The tax office has put the spotlight on family trusts

Financial advisers have received fresh guidance from the tax office regarding family trusts — it’s time to review your arrangements.

Financial advisers have received fresh guidance from the Australian Taxation Office on family trusts — here’s what you need to know

In a timely reminder, as we approach the time where year-end affairs need to be finalised, the ATO message is surprisingly simple: get the basics right.

The problem though, is family trusts are governed by complex taxation law which often requires a skilled team of professionals to manoeuvre through the system.

One of the common areas where the ATO picks up mistakes centres around the trustee not making decisions in line with the directives set out in the trust deed. This is sometimes attributed to the trustee not checking the trust deed, while in other cases it is due to the deed being out of date.

Mark Molesworth, tax partner at BDO Australia, says: “The trust deed is like a rule book for the trustee. Trustees need to make sure that they comply with its requirements, and don’t do things that are not authorised.

“For example, when considering distributions, a trustee should ensure that they resolve to distribute in the correct form. The deed might specify that any resolution needs to be in writing and not distributed to an entity who is not entitled to receive a distribution.”

As you can see, it is prudent to have the family trust deed reviewed by a legal or tax professional every few years and apply necessary updates regarding law changes and best practice principles.

It is important to review your trust deed often and make changes where necessary.

Another area the ATO highlights for review is the communications provided to trust beneficiaries regarding distributions each financial year.

The ATO often sees beneficiaries reporting incorrect or missing trust distributions in their personal tax return.

The way the family trust declares who is getting what from the trust each year is via a ‘trustee resolution’. In addition to confirming the amount of income and gains each beneficiary is to receive through the distribution, the resolution also deals with administrative issues such as deed changes, trustee changes and other significant transactions.

If a valid trustee resolution is not in place by 30 June, the family trust runs the risk of all trust-taxable income for the financial year being taxed in the hands of the trustee at a rate of 45 per cent.

Consequently, it is useful to check if your family trust deed has a ‘default beneficiary’. In cases where there is a failure to distribute income via the trustee resolution process, the default beneficiary would be allocated all the trust’s taxable income, and the hope is the default beneficiary has a tax rate of less than 45 per cent.

Assuming a valid trustee resolution has been produced, a common strategy is to split family trust income between spouses in an attempt to spread the tax burden of the trust. In the past, children under 18 were also commonly used as beneficiaries.

Before the early 2010s, the tax free threshold for minors was $3333 but this has now been reduced to $416, making it far less attractive to distribute family trust income to minors.

And, if you get it wrong and allocate more than $416 to a minor in a single financial year, the tax rate applied is between 45 to 66 per cent.

With such a sting, trustees tend to hold back distributions to children until they are 18, at which point they benefit from adult tax rates, allowing approximately $20,000 per year to be distributed to them without any tax payable and up to $45,000 with an effective maximum tax rate of 11 per cent.

Another common set-up in a family trust structure is to have what is known as a ‘bucket company’ as a beneficiary of the family trust.

Where all other beneficiaries are exhausted in terms of distributing tax effectively, a company is set up for the sole purpose of being a ‘beneficiary of last resort’.

The bucket company allows the family trust income to be distributed at a tax rate of between 25 to 30 per cent.

In terms of whether the bucket company picks up the lower 25 per cent rate which applies to companies with less than $50m turnover, or the higher 30 per cent tax rate, depends on several factors, including whether less than 80 per cent of the bucket company’s income came from passive income sources.

Molesworth explains the intricacies of working out the bucket company tax rate: “There’s a half day training session required to work out whether the proper tax rate is 25 per cent or 30 per cent. And a further hour’s add-on to determine the proper franking rate if that company then wants to pay a dividend — and no, the answer is not that they are always the same.

“This illustrates one of the ongoing frustrations of the Australian tax system. It is inordinately complex and that complexity falls mostly on those who can least afford it — those who are potentially eligible for concessions because of their smaller size.”

Known as reimbursement agreements, there are some exemptions under ‘ordinary family dealings’.

However, in situations where one person is distributed income on paper but another receives the benefit and if the main driver is to reduce tax it is likely to attract the scrutiny of the ATO under 100A provisions.

The new ATO guidance tells advisers overall, family trusts are a powerful vehicle for management of assets, tax planning and asset protection, but the complexities of managing a family trust can cost thousands in accounting and legal fees each year and also requires a significant amount of time to administer.

As an adviser I always recommend to err on the side of caution and engage expert accounting and legal advice to navigate the family trust rules and stay compliant, while still yielding the benefits of the structure.

James Gerrard is principal and director of Sydney financial planning firm www.financialadvisor.com.au