Trusts are a fundamental element in the planning of business, investment and family financial affairs. Although trusts are commonplace, they are frequently misunderstood.
There are many examples of how trusts figure in everyday transactions:
- Shares are frequently held in trust by “nominees”
- Cash management trusts and property trusts are used by many people for investment purposes
- Joint ventures are frequently conducted via unit trusts
- Money held in accounts for children will generally involve trusts
- Superannuation funds are trusts
- Many businesses are structured as “trading trusts”
- Executors of deceased estates act as trustees
- There are charitable trusts, research trusts and trusts for animals
- Solicitors, real estate agents and accountants operate trust accounts
- There are trustees in bankruptcy and trustees for debenture holders
- Trusts are frequently used in family situations to protect assets and assist in tax planning
- There are some large companies established by statute which carry on business as trustee companies
- In short, trusts are everywhere and the purpose of this document is to assist an understanding of the nature of a trust, the role and obligations of a trustee, the accounting and income tax implications of trusts and some of the advantages and pitfalls in using or becoming involved in a trust structure. Of course, there is no substitute for specialist legal, tax and accounting advice when a specific trust issue arises and the general information given in this document needs to be understood in that context.
What is a trust?
This is probably the most misunderstood aspect of trusts. A frequently held, but erroneous view, is that a trust is a legal entity or person, like a company or an individual.
A trust is not a separate legal entity or person at all – it is essentially a relationship that is recognised and enforced by the courts in the context of their “equitable” jurisdiction. Not all countries recognise the concept of a trust, which is an English invention. While the trust concept can trace its roots back centuries in England, many European countries have no natural concept of a trust. However, as a result of trade with countries which do recognise trusts their legal systems have had to devise ways of recognising them.
The nature of the relationship is critical to an understanding of the trust concept. In English law the common law courts recognised only the legal owner and their property, however, the equity courts were willing to recognise the rights of persons for whose benefit the legal holder may be holding the property.
Put simply, then, a trust is a relationship which exists where A holds property for the benefit of B. A is known as the trustee and is the legal owner of the property which is held on trust for the beneficiary B. The trustee can be an individual, group of individuals or a company. There can be more than one trustee and there can be more than one beneficiary. Where there is only one beneficiary the trustee and beneficiary must be different if the trust is to be valid.
The courts will very strictly enforce the nature of the trustee’s obligations to the beneficiaries so that, while the trustee is the legal owner of the relevant property, the property must be used only for the benefit of the beneficiaries. Trustees have what is known as a fiduciary duty towards beneficiaries and the courts will always enforce this duty rigorously.
The nature of the trustee’s duty is often misunderstood in the context of family trusts where the trustees and beneficiaries are not at arm’s length. For instance, one or more of the parents may be trustees and the children beneficiaries. The children have rights under the trust which can be enforced at law, although it is rare for this to occur.
Types of trusts
In general terms the following types of trusts are most frequently encountered in asset protection and investment contexts:
- Fixed trusts
- Unit trusts
- Discretionary trusts
- Bare trusts
- Hybrid trusts
- Testamentary trusts
- Charitable trusts
- Superannuation trusts
A common issue with all trusts is access to income and capital. Depending on the type of trust that is used, a beneficiary may have different rights to income and capital. In a discretionary trust the rights to income and capital are usually completely at the discretion of the trustee who may decide to give one beneficiary capital and another income. This means that the beneficiary of such a trust cannot simply demand payment of income or capital. In a fixed trust the beneficiary may have fixed rights to income, capital or both.
In essence these are trusts where the trustee holds the trust assets for the benefit of specific beneficiaries in certain fixed proportions. In such a case the trustee does not have to exercise a discretion since each beneficiary is automatically entitled to his or her fixed share of the capital and income of the trust.
These are generally fixed trusts where the beneficiaries and their respective interests are identified by their holding “units” much in the same way as shares are issued to shareholders of a company. The beneficiaries are usually called unitholders. It is common for property, investment trusts (e.g. managed funds) and joint ventures to be structured as unit trusts. Beneficiaries can transfer their interests in the trust by transferring their units to a buyer. There are no limits in terms of trust law on the number of units/unitholders, however, for tax purposes the tax treatment can vary depending on the size and activities of the trust.
These are often called “family trusts” because they are usually associated with tax planning and asset protection of family members. In a discretionary trust the beneficiaries (who are sometimes referred to as “objects”) do not have any fixed interests in the trust income or its property but the trustee has a discretion to decide whether any of them is to be entitled to income or capital and, if so, to how much.
For the purposes of trust law, a trustee of a discretionary trust could theoretically decide not to distribute any income or capital to a beneficiary, however, there are tax reasons why this course of action is usually not taken. The attraction of a discretionary trust is that the trustee has greater control and flexibility over the disposition of assets and income since the nature of a beneficiary’s interest is that they only have a right to be considered by the trustee in the exercise of his or her discretion.
