Trusts have acquired an almost mythical status in the media in recent years as the tax planner’s tool par excellence. Whenever talk turns to so-called tax ‘rorts’, the use of family trusts is always right up there with negative gearing and superannuation tax concessions as ripe for reform.
But is this reputation as a tricky tax planning tool really deserved?
In truth, probably not.
For a start, trusts are certainly not a recent innovation. They have been a cornerstone of English estate planning law for centuries as a way for the wealthy to avoid death duties, and along the way, many of the concepts that we apply to their use in Australia have developed.
Chief among these is the ability to allocate the income of the trust to different beneficiaries based on the whim of the trustees, and to separately allocate the capital of the trust (the corpus) to a potentially quite different pool of beneficiaries.
These days trusts have many uses, but they have come to be seen as a cornerstone of family business planning, both in terms of the day-to-day operation of the business and in terms of providing a road map for business succession from one generation to the next.
The most commonly used trust structure – and also the most versatile – is the discretionary trust.
The trustees of the trust have absolute discretion to pay the income (and the capital) of the trust to any of the beneficiaries in whatever proportion they see fit.
For tax purposes, as we’ll see in a moment, this gives considerable flexibility and scope for planning, since the trust is basically 'looked through' for tax purposes and the beneficiaries pay tax on the income at their marginal rate.
What the trustees can’t do – at least if they are sensible – is retain the income within the trust (it will suffer a punitive rate of tax within the trust if they do).
On a day-to-day basis, the key reason why people use discretionary trusts as a business vehicle is that they give the trustee the power to 'stream' trust income from business activities between beneficiaries of the trust, typically members of the family.
To give a practical example of how that might work, if you’re a high-income earner who runs a professional services business through the trust, you might look to ensure that some of the trust income from the business is 'streamed' to family members with lower taxable incomes, who are hence taxed at lower rates.
Overall, the tax paid on the income of the trust derived from the business is therefore minimised.
Although firmly within the tax rules, this is nonetheless an area that the ATO constantly scrutinises for possible abuse, so it’s always worth talking to an accountant to make sure that you stay within the rules.
The other main benefit of using a trust is in succession planning. By locking business assets within the trust – and removing ownership from any particular family member – the potential is created for a smooth and tax-efficient transition from one generation to the next.
There’s no need to dispose of assets from the retiring family member to the successor (with the capital gains tax implications that might come with); the trust simply carries on, unaffected by the change of management.
Mark Chapman is the director of tax communications at H&R Block, and a former senior director of the ATO.