Using trusts to minimise tax burdens
High income earners use trust structures to distribute income and tax burdens across more individuals. Here’s how they work.
For investors, tax is one of the largest detractors from total returns. I ran a model on a $100,000 initial investment, with $1,000 additional investments every month, in 20 years (with returns reinvested). I would have $1,391,009 with a 10% p.a. return. Of course, this scenario completely ignores all the realities of investing – including the costs of tax.
For example, there are four people in a trust. There are two high income earners on the highest marginal tax rate, and two individuals over 18 who are full time students with no income. The investment income redistributed across all trust members would result in a lower overall tax burden.
If you’re in a situation where you may have a one income household or have children or elderly parents in a lower tax bracket that are reliant on your income, it may be a way to share the tax burden and lower the overall taxes paid on any earnings.
Trusts must distribute income in the same year that the income was earned – it cannot be carried forward. If there’s undistributed income for the financial year, tax must be paid at the highest marginal tax rate. Although it can distribute income, it cannot distribute any losses. The only way that these losses can be distributed is by offsetting them against gains. These losses can be offset in the same year or carried forward to offset against future income.
Trusts can still utilise the 50% capital gains tax discount after holding an asset for 12 months.
The logistics of a trust
Trusts require management. They have a separate tax return and obligations to be managed and it needs to follow the rules and responsibilities that are set by the deed in the trust.
It is also important to note that the distribution of income is not tax effective to those under 18 as they have different tax treatments. This has been purposefully set up to discourage minors from taking on trust distributions to lower tax burdens. For those beneficiaries that are under 18, the top marginal tax rate (45%) is imposed when they receive over $1,308 in that financial year.
When the beneficiaries are over the age of 18 and there’s a discrepancy between the marginal tax rates of the individuals, trust income can be redistributed to minimise aggregate tax payable on distributions.
Trusts also are not able to, as mentioned before, distribute any losses or franking credits, if the trust receives them.
If the trust contains Australian equities that issue franking credits, it may be worth considering a Family Trust Election ‘FTE’.
Family Trust Election ‘FTE’
An FTE is an election for a trust that sets a maximum range of beneficiaries. The family group may include spouses, parents, grandparents, siblings, children or nephews/nieces and the spouse of all mentioned.
This election is primarily used when the trust wants to take advantage of a few benefits that are not available to a discretionary trust without the election. These benefits primarily being the ones mentioned – being able to distribute franking credits and losses.
If any of the conditions of an FTE are violated, the trust may be liable for family trust distributions tax. It is always prudent to have a tax professional heavily involved in the management of a trust. There’s more information around FTE on the ATO website.
How much does a trust cost?
The costs for running a trust vary based on the complexity of the set up and regulations. As trusts are maintained, you would pay for the services of a lawyer during initial set-up and any amendments to the trust in the future. You would also pay a tax professional for the annual filing and any maintenance.
A general guideline of the costs are below:
- Trust set up. According to McEwen Investment Services, the general cost to establish a trust is between $1,000 and $2,000.
- Maintaining the trust: Annual maintenance fees average around $1,500 to $2,500, mainly due to service costs.
Looking at these numbers, it is important to recognise that you would need a large base of assets to justify the costs for a trust.
Ensure that if you are considering a family trust, you consider the implications in collaboration with a tax professional.
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