Understanding Australian Family Trusts: How Discretionary Trusts Work, Income Splitting, and When to Use One

A discretionary trust - commonly called a family trust - is one of the most widely used wealth and tax structures in Australia. Understanding how it works before being sold one (or advised to establish one) is essential.

• Trust structure basics: A trust is a legal arrangement where a trustee holds assets for the benefit of beneficiaries. A discretionary trust gives the trustee full discretion over how income and capital are distributed to beneficiaries each year - hence 'discretionary'. No beneficiary has a fixed entitlement until the trustee makes the annual distribution resolution
• Key parties: Settlor (establishes the trust, contributes a nominal settlement sum, and typically has no ongoing role); Trustee (manages the trust and exercises distribution discretion - can be an individual or company); Appointor (has the power to replace the trustee - the most powerful role in the trust structure); Beneficiaries (defined in the trust deed, typically a wide class: children, grandchildren, companies, related trusts)
• Corporate vs individual trustee: A corporate trustee (a company acting as trustee) is strongly preferred for family trusts: the company's name appears on all asset titles rather than individuals', members can change without triggering title transfers, and corporate structure limits personal liability for trustee acts. Additional ASIC cost: $597 establishment + $63/year
• The discretion - and its limits: The trustee's discretion to distribute income is limited by the trust deed (which defines the beneficiary class) and tax law. Distribution to beneficiaries with lower marginal tax rates reduces the overall family tax burden. However, the ATO's trust income tax rules (particularly s100A and s97) constrain aggressive income splitting - especially to beneficiaries who don't genuinely benefit from the distribution
• 80-year perpetuity period: Trusts cannot last forever - the rule against perpetuities limits most Australian trusts to 80 years. On vesting (at 80 years), the trust assets are distributed to the beneficiaries according to the deed. Planning for vesting - including potential CGT on deemed disposal - is important for multigenerational wealth planning

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The ability to distribute trust income to multiple beneficiaries at their individual marginal tax rates is the core tax advantage of a discretionary trust. In a family where members have different income levels, this can save tens of thousands of dollars per year.

• How income splitting works: The trust derives income (from business, investment, rent). At year end (before 30 June), the trustee resolves to distribute income to beneficiaries. A beneficiary on a 0% rate (below the tax-free threshold) or 19% rate pays minimal tax on their share. The trust itself pays no tax - all income is attributed to beneficiaries
• Worked example: A family trust earns $200,000 in investment income. Distributing $200,000 to the principal (at 47% marginal rate) = $94,000 in tax. Instead: $18,200 to adult child 1 (0% tax), $18,200 to adult child 2 (0% tax), $45,000 to non-working spouse (19% on $26,800 above threshold = ~$5,000 tax), and $118,600 to principal (still $47,000+ in tax). Total tax: ~$52,000 vs $94,000 - saving $42,000/year in this scenario
• Adult children as beneficiaries: Distributing to adult children who are students or part-time workers is a legitimate and common strategy. However, the ATO's section 100A integrity rules apply: if an adult child beneficiary doesn't genuinely receive and enjoy the funds (e.g., they immediately loan it back, it stays in the trust, or the parents use it), the ATO can tax the distribution at the top 47% rate in the hands of the trustee
• Minor beneficiaries - penalty rates apply: Minors (under 18) who receive trust distributions from non-employment income pay tax at penalty rates (up to 66%) on amounts above $416. Distributing large trust income to minor children is almost always counter-productive from a tax perspective. Testamentary trusts are an exception - distributions from a testamentary trust to minors are taxed at adult rates
• Family trust election: A trust can make a Family Trust Election (FTE) - designating a 'family group'. Benefits include: access to trust loss provisions (allowing business losses to be carried forward within the family group) and franking credit distribution flexibility. The FTE constrains future distributions to the defined family group - consider carefully before electing, as it cannot easily be undone

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Division 7A of the Income Tax Assessment Act 1936 is a complex anti-avoidance provision targeting loans, payments, and forgiven debts from private companies to shareholders and associates. Family trusts that interact with corporate beneficiaries or company structures face significant Division 7A risk.

