Choosing between a discretionary trust and a family trust can feel like a choice between two completely different structures. In many cases, however, they are closely connected. The real question is whether your family needs broad distribution flexibility, or whether the potential benefits of making a family trust election outweigh the restrictions that come with it.
For Australian families, investors and small business owners, that decision can affect how income, capital gains and franked dividends are managed over time. It can also affect eligibility for some tax loss and franking credit rules. The right outcome depends on your trust deed, beneficiaries, business plans and family circumstances, not simply on which label sounds more tax-effective. (legislation.gov.au)
Understanding the difference: a structure versus a tax election
A discretionary trust is a legal arrangement where a trustee holds and manages assets for beneficiaries. Rather than each beneficiary having a fixed share, the trustee generally has discretion, within the limits of the trust deed, to decide which eligible beneficiaries receive income or capital in a particular year.
This flexibility is why discretionary trusts are commonly used by family businesses, professional practices and investment groups. Subject to the deed and tax law, a trustee may be able to direct different categories of trust income to different beneficiaries as circumstances change.
A “family trust” is often used informally to describe a discretionary trust controlled by a family. In tax law, though, a trust becomes a family trust when its trustee has made a family trust election and that election remains in force. The election identifies an individual whose family group becomes central to the trust’s future distribution choices. (legislation.gov.au)
This means the comparison is not always discretionary trust versus family trust. A more accurate comparison is often:
- a discretionary trust with no family trust election; versus
- a discretionary trust that has made a family trust election.
The underlying trust deed still matters. It determines who can benefit, what the trustee can distribute, how income and capital are defined, whether a corporate trustee is used, and what happens if the trustee does not make a distribution decision on time.
How a discretionary trust may create tax flexibility
A discretionary trust does not automatically reduce tax. Its value is that it may allow income to be distributed among eligible beneficiaries who have different taxable incomes, deductions, losses or financial needs.
For example, a family business may have adult beneficiaries who are legitimately eligible under the trust deed, each with different income positions. If the trustee makes valid distribution decisions, and the arrangements are implemented properly, the overall tax result may differ from a situation where all income is earned by one individual.
Under the core trust taxation rules, beneficiaries who are presently entitled to a share of trust income may be assessed on a corresponding share of the trust’s taxable income. If no beneficiary is presently entitled, or the trust arrangements are not properly managed, the trustee may instead be assessed. (legislation.gov.au)
The potential tax advantages depend on several practical requirements:
- The intended recipient must be a valid beneficiary under the trust deed.
- The trustee must exercise its discretion properly and within the required timeframe.
- The trustee resolution must clearly state how income, capital gains and franked distributions are dealt with.
- The beneficiary’s entitlement must be recorded and handled consistently with the arrangement.
- The distribution must have a genuine family or commercial basis, rather than being a paper exercise designed solely to redirect tax.
Trustees of discretionary trusts generally need to make their income distribution resolution by the end of the relevant income year for beneficiaries to be presently entitled. Separate and careful treatment may also be needed for franked distributions and capital gains. (ato.gov.au)
This is where many trusts run into trouble. A trust structure can be flexible, but it is not informal. A last-minute resolution prepared without checking the deed, the trust accounts and the beneficiaries’ circumstances can create unintended tax consequences.
Why distributions to children are rarely a simple tax-saving strategy
Some families assume they can reduce tax by distributing trust income to young children. In most ordinary situations, this is not an effective strategy.
Special rules apply to many types of unearned income received by minors, including trust distributions. Unless the minor is an excepted person or the amount is excepted income, that income is generally subject to higher rates of tax. The rules are designed to limit income-splitting arrangements involving children. (ato.gov.au)
There are limited exceptions, such as certain employment income, income connected with a deceased estate, or income from particular compensation payments. These exceptions are fact-specific and should not be assumed simply because a child is named as a beneficiary. (ato.gov.au)
For many family trusts, adult beneficiaries are therefore more relevant when considering legitimate distribution planning. Even then, a trustee should consider more than the person’s marginal tax position. Questions may include whether the beneficiary needs the funds, whether they have other taxable income, whether they are receiving government support, and whether the trust deed permits the proposed distribution.
What a family trust election can add, and what it can take away
A family trust election can provide important advantages for the right trust. In broad terms, it may assist a trust in accessing particular tax loss, bad debt deduction and franking credit rules that would otherwise require the trust to satisfy complex tests. (ato.gov.au)
This can be particularly relevant where a family business trust has carried-forward losses, has received franked dividends, or is likely to use related entities as part of a long-term family business structure.
However, the election comes with a significant trade-off. Once made, distributions of income or capital outside the defined family group can trigger family trust distribution tax. The rules can also apply to certain distributions involving interposed companies, partnerships and trusts unless the relevant entities are appropriately included in the family group. (legislation.gov.au)
The practical message is straightforward: a family trust election can narrow the trustee’s freedom to distribute. It may be suitable where the family group is stable and the trust is intended to benefit that group over the long term. It may be less suitable where the trust may later need to distribute to unrelated business partners, new investors, non-family beneficiaries or entities outside the family group.