Where there is only one trustee, one legally competent beneficiary and no specified obligations, the beneficiary has complete control of the trustee (or “nominee”) and this is known as a bare trust. A common example of a bare trust is a nominee shareholding – where the shareowner holds shares on behalf of someone else who does not want to be identified.
These are trusts which have both discretionary and fixed characteristics. The fixed entitlements to capital or income are dealt with via “special units” which the trustee has power to issue.
As the name implies, these are trusts which only take effect upon the death of the testator. Normally, the terms of the trust are set out in the testator’s will and are often established where the testator wishes to provide for their children who have yet to reach their adulthood or are handicapped.
These Trusts provide a vehicle for the establishment of philanthropic Trusts that are allowed concessional taxation treatment and deductions to taxpayers for gifts to such Trusts.
We offer Deeds for two kinds of Charitable Trusts:
- Private Charitable Foundation - this type of Trust is a private charity which is not required to seek donations from the public or be controlled by a committee a majority of whom have a degree of responsibility to the general community. It can have one Trustee or a committee of Trustees provided the Trustee or one of the Trustees is a person who has a general responsibility to the community and is not associated with the founder or a major donor. This Trust must only distribute money, property or benefits to charities which have deductible gift recipient status or to establish such recipients. These Trusts are called Prescribed Private Funds.
- Charitable Trusts with Gift Deductible Status - this type of Trust is a public charity which is required to seek donations from the public. There are strict requirements for such a Trust to obtain and maintain Gift Deductible Status. It must be established for genuine charitable purposes within Australia. The Trustee must be a committee of persons a majority of whom have a general responsibility to the community or a company the directors of which satisfy that requirement (a committee or board of at least 5 is recommended). Application must be made to the Australian Tax Office (ATO) for approval as a Gift Deductible Recipient. These Trusts are called Public Charitable Trusts.
All superannuation funds in Australia operate as trusts. The deed (or in some cases, specific acts of Parliament) establishes the basis of calculating each member’s entitlement, and sometimes the contributions that have to be made for a member, while the trustee will usually retain discretion concerning such matters as the fund’s investments and the selection of a death benefit beneficiary. The Federal Government has legislated to establish certain standards that all funds (for which tax concessions are sought,) must comply (and which are called “complying funds”). For instance, the “preservation” conditions, under which a member’s benefit cannot be paid until a certain qualification has been reached (such as reaching age 65), are a notable example.
Instalment Warrant Trusts (Superannuation)
Self Managed Superannuation Funds now have the ability to borrow funds from financial institutions and others under an instalment warrant arrangement.
The transaction between the Financial Institution and the Trustee of the Superannuation fund is conducted by way of the establishment of a second Trust Deed with an independent Trustee. This Deed (Entity) is the mechanism for the borrowing facility with the Financier.
Establishing a trust
Although a trust can be established without a written document, it is preferable for it to be evidenced by a formal deed known as a declaration of trust or a deed of settlement. The declaration of trust involves an owner of property declaring themselves as trustee of that property for the benefit of the beneficiaries. The deed of settlement involves an owner of property transferring that property to a third person on condition that they hold the property on trust for the beneficiaries.
The person who transfers the property in a settlement is said to “settle” the property on the trustee and is called the “settlor”.
In practical terms, the original amount used to establish the trust is relatively small, often only $10 or so. More substantial assets or amounts of money are transferred or loaned to the trust after it has been established. The reason for this is to minimise stamp duty which is usually payable on the value of the property initially affected by the establishing deed.
The identity of the settlor is critical from a tax point of view and it should not generally be a person who is able to benefit under the trust, nor be a parent of a young beneficiary. Special rules in the tax law can affect such situations.
Also critical to the efficient operation of a trust is the role of the “appointor”. This role allows the named person or entity to appoint (and usually remove) the trustee, and for that reason, they are seen as the real controller of the trust. This role is generally unnecessary for small superannuation funds (those with fewer than five members) since legislation generally ensures that all members have to be trustees
The trust fund
In principle the trust fund can include any property at all – from cash to a huge factory, from shares to one contract, from operating a business to a single debt. Trust deeds usually have wide powers of investment, however, some deeds may prohibit certain forms of investment.
The critical point is that whatever the nature of the underlying assets, the trustee must deal with the assets having regard to the best interests of the beneficiaries. Failure to act in the best interests of the beneficiaries would result in a breach of trust which can give rise to an award of damages against the trustee.
A trustee must keep trust assets separate from the trustee’s own assets.
The trustee’s liabilities
A trustee is personally liable for the debts of the trust as the trust assets and liabilities are legally those of the trustee. For this reason if there are significant liabilities that could arise, a limited liability (private) company is often used as trustee.
However, the trustee is entitled to use the trust assets to satisfy those liabilities as the trustee has a right of indemnity and a lien over them for this purpose.
This explains why the balance sheet of a corporate trustee will show the trust liabilities on the credit side and the right of indemnity as a company asset on the debit side. In the case of a discretionary trust it is usually thought that the trust liabilities cannot generally be pursued against the beneficiaries’ personal assets, but this may not be the case with a fixed or unit trust.
