What is a Discretionary Trust? Pros and Cons
A discretionary trust allows the trustee to exercise power over how income and assets are distributed. This can be a positive or negative aspect, depending on what you’re looking for in a trust.
In this blog post, we’ll explore some general key pros and cons of discretionary trusts so you can make an informed decision about whether they’re right for your circumstances.
How Does a Family Discretionary Trust Work?
A discretionary trust is a legal agreement in which the trustee (a person or company) holds and manages assets and trust capital on behalf of another person or people (the trust beneficiaries).
The difference between a discretionary trust and other types of trust structures is that the trustee exercises complete discretion regarding distributing the relevant income and/or capital amongst the beneficiaries as per the trust deed.
The most common example of this type of structure is a family trust.
In addition to asset protection, a family discretionary trust is often set up to distribute the net income and capital gains from investments between the beneficiaries.
Discretionary Trust vs Family Trust
While the terms ‘discretionary trust’ and ‘family trust’ are often used interchangeably, there are subtle distinctions between the two.
A discretionary trust is defined by the trustee’s power to decide how and when to distribute the trust’s income and assets among the beneficiaries.
On the other hand, a family trust is a type of discretionary trust specifically designed for family members. The primary purpose of a family trust fund is to protect the family’s assets and manage the distribution of income within the family unit.
Essentially, all family trusts are discretionary trusts, but not all discretionary trusts are family trusts.
What is a Discretionary Trading Trust?
A Discretionary Trading Trust is a specialised form of discretionary trust set up primarily to conduct a business. Unlike a traditional discretionary trust, which is often used for holding and distributing assets or investments, a Discretionary Trading Trust actively engages in trade or commerce.
The trustee can distribute the business income among the beneficiaries, allowing for tax-effective income distribution strategies. This type of trust provides the flexibility of income distribution in most cases while also offering the potential benefits of asset protection.
However, you need to understand that the assets and liabilities of the business are held within the trust. So, as with any trust structure, you should seek professional advice to ensure that a Discretionary Trading Trust aligns with your business goals and risk profile.
Characteristics of Discretionary Trusts: Trust Deed and Trust Property
Discretionary trusts are classified according to the following characteristics:
- The trustee (or trustees) can be an individual or a company (corporate trustee)
- Beneficiaries don’t have an automatic right to the property of the family trust
- The trustee is the legal owner of the assets held
- Depending on the deed, trustees are usually given complete discretion when it comes to distributing income and capital to the beneficiaries.
- While not recommended, minors can be named beneficiaries (although distributions to minors can be taxed up to 66%). In most deeds they will be included under a class of beneficiaries and not named.
What Are the Key Advantages of Setting Up a Discretionary Trust?
The flexibility that discretionary trusts offer means that there are plenty of advantages to using this type of structure for your family assets or business.
Tax Efficient Trust Income Distribution
Due to the nature of this type of discretionary trust structure, trustees can distribute income in a tax-efficient manner. For example, they can allocate funds according to each beneficiary’s income tax bracket.
The trustee can distribute most of the trust income amongst beneficiaries who fall under a tax bracket with lower marginal rates. This way, the trustee can legally minimise the amount each beneficiary must pay. This can be one of the attractive benefits for individuals looking to establish a family trust.
Another benefit of this structure is the 50% discount on capital gains tax. Where the property is held for longer than 12 months and is sold at a capital gain, the beneficiary may be eligible for a 50% capital gains tax discount, which can be streamed to the individual beneficiaries. For example, this may be advantageous where one of the eligible beneficiaries has a capital loss.
Estate Planning
For many Australians, setting up a discretionary trust gives them more control over how their estate devolves after their passing. This is particularly important in managing a deceased estate, where the trustee must act according to the intentions laid out in the will, which serves as the trust deed. By holding assets in a discretionary trust instead of in their personal names, they can legally minimise the hassle and cost of transferring them according to a Will.
For example, if your Will specifies that your property will be devolved amongst your spouse and children, they may ultimately be burdened by capital gains tax and stamp duty. But, if the assets are retained in a trust, the beneficiaries can continue to benefit from them without triggering the costs of transferring the assets.
Asset Protection
Because the assets are held within the discretionary trust for the benefit of the beneficiaries, they don’t legally own them. In other words, they belong to the trust, and the beneficiaries simply benefit from the trust income and gains generated.
This means that, in most cases, creditors may only have access to trust assets if the claim relates to debt within the trust.
However, it’s important to note that you should not establish a trust simply to defeat creditors and their rights, as there are laws and rules that prohibit this.
Do Discretionary Trusts Have Disadvantages?
As with any form of legal structure, discretionary trusts carry disadvantages.
For instance, you’ll need to consider the following factors and weigh them against the benefits we listed above in light of your personal circumstances. This will allow you to determine whether or not a discretionary trust is a beneficial structure for you and your family.
Losses are Retained in the Discretionary Trust
Typically, if one of your assets were negatively geared (i.e. running at a loss), the ATO would allow you to offset the loss against your other income. In other words, you can deduct the loss from your assessable income, reducing your tax obligations.
Unfortunately, the same concession doesn’t apply to assets held within a trust. As a result, should one of the assets run at a loss, you can’t use it to offset a beneficiary’s taxable income. Instead, the loss is “trapped” inside the trust until it generates enough income to cover the loss. So, only profits are distributed to beneficiaries, not losses.
You May Miss Out on the Land Tax-Free Threshold
In some states and territories, such as New South Wales and Victoria, property held within a trust doesn’t qualify for a land tax-free threshold. But if you are paying land tax anyway, then this is a moot point.
Cost to Set Up and Maintain
It’s always important to assess the costs of set-up and annual compliance against the benefits gained from tax planning, asset protection, and succession planning.
How to Set Up a Discretionary Trust
Setting up a discretionary trust involves a few key steps.
First, decide on the trust’s purpose and identify the beneficiaries. Next, draft a trust deed outlining the trust’s rules and appoint a trustee. Ensure you obtain a trust tax file number and, if necessary, register for GST.
Finally, open a bank account in the trust’s name and transfer the initial trust property or funds.
Remember, while these steps provide a basic overview, the process can be intricate. So, it’s best to ensure that you consult a professional to help you set up your trust.
Key Takeaways
- A discretionary trust is a legal arrangement in which the trustee can decide who will get income from the trust property and when.
- This type of trust structure particularly appeals to Australian families or business owners who want to establish a more tax-effective structure.
- There are pros and cons associated with choosing this type of trust, so you need to weigh up all options before deciding what might work best for your financial circumstances.
- It’s generally best to consult a financial advisor and qualified tax agent to help guide you in the right direction.
The team at Property Tax Specialists provides investors with expert advice, helping them navigate complex tax laws and achieve the best financial outcomes.
Our mission is to provide professional property tax advice, consulting and expertise in all areas of taxation and asset protection so that our clients can maximise their investment profits while legally minimising any tax liabilities.
Contact us today if you need help with how to proceed with your portfolio and discretionary trusts.
Disclaimer
Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to property buyers and investors. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal, tax or investment advice. You should, where necessary, seek your own advice for any legal, tax or investment issues raised in your affairs.
