Q: I have been advised to set up a Discretionary Family Trust. Could you simply explain how they work and the pros and cons?

A: A trust is a legal entity where a trustee (typically a person or a company) holds property for the benefit of beneficiaries.

While the Trustee is the legal owner of the trust assets, the trusts beneficiaries hold the beneficial interest in the trust assets.

Under a Discretionary Family Trust, the beneficiaries do not have a fixed entitlement or interest in the trust assets. Instead, the Trustee has the discretion to determine which of the beneficiaries are to receive the capital and income of the trust and how much each beneficiary is to receive. However, the Trustee can only distribute to beneficiaries as set out in the terms of the trust deed.

There are typically four roles that need to be considered when establishing a discretionary trust; the Settlor who creates the trust by “settling” a sum of money, investments or property on trust for the beneficiaries. The Trustee who is the legal owner of the trust property but not necessarily the beneficial owner of the assets. The Appointor who is the person named in the Trust Deed who has the power to remove and appoint a replacement Trustee if a Trustee dies, becomes bankrupt or incapacitated. Finally beneficiaries, who are the people and possibly companies and other trusts, for whose benefit the Trustee holds the trust assets.

The Trust Deed sets the rules and defines the relationship between the Trustee and the beneficiaries. The Trust Deed specifically sets out the duties, powers and range of permitted investments for the Trustee, the beneficiaries, and all obligations for the parties to the trust.

A trust runs for a specified period of time determined within the Trust Deed. The maximum the law permits is 80 years.

The Trustee carries out all transactions of the trust and must sign all documents, for and on behalf of the trust. The Trustee’s overriding duty is to follow the terms of the trust deed and to act in the best interests of the beneficiaries.

There are three main advantages of Family Discretionary Trust; Asset control and protection, tax benefits and protecting vulnerable family members.

Family trusts may be used to protect assets from bankruptcy. As the assets of the trust belong to the Trustee and not the individual beneficiaries they cannot generally be used to pay the creditors of individual beneficiaries (unless assets were contributed to the trust with the intention of defeating creditors).

They may also be used for protecting family assets from future marriage breakdowns. In the event of a family law property settlement, assets held in a family trust may have a higher likelihood of being excluded from a property settlement than assets held directly by an individual.

Holding assets in a family trust may also assist in avoiding challenges to a Will since any assets held in the family trust will not form part of a deceased estate.

Retaining assets within a family group for inter-generational purposes can also be a motivator for holding assets in a trust, for example, a family farm.

Family trusts may also provide tax benefits to a family group to manage tax within a family through the distribution of income. This can be particularly helpful in supporting adult children who are studying or older parents who are retired as they are likely to be in a low tax bracket.

Family trusts can be beneficial for protecting vulnerable beneficiaries who are at risk of making poor spending decisions if they controlled assets in their own name. For example, a spendthrift child can have access to income but no access to a large capital sum that could be quickly spent.

There are disadvantages to family trusts; any income earned by the trust that is not distributed is taxed at the top marginal tax rate. Distributions to minor children may be taxed at up to 66%. The trust cannot allocate tax losses to beneficiaries. There are establishment costs involved for establishing and additional expense in maintaining the trust. Running the trust can become difficult particularly when family disputes arise.

Q: What is the difference between a Discretionary Trust and a Unit Trust?

A: Discretionary Trusts provide the Trustee with the discretion to determine which beneficiaries receive distributions and the amount each year.

Discretionary trusts are flexible in that the Trustee can take into consideration the personal circumstances and tax position of the various beneficiaries from year to year. They have the flexibility to distribute the trust income in the most tax effective manner.

Unit Trusts are a type of fixed trust where the Trustee holds the assets of the trust for the benefit of unitholders as opposed to beneficiaries. This benefit will be in proportion to the number of units that each unitholder acquires.

The Trustee divides the assets of the trust into fixed and measurable parts, called units. Unit holders receive a fixed number of units in a similar way that shareholders acquire shares in a company.   The value of the units within the Unit Trust will vary based on the valuation of the underlying assets of the Trust. Unitholders can be individuals or companies.

Unit trusts provide no discretion to the Trustee around distributions. The investment return from the unit trust is distributed to unit holders based on the number of units that they hold within the trust. For example, if you have five unitholders who each own 20% of the units, they each receive 20% of the distribution. This makes Unit Trusts attractive if third parties are investing together and seeking certainty to distribution rights.

Before establishing any trust, unitholders or beneficiaries should carefully consider the tax, stamp duty and estate planning implications of the trust structure and the Trustee’s decisions. It is important to seek accounting and legal advice on these matters.