Family trust distributions explained

Summary

Discretionary trusts are a feature of many business structures in Australia and rightly so.  They provide fantastic flexibility and are a great tool for tax and estate planning.  However, they are complex and can be difficult to understand.

In this article we’ll try to provide some clarity on one important aspect: distribution of trust income. 

In Detail

A discretionary trust, also commonly referred to as a family trust, is a agreement (the trust deed) whereby a person or company (the trustee) is appointed to operate a business or manage investments for the benefit of others (the beneficiaries).

At the end of the income year, the trustee has the discretion (hence the name) to distribute the income of the trust to the beneficiaries in whatever proportions they think fit provided that any distribution is in accordance with the requirements set out in the trust deed.

The trustee may adopt a different distribution strategy each year and can include or exclude beneficiaries on a year-by year basis (there are some caveats to that of course).  Given the trustee has such broad discretion, trusts are an excellent structure for tax planning and estate planning purposes.

There are a few terms in the above comments so let’s clarify the important ones:

• Beneficiaries – Generally, the beneficiaries of a discretionary trust will be the family group (spouse, children, parents etc.) of the person that calls the shots as well as any other entities that are associated with that family group.
• Income – To determine what the income of each trust is you need to refer to the trust deed.  However, when we refer to the ‘income’,  this will generally be aligned with either the accounting profit or taxable income of the trust for the year.
• Distribution – The distribution creates the entitlement to the income of the trust. Distribution does not necessarily mean payment of cash and there is regularly a disconnect between the distribution and any actual payment to beneficiaries.

Let’s use a couple of examples to illustrate how discretionary trust distributions operate in practice.

Example 1

Assume Charlie operates a business of writing and licensing jingles through the Jingle Trust.  The beneficiaries of the Jingle Trust are Charlie, his brother Alan, his nephew Jake and his mother Evelyn.

At the end of the year, it is estimated that the Jingle Trust will have made a profit of $100,000 which is the income to be distributed.  Charlie, as trustee of the Jingle Trust resolves to distribute the income in the following proportions:

• $50,000 to Charlie
• $25,000 to Alan
• $20,000 to Jake
• $5,000 to Evelyn

Each of the beneficiaries will include the above income in their respective tax returns and will pay tax on the taxable component of the income.  Their tax liabilities will be dependent on their other income, amongst other things.

Charlie, as trustee, can then use the cash generated by the business operations to pay the beneficiaries their entitlement that was created from the distribution.

Example 2

Assume the same facts as above but in this case, Charlie has decided to use $20,000 cash of the business to buy a new piano which will be depreciated over time.  In this example, the Jingle Trust has still made a profit of $100,000 but only has $80,000 in cash.

Each of the beneficiaries will include their share of the $100,000 in their tax returns but will receive less cash.  As you can see, there is a disconnect between the cash payment and the income that the beneficiary is taxed on.  It’s important to understand that the amount included in the beneficiary’s tax return and the cash payments will often be different and you need to budget for tax liabilities based on the share of income not the cash payment.

The importance of tax planning

Tax planning is a vital exercise for all businesses to undertake, especially those utilising trusts within their structure.  A good tax planning process will:

• Estimate the amount of income to be distributed for the financial year.
• Identify the beneficiaries that will receive the income and estimate the resulting tax liability and other tax consequences of the distribution strategy.
• Allow the trustee to prepare the distribution resolution documentation prior to the end of the financial year.

Tax planning allows the trustee to identify the best distribution strategy for the year and plan for the tax liabilities that arise.  If you’re not undertaking annual tax planning, you should be!