Family Trust Elections
Family trusts may not be for Tax Law Purposes. Many High Net Worth Groups and smart business structures include Discretionary Trusts. Many Tax Agents often confuse or refer to these as “Family Trusts” simply because the Trust Deed includes the words “Family Trust” in the name and do not fully understand family trust elections. Even trusts which are called Family Trusts in their trust deed are not to be automatically assumed to be Family Trusts for the purpose of the tax laws.
What is a family trust election (“FTE”)?
FTE is a choice by a trustee to specify a particular individual (test individual) around whom a family group is formed. This family group then sets the maximum range of beneficiaries the trustee can distribute to without triggering significant adverse tax outcomes, such as family trust distributions tax.
The test individual is critical, as not all family members will be part of the ‘family group’ for tax purposes. Broadly, the family group includes:
– Test individual and their spouse (“test individuals”);
– Parent, grandparent, brother or sister of the test individuals;
– Nephew, niece or child of the test individuals, and any lineal descendants;
– Spouse of anyone mentioned above
Companies, partnerships and trusts can also be members of the family group, although this will generally only be where the family members listed above have an entitlement to all of the capital and income of the entity. Or where a FTE or interposed entity election (“IEE”) has been made.
It should also be noted that just because a person falls within the family group mentioned above, doesn’t mean that a distribution can be made to them. The trustee will still need to refer to the trust deed to ensure that the particular person or entity is an eligible beneficiary under the terms of the deed.
When should an FTE be made?
FTE restricts the people and entities to which a trustee can distribute in a tax effective manner so it is important to understand when an FTE may be required. If an FTE is not required, then there may be no benefit in making the election because once an election is made for a Discretionary Trust, it cannot be revoked with the test individual only allowed to be changed once within the same family group. A trustee may consider making an FTE for a Trust in the following situations:
– Receipt of franking credits;
– Trust has losses;
– Owns shares in a company with losses;
– Bringing the trust within the family group of another trust; or
– Trust is part of a restructure where the new small business restructure roll-over is accessed
If a discretionary trust has received a franked dividend, the franking credits can only be passed to beneficiaries if one of the following conditions is satisfied:
– The credits flow from shares acquired pre-31 December 1997; or
– The credits flow from post-31 December 1997 shares and the beneficiary an individual who does not receive more than $5,000 in franking credits from all sources during the year of income (small shareholder exemption)
– A trust which has made an FTE and is able to pass the 45 day holding period rule itself can pass the franking credits out to beneficiaries as part of their distributions
Trusts are subject to complex taxation measures which need to be passed before claiming tax deductible losses from prior income years. There are different tests that need to be passed depending on whether the trust is a fixed or discretionary trust.
Based on court decisions most trusts that clients and practitioners believe to be fixed trusts (such as unit trusts) may actually be non-fixed trusts for the purpose of the trust loss rules.
In the absence of a valid FTE, all of the following tests need to be satisfied by a discretionary trust to claim prior year tax losses:
– Income injection test;
– Control test;
– 50% stake test; and
– Pattern of distributions test
In practice, each of these tests is complicated and requires detailed analysis. Despite this, where an FTE has been made, the only test which needs to be satisfied is a modified version of the income injection test, which is much easier to satisfy than the standard income injection test.
As a common example, the standard income injection test is likely to be failed if a discretionary trust (with profits) distributes income to another discretionary trust in order to utilise its losses or deductions. In contrast, if both trusts have made an FTE choosing the same test individual, the income injection test would not apply to disallow the losses or deductions.
Shares in a company with tax losses
A company can carry forward and claim its losses against future income earned if it passes one of two tests:
– Continuity of Ownership Test (“COT”); or
– Same Business Test (“SBT”)
In order to pass the COT, shares carrying more than 50% of all voting, dividend and capital rights must be beneficially owned by the same persons at all times during the test period. The test period runs from the start of the loss year to the end of the income year.
The COT takes a look through approach where the shares in a company are owned by another company or a trust, in which case the ownership is traced through interposed entities back to the ultimate owners who are natural persons.
Where the shares in a company are owned by a discretionary trust, a company may not be able to pass the continuity of ownership test. This is because beneficiaries of discretionary trusts do not hold a specified interest in the trust and therefore it is not possible to trace through the discretionary trust to identify natural persons who indirectly hold an interest in the company.
While it may be possible to pass COT by undertaking a detailed analysis of whether the trust shareholder satisfies various loss tests, it will often be easier to pass COT where the trust has made an FTE. This is because a trust with an FTE can be treated as an individual for the purposes of assessing whether the COT is passed.
Bringing trusts into another family group
In some cases, it may be desirable to distribute from one discretionary trust to another discretionary trust. However, if a trust with profits has made an FTE, it can only distribute to another trust if it has also made an FTE with the same test individual.
Small business restructure roll-over
If a business is planning to restructure its operations, tax is often an important consideration. With effect from 1 July 2016, eligible small businesses may be able to restructure their operations in a manner which meets the requirements to access the small business restructure roll-over provisions. If these provisions are accessed, certain gains or losses which would otherwise be made for tax purposes can be disregarded.
One of the key eligibility requirements to access the new roll-over is that the restructure does not have the effect of materially changing the individual (or individuals) who have the ultimate economic ownership of the assets. Where a discretionary trust is involved, satisfying this aspect may not ordinarily be possible.
However, where the trust involved has made an FTE, the individuals within that family group can qualify as ultimate economic owners. Accordingly, where an FTE has been made, it could be possible to tax effectively restructure a small business into, or out of, a ‘family trust’ using these roll-over provisions.
Limitations of family trust elections
Given the above benefits, many practitioners would automatically lodge a FTE for clients without considering some of the limitations of a FTE:
– Payments outside the family group
– Family Distributions Tax
– Limitations to potential beneficiaries
These areas will be covered separately but should be considered prior to automatically lodging a FTE.
Where a discretionary trust receives franked dividends, has losses, or owns shares in a company with losses, the trustee should seriously consider whether it needs to make an FTE. A trust may also need to make an FTE to bring it within the family group of another trust that has made a FTE, or to access the new small business restructure roll-over.
Unless a FTE is needed for one of the reasons set out above, it is generally not recommended that a trustee make one as you cannot revoke this election.