Many Australian families and small business owners ask whether a discretionary trust or a family trust could reduce tax, protect investments or make succession planning easier. The first important point is that these are not always two separate choices.
In everyday conversation, a “family trust” often means a discretionary trust set up for family members. In tax law, however, a trust is only a family trust when its trustee has made a valid family trust election. That election can create useful tax outcomes in the right circumstances, but it also narrows who can receive trust distributions without serious tax consequences.
The better structure depends on what your family owns, who may benefit from it, the level of business risk involved and how much flexibility you want to retain over time.
Discretionary trust vs family trust: the key difference
A discretionary trust is a legal arrangement where a trustee holds and manages assets for a group of potential beneficiaries. The trust deed sets out who can benefit and gives the trustee powers to decide how income and capital are distributed.
Unlike a unit trust, beneficiaries in a discretionary trust generally do not have fixed percentage ownership interests. The trustee can usually decide, within the terms of the deed, which eligible beneficiaries receive income or capital in a particular year.
A typical discretionary trust may include:
– A family group as primary beneficiaries.
– Spouses, children, grandchildren and other relatives.
– Family companies or other trusts, where permitted by the deed.
– Charities or other classes of beneficiaries, depending on the deed.
– A corporate trustee, which is a company acting as trustee of the trust.
A family trust, in the strict tax sense, is a trust with a family trust election in force. The election identifies a particular individual and establishes a defined family group for tax purposes.
This distinction matters because a discretionary trust can be broad and flexible, while a trust with a family trust election may face tax consequences if it distributes income or capital outside the relevant family group.
So the practical comparison is usually not:
> “Should I choose a discretionary trust or a family trust?”
It is more often:
> “Should I establish a discretionary trust, and should that trust make a family trust election?”
Those are separate decisions and should be considered carefully.
How a discretionary trust may help with family tax planning
A discretionary trust can offer flexibility because its trustee may be able to distribute trust income among eligible adult beneficiaries each year. This can be useful where family members have different taxable incomes, provided the distributions are genuine, permitted by the trust deed and supported by proper records.
For example, a business-owning couple may have adult family members who are legitimately included as beneficiaries and have lower taxable income from other sources. Depending on the circumstances, the trustee may consider distributions to those beneficiaries rather than concentrating all trust income in one person’s tax return.
However, this is not a simple exercise of choosing the lowest-taxed person in the family. Trust distributions must be legally effective and commercially supportable.
Important considerations include:
– The trust deed must permit the proposed distribution.
– The trustee must make a valid distribution resolution within the required timeframe.
– The beneficiary must actually be entitled to the distribution.
– Tax records, financial statements and beneficiary statements must align with the resolution.
– The arrangement must not involve a reimbursement agreement or other tax avoidance concern.
– The beneficiary’s age, residency, legal capacity and other income may affect the result.
The trustee needs to distinguish between trust income under the deed and the trust’s taxable net income under tax law. These amounts do not always match. Capital gains, franked dividends, expenses, prior-year losses and specific provisions in the trust deed can all affect the final tax position.
This is why an EOFY trust distribution should not be treated as a last-minute administrative task. It is a legal and tax decision that requires review before the end of the income year.
Distributions to children require particular caution
Distributing ordinary trust income to children is often less attractive than people expect. Special tax rules can apply to certain income received by minors, particularly where the income is not excepted income.
There are limited situations in which income received by a child may receive different treatment, such as certain income connected with deceased estates or compensation arrangements. These rules are complex and should not be assumed to apply just because a child is named as a beneficiary.
For many family groups, the more practical tax-planning focus is on adult beneficiaries who are genuinely entitled to receive and benefit from the distribution.
A corporate beneficiary can add flexibility, but not a shortcut
Some discretionary trusts include a company as a beneficiary. This is sometimes called a bucket company strategy, because income may be distributed to the company and taxed under the company tax system rather than immediately distributed to an individual on a higher marginal rate.
That approach can be useful in some circumstances, particularly where profits are being retained for working capital or future investment. But it needs careful management.
If the company’s entitlement remains unpaid and the trust uses the funds, Division 7A issues may arise. The rules can treat certain payments, loans, debt forgiveness arrangements or unpaid present entitlements involving private companies as taxable dividends unless the arrangement is managed correctly.
A corporate beneficiary can therefore be part of a sound structure, but it creates its own compliance obligations. It is not a way to permanently avoid tax or use company funds personally without consequences.
