A discretionary trust allows a Trustee broad discretionary powers. As well as the Trustee there are various other roles around a Trust that are important to understand too.
What is a discretionary Trust?
A discretionary trust is a type of express trust (i.e. it is written rather than arising from conduct or a verbal declaration). It is called a ‘discretionary’ trust because the Trustee has a broad discretion to benefit any person who from time to time fall within the class of ‘Beneficiaries’ as defined in the deed and a further discretion as to the amount of income or capital that each person will receive when the trustee exercises its discretion.
A ‘trust’ is a relationship recognised by law under which one party (the Trustee) holds trust property for the benefit of certain persons (beneficiaries). Annexed to the trust property are certain rights, obligations and powers which can only be exercised for the ultimate benefit of the beneficiaries. Trust law originates from feudal England, where trusts known as ‘uses’ were commonly used to minimise royal taxation upon agricultural land and to ensure succession and control over land through successive generations.
As such, a ‘trust’ is technically not a separate legal entity. Rather, it is a relationship and the Trustee is the person or persons who enter into transactions with other parties and manages the trust property held under the trust.
Like any trust estate, the legal title to the cash and other assets held under the trust is held by the Trustee. The trust can only operate via the trustee which may be either one or more natural persons or a company that has agreed to act as trustee of the trust.
Roles in a Discretionary Trust
Settlor
The ‘settlor’ is the party who gifts the settled sum (usually $10, $20 or $50) to the Trustee to hold it upon the trust powers and obligations contained in the trust deed. Without the settled sum there is no initial trust property and no trust estate. The settlor is excluded from being a beneficiary under this trust deed (see definitions of ‘Beneficiaries’ and ‘Excluded Persons’ in the deed). The main risk in having a relative act as settlor rather than an independent person such as your accountant or financial planner, is that distributions may be made to a related trust or company in which the Trustee assumes that the settlor has no interest (see definitions of ‘Eligible Corporation’ and ‘Eligible Trustee’ but more importantly paragraph (d) of the definition of ‘Excluded Persons’). In fact, if the settlor does have an interest in the related trust or company then the distribution by the trustee will be invalid. An invalid distribution (i.e. one which breaches the terms of the trust deed) may be treated by the Australian Taxation Office (‘ATO’) as being a distribution of income to which no beneficiary was ‘presently entitled’. In that case the Trustee would be assessed by the ATO as liable to taxation upon the distribution amount at the penal tax rate of 45% under s.99A of ITAA 1936.
To avoid any accidental distributions it is recommended that the settlor be an independent person such as an accountant, financial planner or family friend.
Trustee
The trustee is the person who at law is responsible for complying with the terms of the trust deed, investing trust property or conducting a business, making distributions of income or capital to beneficiaries and otherwise administering the trust (e.g. taxation returns, financial statements, entering into transactions such as leases or contracts to borrow or acquire property). The trustee can be either personal or a company trustee.
The role of trustee potentially carries personal liability because although any conduct of the trustee that is authorised by the trust deed will lawfully allow the trustee to be indemnified out of trust property, any conduct which is fraudulent or intentionally undertaken with bad faith could lead to damages being payable by the trustee in favour of beneficiaries (see clauses 7.10, 7.11, 7.12 and 7.13). Also, a natural person trustee or trustees who conduct a business could be liable for any shortfall arising under a legal claim against the trustee (i.e. example a default judgment for $10,000 but the trust’s assets are only $8,000 and so indemnification of the trustee still leaves a shortfall of $2,000).
If you are specifically concerned about liability you should consider using a corporate trustee, especially where it is proposed that the trust is to conduct a business or enter into major transactions such as borrowing substantial amounts from a Bank to make investments or acquire real property. This will mean, as a general rule, that the company acting as trustee will be liable for any shortfall and if the company has no other assets then the personal assets of the directors cannot be resorted to by the creditor of the trust (provided the corporate trustee was acting within its powers and there is no fraud or breach of trust involved) (see s.197 of the Corporations Act 2001).
Note that a personal trustee is simpler in nature with only a tax return required for the trust itself, whereas if you're using a corporate trustee you will to complete a tax return for the trust as well as complete a tax return and ASIC returns for the company trustee.
