Future Focus: Can you lower your tax rate with a trust?
Many higher income earners look at opening a trust to distribute income and lower their tax burden. Here’s what you need to consider before going down this path.
A large part of optimising your finances is engaging professionals when needed. A couple of years ago, my husband and I decided to engage with a tax professional to understand if there are better ways to structure our finances as we started to earn more as a household. We were getting pushed into higher marginal tax rates and wanted to plan for the future.
Surprisingly, the first question he asked us was, ‘When are you having kids?’.
It’s more common than you think for families with a high household income to set up trusts. Trusts allow a vehicle to minimise overall tax, by distributing income – and therefore tax obligations – across more individuals.
Tax is a significant drag on returns, but in most circumstances, unavoidable. There are different entities that you are able to invest as with their own tax obligations and rates.
One such structure is a discretionary trust. Trust structures can help redistribute income, and therefore tax obligations, amongst multiple people. The most common use of trusts is for families, where income from investments can be distributed to lower income earners.
As an example we can consider a scenario with four people in a trust. There are two high income earners on the highest marginal tax rate, and two individuals over 18 who are full time students with no income. The investment income redistributed across all trust members would result in a lower overall tax burden.
There are several scenarios where a trust may make sense. These include a single income household with two adults, or a situation where children or elderly parents are dependents and reliant on your income. If the dependents are over 18 and in a lower tax bracket a trust may be a way to share the tax burden and lower the overall taxes paid on any earnings.
Trusts must distribute income in the same year that the income was earned – it cannot be carried forward. If there’s undistributed income for the financial year, tax must be paid at the highest marginal tax rate. Although it can distribute income, at trust cannot distribute any losses. The only way that these losses can be distributed is by offsetting them against gains. These losses can be offset in the same year or carried forward to offset against future income.
Trusts can still utilise the 50% capital gains tax discount after holding an asset for 12 months.
The logistics of a trust
Trusts require management. They have a separate tax return and obligations to be managed and need to follow the rules and responsibilities that are set by the deed in the trust.
One thing to note is that the distribution of income is not tax effective to th
ose under 18 as they have different tax treatments. This has been purposefully set up to discourage minors from taking on trust distributions to lower tax burdens. For those beneficiaries that are under 18, the top marginal tax rate (45%) is imposed when they receive over $1,308 in a financial year.
When the beneficiaries are over the age of 18 and there’s a discrepancy between the marginal tax rates of the individuals, trust income can be redistributed to minimise aggregate tax payable on distributions.
Along with not being able to distribute any losses a trust also can’t distribute franking credits, if the trust receives them.
If the trust contains Australian equities that issue franking credits, it may be worth considering a Family Trust Election (“FTE”).
Family Trust Election ‘FTE’
An FTE is an election for a trust that sets boundaries on who can be in the trust in exchange for concessions. The family group may include spouses, parents, grandparents, siblings, children or nephews/nieces and the spouse(s) of all mentioned.
This election is primarily used to take advantage of benefits that are not available to a discretionary trust without the election. These benefits are primarily ones that a discretionary trust is not able to distribute franking credits and losses.
If any of the conditions of an FTE are violated, the trust may be liable for family trust distributions tax. It is always prudent to have a tax professional heavily involved in the management of a trust. There’s more information around FTE on the ATO website.
How much does a trust cost?
The costs for running a trust vary based on the complexity of the set up. As trusts must be maintained, you would pay for the services of a lawyer during initial set-up and any amendments to the trust in the future. You would also pay a tax professional for the annual filing and any maintenance.
A general guideline of the costs are below:
- Trust set up. According to McEwen Investment Services, the general cost to establish a trust is between $1,000 and $2,000.
- Maintaining the trust: Annual maintenance fees average around $1,500 to $2,500, mainly due to service costs.
Looking at these numbers, it is important to recognise that you would need a large base of assets to justify the costs for a trust.
What are the types of income that can be distributed?
Not all income is equal in the eyes of a trust. Your salary, importantly, cannot be split via a trust. It is limited to investment and business income.
Who might not suit a family trust?
There are a few reasons why a trust might not be right for you.
- Your only source of income is employment income. Also applies if your income from investments is minimal and isn’t enough to justify the flat fees to establish and maintain a trust.
- You are a sole income household and have no beneficiaries to split with.
- You have children under the age of 18 who have a high tax rate for income from trusts.
- You don’t want the burden of yearly administration and want to maintain a simple tax structure.
A trust might be worth considering for those who:
- Have a high marginal tax rate, will maintain a high marginal tax rate for the foreseeable future and generate considerable passive income that will justify the costs of the trust.
- Have children over the age of 18 that have little to no income. For example, university students.
- Have retired parents that are on low marginal tax rates and can receive extra income at this lower rate.
- You have a non-working spouse, or they are on a lower marginal tax rate.
What are the other options?
In certain circumstances, you may be able to get similar benefits without the added complexity and the flat fees incurred by a trust.
The first and simplest approach is to have joint ownership of assets. Doing so means that you are able to split the tax burden from income between multiple owners. It is assumed by the ATO that the tax obligations will be split equally. The ATO allows you to deviate from a 50/50 split if you can prove ownership. For example, if I contributed 30% of the initial capital to an investment and my husband contributed 70%, he can pay 70% of the tax obligation which leaves me with 30%.
You could also consider a company structure. I’ve written an article before on who this may suit.
Final thoughts
My husband and I are not establishing a trust. We don’t have the passive income from investments to justify it. Nor do we have the right circumstances with our family unit to justify the distribution advantage. I’ve chosen to focus on minimising taxes in ways that are within my control – investing in tax efficient investments and minimising turnover in my portfolio.
Ultimately, the fact that you are paying tax means that you are earning income. Tax is part and parcel of being a successful investor. Trusts may help some investors who derive considerable passive income from their investments. For others, it may be worth keeping to a simple structure and paying tax at their individual tax rate.
Ensure that if you are considering a family trust, you consider the implications in collaboration with a tax professional.
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