Wed Jun 26

What are family trusts?

Written by: Jamie Thwin, PhD Student (Tax Law), Griffith University

This article is part of The Conversation’s “Business Basics” series where we ask experts to discuss key concepts in business, economics and finance.

Many of us associate trust funds with their depictions in popular culture – tools used by the mega-rich to distribute enormous family incomes among “trust-fund babies”.

Recently, they even went viral as the centrepiece of a TikTok audio ^[1] by user @girl_on_couch, who was famously “looking for a man in finance. With a trust fund. 6'5. Blue eyes.”

But trusts – which allow assets to be managed by one party for the benefit of others – are more widespread than many people realise.

And they’re not just for the super wealthy. In 2020-21, more than a tenth ^[2] of all Australians who lodged a tax return reported trust income.

Among the most common types of trust in Australia are family trusts, which are often designed to hold family assets or manage a family business. But their popularity has seen them regularly in the sights ^[3] of government and the tax office.

So what exactly are family trusts, and why are they so controversial?

First, what’s a trust?

A trust is a legal arrangement where a person nominated as a “trustee” manages assets for the benefit of another person or particular group of people. It isn’t a separate legal entity, but rather a kind of legal relationship.

A trustee is appointed to manage assets on behalf of others. Wasana Kunpol/Shutterstock ^[4]

A trust imposes what’s called an “equitable obligation” on its trustee to hold and manage trust assets according to specific conditions. These are set out in a “trust deed” for the explicit benefit of others, known as the trust’s “beneficiaries”.

The trustee acts as the legally appointed administrator of trust assets. But the beneficiaries still have what’s called “equitable interest” under the arrangement – certain rights to benefit from those assets.

Trustees can be individuals or companies. And many trusts include an “appointor” who has ultimate control. This appointor can appoint or remove the trustee at any time, and in many cases must consent to any changes in the trust deed.

What’s a family trust, and why do people use them?

In Australia, a family trust is a type of “discretionary trust”. Unlike a “fixed trust”, this means the trustee can make decisions about how assets and income are allocated among beneficiaries.

Family trusts are typically set up by a family member for the benefit of the family as a whole. A family trust deed can nominate multiple beneficiaries. These could include not only parents, children, grandchildren and other family members, but also other trusts and even companies.

Family trusts are often used to take advantage of their tax implications. This is because between years, trustees can vary the distribution of income among beneficiaries.

Any undistributed income left in the trust is taxed at the top marginal tax rate of 45%. But if distributed to beneficiaries with lower personal marginal tax rates, it is instead taxed at those rates, which can lower the total tax paid.

This explanation oversimplifies the picture, and there are a range of important caveats.

For example, if a beneficiary is non-resident of Australia for tax purposes, the trustee will be liable to pay tax on their behalf. And distributing trust income to beneficiaries aged under 18 can attract penalty taxes at the top marginal rate.

Closeup of woman handing cash to a child

There are rules in place that deter the use of young children as trust beneficiaries to lower tax. tomeqs/Shutterstock ^[5]

Why are they controversial?

Family trusts have attracted scrutiny from regulators and the public for a range of reasons – perhaps chief among them, this broad ability to lower taxation by splitting income.

The private nature of many trusts means there is often minimal public reporting, so it can be difficult to determine who in society is benefiting from trust income, and how. There are also concerns that they can be structured inappropriately to hide income.

Trusts can also help safeguard a family’s wealth by shielding a family’s assets from the liabilities of individual members. The beneficiaries of a discretionary trust generally have no legal entitlement to its assets.

This means that if the beneficiary goes bankrupt or gets divorced, the trust’s assets may often be protected from any claims.

In 2019, the Australian Taxation Office (ATO) released the findings of an independent review ^[7] into trusts and the tax system. Some key areas of concern include:

income tax shuffles (individuals exploiting differences in income definitions between trust law and tax law to dodge higher marginal tax rates)
using convoluted structures like circular trusts (two trusts that are beneficiaries of each other) to obscure trust income and who the ultimate beneficiaries are, and
trusts failing to lodge tax returns.

The use of trusts as a business structure in Australia may yet require further review.

This should not only seek to examine the legislation underpinning trusts, but also improve education for accountants to better understand trust and tax law.