• Why Division 7A matters for family trusts: Many family trust structures include a corporate beneficiary (a company) to 'park' income at the 25-30% corporate tax rate rather than distributing it to individuals at marginal rates. When trust income is distributed to the company but the company doesn't retain those funds - instead lending them back to the trust or to individual beneficiaries - Division 7A applies
• Division 7A loan agreements: If a private company (e.g., a corporate beneficiary) lends money to a trust or its beneficiaries, the loan must be documented under a Division 7A compliant loan agreement - with a maximum term (7 years for unsecured), minimum interest rate (the ATO's Benchmark Interest Rate, currently around 8%), and principal repayments. Failure to comply deems the loan a dividend - assessable as income at marginal rates
• The UPE trap: When a trust distributes income to a corporate beneficiary but doesn't physically transfer the cash (an 'unpaid present entitlement' - UPE), the UPE is treated as a financial accommodation by the company to the trust. From 2010 changes, UPEs must be placed on compliant Division 7A loan terms or the deemed dividend risk applies
• Forgiven debts: If a company forgives a loan to a trust (or individual beneficiary), the forgiven amount is a deemed dividend - assessable income. Debt forgiveness in trust structures must be carefully structured with tax advice to avoid unexpected income recognition
• Annual compliance for Division 7A: Division 7A compliance is a year-end activity that must be completed on or before the company's tax return lodgement date. Minimum interest repayments must be made by 30 June each year. Missing a year-end repayment triggers deemed dividend treatment on the entire outstanding balance - a potentially catastrophic tax event

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Capital gains tax treatment inside a discretionary trust has important nuances - including access to the 50% CGT discount and the ability to stream capital gains to specific beneficiaries.

• 50% CGT discount in trusts: A trust that holds an asset for more than 12 months before selling qualifies for the 50% CGT discount. The discounted capital gain is distributed to individual beneficiaries who can apply the 50% discount - effectively taxing the gain at half the marginal rate. Superannuation funds (as trust beneficiaries) can only apply a 33% discount. Companies receive no CGT discount
• CGT streaming: Trust deeds that permit it allow trustees to stream capital gains to specific beneficiaries (e.g., a beneficiary with capital losses to offset, or a beneficiary in a lower tax bracket). The 2011 trust tax rules introduced specific streaming provisions - the trust deed must expressly permit streaming for this strategy to work
• Main residence exemption - not available: A trust cannot access the main residence CGT exemption. If a trust owns residential property that is used as the family home, a CGT liability arises on sale. This is a common mistake - families who transfer their home to a family trust lose the main residence exemption
• Trust losses cannot be distributed: A trust that makes a capital loss cannot distribute that loss to beneficiaries - it is quarantined in the trust and can only offset future capital gains of the trust itself. Trusts with significant investment losses cannot pass those losses through to the family
• Asset protection and CGT event on resettlement: A trust 'resettlement' - changing the core purpose or terms of the trust in a way that creates a new trust - triggers a CGT disposal of all trust assets at market value. This is a dangerous trap in trust restructuring. Any changes to the trust deed must be reviewed by a specialist solicitor to confirm no resettlement has occurred

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Family trusts are powerful but have real costs and compliance requirements. They are not universally appropriate - and the wrong structure can create more complexity and cost than benefit.

• When a family trust adds clear value: Business income above $100,000 where income splitting to family members on lower rates saves $15,000+ per year in tax; investment portfolio above $500,000 where streaming capital gains and income to lower-rate beneficiaries is meaningful; asset protection for business owners (protecting investment assets from business creditors); and multi-generational wealth planning where the trust holds the family investment portfolio indefinitely
• Setup and running costs: Trust deed: $1,500-$3,000 (from solicitor); corporate trustee: $597 establishment + $63/year ASIC fee; annual accounting and tax return: $1,500-$4,000; tax advice for distribution resolutions: $500-$2,000/year. Total annual cost: $2,500-$6,500. This cost must be justified by genuine tax savings - below ~$50,000 in distributable income, the trust costs may exceed the tax benefit
• When a family trust is NOT right: Salary and wage income (PSI rules prevent distributing your personal services income through a trust); income below $100,000 (tax savings likely don't cover costs); plans to sell a family home (trust ownership destroys the main residence exemption); situations where genuine Section 100A compliance is difficult (adult children who won't genuinely receive funds)
• The ATO's s100A risk: Section 100A applies where a trust distribution is made as part of an arrangement that provides a 'reimbursement agreement' - the beneficiary receives the income on paper but the benefit flows back to another person (typically the trustee or a related party). The ATO has recently increased enforcement of s100A - distributions to adult children who loan money back to parents, or distributions to adult children's accounts controlled by parents, are high-risk scenarios
• Get specialist advice before establishing: The decision to establish a family trust is not reversible without potential CGT consequences (resettlement risk) and compliance cost. A specialist tax adviser or commercial solicitor should assess your specific situation, income projections, and asset profile before recommending a trust structure. Generic online trust setup without tailored advice is a significant compliance risk

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