A trust is essentially where one entity (a person or company), known as the trustee, holds property on behalf of another person known as the beneficiary. The trustee is the one controlling the trust and the beneficiary is the one that benefits from it. Discretionary trusts are a type of trust where the beneficiary does not have a fixed interest in the trust’s assets. It only provides beneficiaries with an interest to compel the administration of the trust and it is only after the trustee decides to distribute the assets will a beneficiary have an interest in a trust.
Discretionary Trusts v Fixed Trusts?
A discretionary trust differs from a fixed trust as a beneficiary does not have a fixed entitlement and there is not a fixed amount of assets within the trust. Trustees are not restricted by prior arrangements and agreements governing the trust which occurs with fixed-trusts. This demonstrates the great flexibility and control a trustee will have over a discretionary trust as they can decide to whom they can distribute the trust’s assets and how much they will distribute.
Why Have a Discretionary Trust?
There are several benefits that may entice someone into establishing a discretionary trust.
Flexibility for the Trustee
A discretionary trust is an effective way to provide a trustee with flexibility in managing a trust. This is because the trustee has the discretion to change the arrangements of the trust at any time. They can reduce or increase the asset amount to be distributed or by remove or add beneficiaries of the trust.
A discretionary trust is also advantageous to a beneficiary as it protects their potential assets within the trust. This is because assets that are held by a discretionary trust are separate to the beneficiary’s assets. This means that any risks to a beneficiary’s assets will not impact on their interest in the discretionary trust. This is evidenced where a beneficiary is in liquidation and a creditor is seeking assets to repay debts they have incurred. Assets in the trust will be protected as the beneficiary is not the legal owner.
Income Tax Reduction
A discretionary trust can also allow for a reduced amount of payable tax as this type of trust does not require income tax. This is because a discretionary trust is neither an individual or company, therefore, it is not taxed like one. Instead, tax is determined by looking at who is entitled to the income of the trust by the end of the financial year. This only requires that a beneficiary pays tax for their share of the trust’s net income in accordance with their tax rate outlined by the Australian Taxation Office. Therefore, if a trustee is strategic, they will arrange to distribute the funds of the trust to beneficiaries with a lower income tax rate.
Additionally, discretionary trusts receive a 50% discount off their capital gains tax attached to any disposed assets. However, this discount is only given to beneficiaries who are individuals and not companies.
Downfalls of a Discretionary Trust
In light of the advantages above, it is important to be aware of the potential risks and downfalls that come with a discretionary trust.
Liability Over Loss
As the trustee is the legal owner of the assets held by the trust, they will be personally liable for any loss or debts incurred by the trust. However, a trustee can use the assets held by the trust to satisfy any debts and liabilities as they have a right over these assets in these circumstances.
It is important to understand that discretionary trusts are not meant to hold any profits made by assets within the trust. Therefore, profits should not be left in the trust by the end of the financial year otherwise a trustee will be responsible for paying the tax over those undistributed profits.
Setting up a Discretionary Trust
Discretionary trusts can be complex and as a result, costly to set up. Administrative costs to set up the discretionary trust could be more expensive than the value of the trust. This is because this process requires various steps with various application processes such as by applying for and acquiring an ABN and TFN for the trust, and identifying a settlor, appointor and beneficiary.
Weighing up these Pros and Cons
If a trustee is seeking flexibility in the arrangements of a trust, a discretionary trust is the best way to go. It affords asset protection barring creditors from accessing the assets held within the trust and provides for a lower income tax rate if a trustee strategies its beneficiaries accordingly. However, there are downfalls that come with a discretionary trust. A discretionary trust will only be most effective where someone has researched its suitability for their needs, therefore, further professional advice is recommended.
If you need assistance with a discretionary trust get in touch with us via the contact form or by calling 1300 337 997.