Why family trust tax arrangements might need some reform: Analysis

Family trusts have featured heavily as part of recent media reporting of the circumstances of two very high-profile families: the Rineharts and the Obeids. Of course, these are not the only families that have a family trust as part of their financial arrangements.

In recent times, the growth in the use of family trusts far outstrips the growth in the use of partnerships and companies (and sole traders). All four of these “vehicles” are used in family settings.

Most families with a substantial asset or assets or a business will act on advice from professionals. Accordingly, it is very unlikely that the faster rate of growth in the use of family trusts is the result of uninformed decision-making. (Nearly all family trusts are discretionary trusts.) There is no systematic data on what is motivating families to prefer using family trusts.

But, from even a quick glance at a small number of cases that have come before the tax tribunals, it is very clear that tax considerations feature very heavily in the choice of vehicle.

What is it about family trusts that makes them so attractive from a tax perspective? The short answer: the family tax liability is very likely to be lower when the family uses a family trust compared to the use of the sole trader, partnership or company. Why is this the case?

The central point is that with a family trust, the collective taxable income of the trust for a year can be allocated to family members (beneficiaries) so that the taxable income attracts the lowest rate(s) of tax possible. This is done by allocating income to family members who have the lowest income from other sources (e.g. 19-year-old full-time university student, a stay-at-home spouse).

After allocating the income tax “efficiently” to use up family members’ tax-free thresholds and low rate bands up to around 30%, any remaining income is often allocated to a family company (a so-called “bucket company”). The rate of tax for companies is capped at 30% and there is no Medicare levy.

The added advantage is that the allocation for one year does not lock in any allocations for subsequent years. This means that for a subsequent year, if a family member’s income profile changes, this can be taken into account in making the allocations for that subsequent year (e.g. a lower allocation to an over 18-year-old, who now has a full-time salary; a higher allocation to family member who has lost their job).

It should also be noted that these income allocations are valid for tax purposes even though the relevant family member has no entitlement to the capital that produced the income.

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