When a family trust election may be useful
A family trust election is not automatically required for every discretionary trust. In fact, making one without a clear reason can reduce future flexibility.
That said, an election may be valuable where the trust needs to access particular tax outcomes. It can be relevant where a trust seeks to rely on certain trust loss rules, pass through franked distributions in some situations, or support ownership continuity rules for a related company.
The election identifies a test individual and their family group. The family group is broader than only a spouse and children, but it is still a defined category under tax law. It can include certain relatives, entities that have made appropriate elections and other connected parties.
Once a family trust election is in force, the trustee needs to be very careful about distributions of income or capital. A distribution outside the permitted family group can trigger family trust distribution tax.
That tax is intended to be punitive. It is not simply an additional administrative cost or a minor adjustment in the trust tax return.
Before making an election, consider questions such as:
– Is the trust likely to distribute only within one family group over the long term?
– Could future business partners, investors, charities or unrelated beneficiaries need to receive distributions?
– Does the trust own shares in a company that may need to use tax losses or franking credits?
– Are there related trusts or companies that may need to be included in the family group?
– Is the nominated family member appropriate for long-term succession and control planning?
– Has the trust already made an election, or has an interposed entity election been made elsewhere in the group?
A family trust election may apply from an earlier income year in some circumstances, but retrospective action is not automatic. Specific conditions must be met, including conditions relating to family control and prior distributions.
It is also important not to assume an election can simply be revoked if family circumstances change. The law permits revocation only in limited situations.
Asset protection: helpful separation, not a personal guarantee
One reason families establish discretionary trusts is to separate valuable assets from personal ownership or from the entity conducting a higher-risk business.
For example, a family may hold investments, equipment or commercial property in a discretionary trust while a separate company operates the trading business. The aim is to avoid placing every asset in the same entity that signs customer contracts, employs staff, borrows money or faces operational liabilities.
This can be a sensible risk-management approach, but the protection is not absolute.
A trust does not make assets untouchable. The practical outcome depends on who owns the asset, who is trustee, what debts have been incurred, the terms of finance documents, insurance coverage and whether anyone has given a personal guarantee.
Asset protection can be weakened where:
– The trust itself carries on the risky business and incurs liabilities.
– The trustee has provided security over trust assets.
– Individuals have given personal guarantees to lenders, landlords or suppliers.
– Funds and assets are mixed between personal, business and trust accounts.
– The trust is not administered in accordance with its deed.
– Transactions are undocumented or not conducted properly.
– Asset transfers are made after claims, debts or insolvency concerns arise.
– Family law, bankruptcy or creditor claims affect a person with control over the trust.
A corporate trustee is often used because it can provide clearer separation between the trust assets and the individuals involved in the family group. It can also make changes to directors and control easier to manage over time than changing trustees in an individual capacity.
However, company directors may still face personal exposure in some situations. A corporate trustee is a useful structural tool, not a substitute for insurance, sound contracts, responsible borrowing and legal advice.
The trust deed, trustee and appointor matter as much as the tax strategy
A trust is only as effective as the legal document and governance behind it. The trust deed is not a generic formality to be filed away after establishment.
The deed should be reviewed before significant actions, including:
– Admitting or removing beneficiaries.
– Making income or capital distributions.
– Streaming capital gains or franked dividends.
– Appointing a new trustee.
– Changing directors of a corporate trustee.
– Changing the appointor or principal role.
– Lending money to beneficiaries or related entities.
– Purchasing property or entering business arrangements.
– Varying the terms of the trust.
– Planning for incapacity, death, separation or sale of a business.
The appointor is often the person with the power to remove and appoint the trustee. In many family trusts, this role can be crucial because it may influence practical control of the trust.
If succession planning is overlooked, a trust can become difficult to manage after the death or incapacity of a key person. Family members may assume that control automatically passes under a will, but the outcome depends on the deed, company constitution, estate-planning documents and the way relevant powers are held.
A coordinated plan may need to deal with:
– The trust deed.
– The appointor role.
– Shares in the corporate trustee.
– Directorships.
– Wills and enduring powers of attorney.
– Binding nominations for superannuation, where relevant.
– Shareholder agreements and business succession arrangements.
This is an area where tax, legal and estate-planning advice should work together.
