What is a Discretionary Trust? Pros and Consamir@propertytaxspecialists.com.au
A discretionary trust is a type of trust that 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.
So, in this blog post, we’ll explore some key pros and cons of discretionary trusts so you can make an informed decision about whether it’s right for your financial circumstances.
How Does a Discretionary Trust Work?
A discretionary trust is a legal agreement where one person (the trustee) 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 how to distribute the relevant income and/or capital amongst the beneficiaries.
The most common example of this type of structure is 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.
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, in most cases, trustees are 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 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 income according to each beneficiary’s 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 is obligated to pay. This is an attractive benefit 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 trust 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 beneficiaries has a capital loss.
For many Australians, setting up a discretionary trust gives them the ability to have more control over how their estate devolves after their passing. 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 is to be devolved amongst your spouse and children, they will 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 associated with transferring the assets.
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 don’t have access to trust assets unless 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.
Do Discretionary Trusts have Disadvantages?
Yes, as with any form of legal structure, discretionary trusts do carry disadvantages.
For instance, you’ll need to consider the following factors and weigh them up against the benefits we listed above, in light of your personal circumstances. This allows you to determine whether or not a discretionary trust is a beneficial financial structure for you and your family.
Capital 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 and therefore reduce 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, properties held within a trust don’t qualify for the 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 and asset protection and succession planning.
A discretionary trust is a legal arrangement in which the trustee has the power to decide who will get income from the trust property and when. The trustee can also decide how much income should be given to each beneficiary of the trust.
As a result, this type of trust structure is particularly appealing for families in Australia or business owners looking to set up 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 making any decisions based on 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.
For example, the team at Property Tax Specialists provides investors with expert advice, helping them to navigate complex tax laws and allowing them to get 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.
If you are unsure how to proceed with your portfolio and discretionary trusts, contact us today.
DISCLAIMER: This information has been prepared without taking into account your objectives, financial situation, or needs. Because of this, you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation, or needs.
Amir Ishak is a Limited Authorised Representative 1269908 of Merit Wealth Pty Ltd, Australian Financial Services Licence 409361, ABN 89 125 557 002