Powers and duties of a trustee
A trustee must act in the best interests of beneficiaries and must avoid conflicts of interest. The trust deed will set out in detail what the trustee can invest in, the businesses the trustee can carry on and on. The trustee must exercise powers in accordance with the deed and this is why deeds tend to be lengthy and complex so that the trustee has maximum flexibility.
Who can be a trustee?
Any legally competent person, including a company, can act as a trustee. Two or more entities can be trustees of the same trust.
A company can act as trustee (provided that its constitution allows it) and can therefore assist with limited liability, perpetual succession (the company does not “die”) and other advantages. The company’s directors control the activities of the trust. Trustees’ decisions should be the subject of formal minutes, especially in the case of important matters such as beneficiaries’ entitlements under a discretionary trust.
All states and territories of Australia have their own legislation which provides for the basic powers and responsibilities of trustees. This legislation does not apply to complying superannuation funds (since the Federal legislation overrides state legislation in that area), nor will it apply to any other trust to the extent the trust deed is intended to exclude the operation of that legislation. It will usually apply to bare trusts, for example, since there is no trust deed, and it will apply where a trust deed is silent on specific matters which are relevant to the trust – for example, the legislation will prescribe certain investment powers and limits for the trustee if the deed does not exclude them.
Income tax and capital gains tax issues
Because a trust is not a person, its income is not taxed like that of an individual or company unless it is a corporate, public or trading trusts as defined in the Income Tax Assessment Act 1936. In essence the tax treatment of the trust income depends on who is and is not entitled to the income as at midnight on 30 June each year.
If all or part of the trust’s net income for tax purposes is paid or belongs to an ordinary beneficiary, it will be taxed in their hands like any other income. If a beneficiary who is entitled to the net income is under a “legal disability” (such as an infant), the income will be taxed to the trustee at the relevant individual rates. Income to which no beneficiary is “presently entitled” will generally be taxed at the flat rate of 47% and for this reason it is important to ensure that the relevant decisions are made as soon as possible after 30 June each year and certainly within 2 months of the end of the year. The two month “period of grace” is particularly relevant for trusts which operate businesses as they will not have finalised their accounts by 30 June. In the case of discretionary trusts, if this is done the overall amount of tax can be minimised by allocating income to beneficiaries who pay a relatively low rate of tax.
The concept of “present entitlement” involves the idea that the beneficiary could demand immediate payment of their entitlement. It is important to note that a company which is a trustee of a trust is not subject to company tax on the trust income it has responsibility for administering.
In relation to capital gains tax (CGT), a trust which holds an asset for at least 12 months is generally eligible for the 50% capital gains tax concession on capital gains that are made. This discount effectively “flows” through to beneficiaries who are individuals. A corporate beneficiary does not get the benefit of the 50% discount. Trusts that are used in a business rather than an investment context may also be entitled to additional tax concessions under the small business CGT concessions.
Since the late 1990s discretionary trusts and small unit trusts have been affected by a number of highly technical measures which affect the treatment of franking credits and tax losses. This is an area where specialist tax advice is essential.
Why a trust and which kind?
Apart from any tax benefits that might be associated with a trust, there are also benefits that can arise from the flexibility that a trust affords in responding to changed circumstances.
A trust can give some protection from creditors and is able to accommodate an employer/employee relationship. In family matters, the flexibility, control and limited liability aspects combined with potential tax savings, make discretionary trusts very popular.
In arm’s length commercial ventures, however, the parties prefer fixed proportions to flexibility and generally opt for a unit trust structure, but the possible loss of limited liability through this structure commonly warrants the use of a corporate entity as unitholder, ie. a company or a corporate trustee of a discretionary trust.
There are strengths and weaknesses associated with trusts and it is important for clients to understand what they are and how the trust will evolve with changed circumstances.
Trusts which incur losses
One of the most fundamental things to understand about trusts is that losses are “trapped” in the trust. This means that the trust cannot distribute the loss to a beneficiary to use at a personal level. This is an important issue for businesses operated through discretionary or unit trusts.
The following procedures apply to a trust established by settlement (the most common form of trust):
- Settlor determined to establish a trust.
- Select the trustee. If the trustee is a company, form the company.
- Settlor makes a gift of money or other property to the trustee and executes the trust deed.
- Open a trust bank account.
- Establish books of account and statutory records and comply with relevant stamp duty requirements.
For discretionary trusts it is necessary to hold a formal meeting to establish the basis of distribution to beneficiaries prior to the close of the income tax year at midnight on 30 June each year. For this purpose it is desirable that preliminary accounts be prepared.
Annual accounts and tax returns need to be prepared If the trustee is a company, directors’ and annual meetings must be held and annual returns lodged.
Ensure that all investments, property transactions and significant decisions are documented and appropriate minutes prepared.
Should you decide you need a Trust, you should seek legal and financial advice to ascertain the most suitable trust for you. Whether you are considering Asset Protection and/or Estate Planning you must also consider Tax Planning prior to creation of the Trust as well as Duties implications.