Choosing the individual specified in the election also deserves careful thought. Family relationships, succession plans, blended families, divorce, remarriage and business ownership can all change over time. What works well for a family today may be restrictive years later.
A family trust election should therefore be treated as a strategic decision, not an annual tax-return checkbox. Revoking an election is only available in limited circumstances and may not be possible where the trust or related entities have already obtained certain tax benefits because of the election. (ato.gov.au)
Capital gains, franked dividends and year-end documentation
Trust tax planning is not only about ordinary business income or rental income. Capital gains and franked dividends have specific tax treatment, and they need to be reflected correctly in the trust’s resolutions and records.
The tax law contains separate rules for beneficiaries who are specifically entitled to trust capital gains and franked distributions. A trustee cannot assume that a general income distribution resolution will always achieve the intended result for every type of trust income. (legislation.gov.au)
For a trust that has sold an investment property, shares or a business asset, the questions can include:
- Does the trust deed allow the relevant gain to be treated as income or capital for trust law purposes?
- Has the trustee made and documented an effective distribution of the capital gain?
- Is a beneficiary specifically entitled to the gain under the tax rules?
- Is the intended beneficiary eligible for any available capital gains tax treatment?
- Have any trust losses, prior-year capital losses or small business concessions been considered correctly?
Similarly, when a trust receives franked dividends, the trustee needs to consider who receives the associated economic benefit and how the entitlement is recorded. The records need to support the tax treatment being adopted. (legislation.gov.au)
This is one reason an annual trust review before EOFY is so important. The trustee should not wait until the tax return is being prepared to decide who was meant to receive the income.
The anti-avoidance risk: beneficiaries must genuinely benefit
A distribution can be valid under a trust deed but still attract ATO attention if the arrangement effectively directs the economic benefit to someone other than the beneficiary who is taxed on it.
The ATO’s guidance on reimbursement agreements focuses on arrangements where a beneficiary becomes entitled to trust income, but another person receives the benefit under an agreement or understanding. Depending on the facts, the relevant anti-avoidance rules can result in the trustee being taxed instead of the beneficiary. (ato.gov.au)
This does not mean family members can never use or reinvest trust distributions. Family and commercial dealings are assessed on their facts. However, a trustee should be able to explain why the distribution was made, how the beneficiary benefited and what happened to the funds.
Useful records may include:
- trustee resolutions and supporting calculations;
- trust financial statements and tax workpapers;
- beneficiary notices;
- loan agreements where amounts remain unpaid or are lent back;
- bank records showing payments or transfers;
- evidence of how retained funds are used; and
- file notes recording the family or commercial reasons for significant decisions.
Careful documentation is not merely administrative. It helps demonstrate that the tax position follows the real arrangement, rather than an arrangement created after the event.
A practical family business example
Consider a family that operates a profitable business through a discretionary trust with a corporate trustee. The trust deed includes the parents, adult children and several related entities as potential beneficiaries.
In a particular year, the business earns income, receives a franked dividend from an investment and realises a capital gain. One adult child has temporarily reduced work hours, another is earning a high salary, and the family intends to retain some funds in the business for working capital.
A sensible process would not start with asking, “Who has the lowest tax rate?” Instead, the family should review the trust deed, identify eligible beneficiaries, consider each person’s broader circumstances, determine whether a family trust election is appropriate, and prepare valid resolutions dealing separately with ordinary income, capital gains and franked distributions where required.
If a corporate beneficiary is involved, the family should also obtain advice on the consequences of unpaid entitlements and how company funds are used. Using company or trust funds privately can raise separate tax and compliance issues, including Division 7A considerations.
The result may be tax-effective, but only if the structure, resolutions, accounting records and cash movements all support the intended outcome.
Which option may suit your family?
A discretionary trust without a family trust election may be more suitable where flexibility is the priority. This can include families with evolving ownership arrangements, anticipated external investors, business partners outside the family group, or a broad range of potential beneficiaries.
A discretionary trust with a family trust election may be more suitable where the family group is established, the trust is expected to remain within that group, and access to the relevant trust loss, bad debt deduction or franking credit rules is important.
Neither option is automatically better. A family trust election can help protect particular tax outcomes, but it can also create long-term restrictions. A discretionary trust can offer broad flexibility, but that flexibility must be exercised carefully and documented properly every year.
The key takeaway is that a family trust is not a separate “tax-saving trust” that automatically produces a better result. It is generally a discretionary trust that has made a tax election, with both potential advantages and meaningful obligations.
This article is general information only and is not personal financial or tax advice. Before establishing a trust, making a family trust election or distributing trust income, speak with a registered tax agent or accountant, such as Ample Finance, about your specific circumstances.