Beneficiaries
Under the trust deed the range of persons who the Trustee might decide to benefit is referenced around the identity of the ‘Primary Beneficiaries’. The Primary Beneficiaries are the persons specifically named in Schedule 1 of the deed and are usually mum and dad and their children. The definition of ‘Beneficiaries’ then extends the class of beneficiaries to include relatives of the Primary Beneficiaries, legal personal representatives of deceased beneficiaries or the trustees of trusts established under the Will of a deceased beneficiary, eligible corporations, eligible trustees, income tax exempt charities, deductible gift recipients and any person added to the class by the Trustee with the Appointor’s consent.
Appointor/s
The appointors are the persons named in Schedule 1 (or them plus their nominated successors or otherwise any person who they pass the role of appointor onto via a deed of succession of appointor). The appointor has ultimate control over the trust estate because they are empowered to remove the trustee and appoint a new trustee. The appointor’s consent is also required for certain acts of the Trustee such as advancing trust property prior to the termination of the trust to a beneficiary and varying the trust deed by a deed of variation.
The appointors are usually also the Primary Beneficiaries although sometimes for strategic reasons an independent appointor such as your accountant, solicitor or a family friend will also be an appointor. Whenever there is more than one appointor then the deed provides that decisions of the appointor must be made by majority (for an odd number of appointors) or unanimously (for an even number of appointors). Should a dispute arise then the deed contains a dispute resolution process (see clause 9.11 of the deed).
Why Use a Discretionary Trust?
There are taxation advantages, family succession advantages and asset protection advantages in utilising a discretionary trust. Discretionary trusts are often used to hold substantial family assets such as a family farm, to hold investment assets that produce regular income streams and to conduct a business.
The taxation advantages are that overall taxation upon income (e.g. dividends, interest, rent or business income) may be minimised by distributing trust income amongst family members who are on lower marginal tax rates than say a high net wealth Primary Beneficiary. This arises because under Division 6 of the Income Tax Assessment Act 1936 (Clth) (‘ITAA 1936’) taxation upon net income is taxed to the particular beneficiaries who become ‘presently entitled’ via the trustee’s exercise of discretion and at their own particular marginal tax rates. It is only if the Trustee fails to exercise its discretion or invalidly exercises its discretion that the Trustee will then be assessable to tax at the penalty tax rate of 45% under s.99A of ITAA 1936.
Further, the 50% general capital gains tax discount and the four types of small business capital gains tax reliefs can be utilised via a discretionary trust structure (subject to careful planning and the passing of certain tests set out in Division 152 of the Income Tax Assessment Act 1997 (Clth).
The asset protection and succession advantages arise due to the nature of a trust at law. Assets held in a purely discretionary trust are not owned beneficially by any particular beneficiary (unless a particular beneficiary has been made presently entitled to an amount of trust income or a particular asset has been vested absolutely in a beneficiary’s name). A member of the beneficiary class only has equitable rights to ensure that the trust is operated properly according to its terms and to be considered by the trustee as an object for a distribution. As a general rule then, a beneficiary who is sued by a third party and is no more than a mere object of the trustee’s discretion will not put any of the trust’s assets at risk. Also, discretionary trust assets do not form part of your personal estate when you die and your will cannot deal with the trust’s assets (although your will may pass ownership of shares held in a corporate trustee). This may make putting key family assets into a discretionary trust advisable where you expect that a testator’s family maintenance claim may be made after your death (although note that NSW has anti-avoidance rules designed to catch this strategy). More generally however, family succession with some appropriate safeguards (such as having an independent appointor involved to ensure that your adult children operate the discretionary trust appropriately) can be easily achieved by passing the role of appointor to your adult children.
It should be noted however, that in family law proceedings the court will generally ignore the above trust principles and will make a commonsense judgment as to whether a spouse controls the trust’s assets (e.g. a family court may determine that a husband has control over the trust’s assets and that accordingly the trust’s assets should be taken into account as a financial resource of the husband).
Administration of the Trust
A trust that has natural person trustees will have to arrange for financial statements to be prepared each year, a trust tax return to be prepared and lodged with the ATO and will need to make various investment decisions and a determination of which beneficiaries are to receive income in each financial year.
A trust that has a corporate trustee will have to undertake the above as well as paying any ASIC fees.