not otherwise be able to take advantage of franking credits attached to share dividends received by the trust and passed on to the beneficiaries, and that the trust would otherwise find it a lot harder to use past year tax losses against current year income.
With a fixed trust, the beneficiaries’ entitlement to the trust property or income (or both), and the way in which this is fulfilled, is fixed by the trust deed. The trustee has no discretion to alter the prescribed entitlement of the beneficiaries. Very few trusts (if any) are wholly fixed because the trustee generally has some element of discretion.
A deceased estate is treated as a trust for tax purposes while being administered, with the executor or administrator of the estate taken to be the trustee.