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The Case for Family Trusts - Eureka Report Article

July 10, 2006
The Case for Family Trusts
By Scott Francis

PORTFOLIO POINT: Investing through a family trust gives people the flexibility, unlike superannuation, of accessing money before they reach a certain age.

Who can resist superannuation? Annual contributions are taxed at the low rate of 15%. The earnings of a superannuation fund are taxed at a maximum rate of 15% and, after age 60, all superannuation withdrawals are tax-free and now the Government is set to add further inducements. But sometimes you can have too much of a good thing.

Superannuation, either in a DIY fund or any other model, has one outstanding limitation: it cannot be accessed, except in extreme circumstances, until a person has reached their preservation age. For anyone born before July 1, 1960, the preservation age is 55; the age limit then "scales up" to a preservation age of 60 for anyone born after June 30, 1964.

This lengthy period of prohibition leaves many people with a planning issue they must address. Superannuation will be a tremendous investment environment to build wealth that will be available upon reaching preservation age, but what about financial goals in the interim ? important financial goals that may include:
  • Paying for children's education.
  • Providing help for young adult children as they move towards independence.
  • Retiring prior to the age at which superannuation can be accessed (most of my clients aged under 40 want to retire before they reach their superannuation preservation age of 60).
  • Taking time off to travel, to study or to pay for costs relating to an illness.

Meeting these goals takes some planning and, as good as superannuation is, will require money long before most people reach their superannuation preservation age. If the intention is to put aside and invest some of today's surplus cash flow to meet these goals, an important consideration is which investment environment should be used.

In the case of a couple, the simplest approach in the past has been to build an investment portfolio in the name of the partner with the lowest marginal tax rate. That way, the investment earnings are taxed at the lowest possible rate. The partner with the highest tax rate would tend to accumulate more superannuation so, at retirement, one partner had superannuation assets and the other had assets outside of superannuation, tending to even out the taxable income received.

Under the proposed superannuation changes, all superannuation withdrawals will be tax-free for people over the age of 60. This means that although the strategy of investing in the name of the partner with the lowest marginal tax rate will work well prior to retirement, at retirement they will end up with all of the taxable income for the couple in their name, as the superannuation withdrawals are tax-free.

As if to remind us of one of the alternatives, the Australian Taxation Office (ATO) issued a tax ruling (TR 2006/4) on June 28 relating to trusts, which provided some certainty about the ability of two identical trusts to transfer assets between them. We will look at this ruling later, but first it is worth considering some of the key characteristics of trusts that may make them useful in meeting the financial goals that people have prior to retirement.

What are trusts?

Trusts are separate entities that have the ability to hold investment assets. The trustee or trustees control the assets of the trust and make decisions about distributing its income and capital. The beneficiaries are those that are eligible to receive the distributions from the trust. Unlike a company where all shareholders of one class of share have to receive an equal dividend from a company, trustees have discretion to distribute income between the beneficiaries unequally. Most people would be most familiar with the term "family trusts", which are trusts that have made a specific election that the trust will serve family members.

Each year the trust is required to distribute all of its income. Often this is a distribution to beneficiaries on the lowest tax rate, who then pay tax on the income. If the income is not needed after being distributed it can be re-contributed to the trust.

This flexibility surrounding the distribution of income is what makes the trust a useful vehicle to meet the needs of a family over time. For example, let us consider a young family who wanted to:
  • Build some assets over a seven-year period.
  • Use the assets to fund their two children's education for the next seven years.
  • Provide support for their children who will then be aged between 18 and 25 over the following seven years.
  • Use their investment assets to help fund their retirement.

A trust could be used to hold the investment assets over the period in which assets were being built. Each year the income could be distributed to the member of the couple with the lowest tax rate and then re-invested in the trust. Similarly, over the next seven years income, and capital if needed, could be distributed from the trust to fund the education of their children.

The third stage, where the couple in question is supporting their young adult children, for example by paying some HECS and living expenses for the children, is where a trust can be particularly useful. Prior to the age of 18, only relatively small distributions of income can be made to children. This is because ATO rules allow very little "unearned" income for minors. (Taking into account the $235 low income tax offset, the most "unearned" income a minor can receive is $772.)

However, once a child has turned 18 income can be distributed to them at adult tax rates. That means the first $6000 of each distribution to each child would be tax-free, assuming that they don't earn any other income. Let's assume that a trust produces gross income of $12,000 in a year. This could be distributed tax-free to two adult children. (Conversely, if the assets of the trust were held in the name of one member of the couple with a tax rate of 31.5%, only $8220 would be available for distribution after paying tax.)

Finally, at retirement, the couple could split the distributions from the trust between themselves. That way they can each make use of their tax-free threshold, their 15% tax bracket and so on. This would complement the tax-free income that they would be able to access from their superannuation accounts from the age of 60.

People may ask why not invest in the name of the lowest tax payer prior to retirement, and then transfer the assets into joint names or superannuation at retirement? The problem with this is that the change in ownership will be seen as a "capital gains tax event", and so tax would have to be paid.

Trusts have the ability to access the 50% reduction on capital gains tax, which cannot be done through company structures. This provides a further ability for a trust to work well with the tax-advantaged superannuation environment, because assets in the trust showing only moderate capital gains may be sold close to retirement, taxed using the 50% discount on capital gains and then contributed to superannuation.

Of course, there are downsides to using a trust. Each year the income of the trust has to be distributed to beneficiaries. There is no ability to retain income although, in practice, income can be distributed to the beneficiary with the lowest tax rate, tax paid, and the remaining income re-invested in the trust. There are also costs involved with a trust including the setting up of the initial trust deed and the ongoing costs of tax returns and reporting.

Earlier we mentioned the ATO ruling last week that referred to trusts. The ruling allows assets to be transferred between trusts where the beneficiaries and terms of the trust are the same. The effect of this is that "it ensures that a transfer of assets between two trusts that have the same beneficiaries and terms is treated in the same way as a change of trustee of a single trust" (ATO TR2006/4). This will provide the ability for trusts to change trustees without having to pay capital gains tax on the assets of the initial trust.

There remains little doubt over the attractiveness of superannuation as an investment environment; however, it has almost no ability to meet your financial goals prior to you reaching your preservation age. A trust presents itself as a flexible investment vehicle for holding investment assets outside of superannuation that will allow:
  • The freedom to distribute income to any beneficiary of the trust.
  • The taxation of income at the lowest tax rate of any beneficiary.
  • Access to the 50% discount on capital gains tax.
  • Tax-effective distribution of income to adult children.
  • The equal splitting of income between two members of a couple in retirement.

For all the talk of superannuation and its benefits, there are many financial goals that people wish to meet prior to retirement. A trust presents itself as a flexible investment vehicle worthy of consideration as you plan to meet these pre retirement financial goals.

Scott Francis is an independent financial planner based in Brisbane.