Common trust mistakes that can undo the intended benefits
Trust structures can be effective, but they come with annual obligations. The ATO pays close attention to trust distributions, record keeping and arrangements that appear designed to direct income to a low-tax beneficiary while someone else receives the economic benefit.
Some common mistakes include the following.
Missing or unclear distribution resolutions
For a discretionary trust, the trustee generally needs to make beneficiaries presently entitled to trust income by the end of the income year. The exact requirements depend on the trust deed.
A resolution that is vague, incomplete or inconsistent with the deed can create uncertainty about who is taxable on the trust income. Backdating documents is not an appropriate solution.
### Treating distributions as bookkeeping entries only
A trust distribution creates an entitlement. It should be recorded properly in the trust accounts and communicated to the beneficiary where appropriate.
If the money is not paid, the unpaid amount should be tracked carefully. It may be a genuine unpaid present entitlement, but it should not become an informal pool of funds used by others without considering the tax and legal consequences.
Distributing to a beneficiary who does not benefit
A distribution arrangement may attract attention where a beneficiary is made presently entitled to income but another person receives or enjoys the funds. These arrangements can raise concerns under the reimbursement agreement rules.
Family support and ordinary household arrangements are not automatically problematic. The risk increases where the steps are pre-arranged and the distribution is used to obtain a tax benefit for someone other than the beneficiary.
Forgetting prior elections
A trustee may not realise that an earlier adviser made a family trust election or an interposed entity election. If that election remains in force, it may restrict the trust’s distribution options.
This is particularly important before making distributions to adult children’s spouses, unrelated business partners, charities, new entities or trusts connected with a different family group.
Assuming a trust solves every property or business issue
A trust may be useful for holding investments or operating a business, but it does not automatically produce the best outcome for a main residence, negatively geared property, external investors, business losses or asset sales.
For example, a trust cannot generally pass tax losses through to beneficiaries in the same way a sole trader may use business losses against their own income. A trust’s losses are generally retained in the trust and subject to rules before they can be used.
State and territory taxes also need separate consideration. Land tax, duty and surcharge rules can differ significantly between jurisdictions, and trusts may receive different treatment from individuals.
A practical scenario: balancing flexibility, tax and protection
Consider a family that operates a growing professional services business. The business generates variable profits each year, the parents have different levels of outside income and they want to build investments for the family over time.
They may establish a discretionary trust with a corporate trustee. The trust could hold business interests or investments, subject to appropriate legal and tax advice. Each year, the trustee could review the trust’s income, eligible beneficiaries, other income sources and cash requirements before making a distribution resolution.
The family might also consider whether a family trust election is useful because of company shareholdings, franked dividends or future trust loss considerations. But they would first need to weigh that benefit against the loss of flexibility to distribute outside the defined family group.
If the business is high risk, the family may also consider whether valuable investments should be held separately from the trading entity. That decision would need to account for finance arrangements, personal guarantees, insurance and the practical need to move funds between entities.
The right answer is not simply “set up a trust”. The useful work is in designing the ownership, control, distribution and succession arrangements to suit the family’s actual plans.
Choosing the structure that fits your family
A discretionary trust may suit a family that wants flexibility to distribute income and capital among a broad group of beneficiaries. It may also assist with long-term investment ownership, succession planning and separating selected assets from personal ownership.
A family trust election may suit a discretionary trust that needs access to particular tax outcomes and expects to distribute only within a defined family group. However, it can be restrictive and should not be made as a default step.
Before establishing a trust or making an election, it is worth considering:
– Who should control the trust now and in the future?
– Who needs to receive income or capital over time?
– Will the trust operate a business, hold investments, or both?
– What assets need greater protection from trading risk?
– Are personal guarantees likely to be required?
– Could the family expand, separate, sell a business or bring in investors?
– Is a corporate beneficiary needed, and can Division 7A obligations be managed?
– Are there existing trusts, companies, elections or tax losses in the group?
– Which state or territory tax rules may apply to property held by the trust?
The key takeaway is that a discretionary trust and a family trust are not necessarily competing structures. A discretionary trust can offer flexibility, while a family trust election can provide access to particular tax treatments but imposes tighter distribution boundaries.
General information only. This article is not personal financial or tax advice. Trust structures, family trust elections, asset protection and distributions depend heavily on your trust deed and individual circumstances. Speak with a registered tax agent or accountant, such as Ample Finance, for advice tailored to your family, business and long-term plans.