Family Trust Elections (FTEs) and Family Trust Distribution Tax (FTDT) have been integral components of Australia’s income tax framework since 1998. While tax professionals across Perth, such as lawyers and accountants, should be well-versed in these concepts, it’s essential not to let familiarity lead to complacency. As families evolve and children grow, establishing new tax, businesses and financial structures, the definition of the “family group” might not align with the family’s perception. This discrepancy can inadvertently lead to appalling tax outcomes, including the imposition of a family trust distribution tax at a rate of 47%.
Benefits of Making a Family Trust Election
Electing to be a family trust offers several tax advantages:
- Simplified Loss Utilization: Family trusts can more easily use trust losses because only a modified “income injection test” is required.
- Company Losses: The continuity of ownership test for loss companies is simplified as it doesn’t require tracing ownership through a family trust.
- Holding Period Rule: Family trusts can meet the “holding period rule,” allowing beneficiaries to benefit more readily from franking credits attached to dividends received by the trustee.
- Small Business Restructure: Capital gains tax relief includes special provisions for family trusts.
- Exemption from Reporting Rules: Family trusts are exempt from certain trustee beneficiary reporting requirements.
Despite these advantages, FTEs come with a trade-off: FTDT applies when distributions are made outside the designated family group.
Establishing a Family Trust Election
A “family trust” is defined by the presence of a Family Trust Election (FTE). To make an FTE, the trust must pass the “family control test” for the specified income year, demonstrating control by members of a particular family. The election must be in writing and the approved format, specifying an individual whose family group will be recognised about the FTE.
Identifying the Test Individual in a Family Trust Election
The selection of the test individual is a critical component in executing a Family Trust Election (FTE). This individual’s family group determines the range of beneficiaries eligible to receive distributions from the trust without incurring Family Trust Distribution Tax (FTDT).
When nominating a test individual, the individual must be alive. So, creating dormant trusts for a family is essential for estate planning so that the family can ensure future generations can add to the existing structure.
Defining the Family Group
The family group of the test individual typically includes:
- The test individual and their spouse.
- Parents, grandparents, and siblings of the test individual or their spouse.
- Nephews, nieces, and children of the test individual or their spouse, along with any lineal descendants.
- Spouses of any of the individuals mentioned above.
- Former spouses who are no longer family members due to a marriage or relationship breakdown, or due to the death of the test individual or another family member.
- The trust itself and other trusts with a matching FTE.
- Companies, partnerships, and trusts that have made Interposed Entity Elections (IEEs).
It’s important to note that not all relatives of the test individual, such as aunts, uncles, and cousins, are included in the family group. Awareness of this limitation is crucial to prevent inadvertent exposure to FTDT.
Changing the Test Individual
The identity of the test individual can be altered once, subject to strict conditions. Any variation must occur within four income years from the year specified in the original FTE.
The Family Control Test
A trust must meet the family control test to qualify for an FTE. This requirement is fulfilled when control of the trust is vested in some or all the following parties:
- The test individual and/or members of their family.
- A professional legal or financial adviser to the family.
- Trustees of one or more family trusts, where the same test individual is specified in the FTE, and the individual and family members hold more than 50% interest in the trust’s income or capital.
A group of the above individuals is considered to have control if they can direct or benefit from the trust’s income or capital or if they have the authority to appoint or remove the trustee.
The definition of “family” for the control test closely aligns with that of the test individual’s family group, except that a former spouse is not considered part of the “family” but remains part of the family group.
Understanding Family Trust Distribution Tax
FTDT is applicable when:
- The trustee makes an FTE, or a company, partnership, or trust has made an IEE for inclusion in the family group of a family trust.
- The trust, company, or partnership distributes income or capital to anyone outside the specified family group.
FTDT is charged at the highest marginal tax rate plus the Medicare Levy, totalling 47% when applicable.
Challenges with Expanding Families
A key issue arises when family dynamics change over time. For instance, if an FTE was made in 1998 specifying an individual with young children, those children may now be adults with their businesses and financial interests. The risk of FTDT increases when these grown children establish their trusts and engage separate tax, accounting, legal and investment advisors.
For example, consider Trust 1, which designates Individual A as the test individual. Individual B, A’s child, establishes Trust 2 and makes an FTE, designating themselves as the test individual. If Trust 1 distributes income to Trust 2, FTDT may apply if Trust 2 is not part of Individual A’s family group.
Such a situation can catch family members and their Perth tax advisors off guard, leading to unexpected tax liabilities. So, the tax structuring advice must always consider the impact of existing and future family trust elections.
Addressing FTDT Liability: Considerations and Implications
When facing liability for Family Trust Distribution Tax (FTDT), one potential solution is for the beneficiary to disclaim the distribution. The effectiveness of such a disclaimer depends on various facts and circumstances surrounding the case. A recent decision by the Full Federal Court in Carter v Commissioner of Taxation highlights the retrospective effectiveness of disclaimers. In this case, disclaimers were deemed to have a retrospective effect, but it remains crucial for the distribution to be disclaimed before the beneficiary accepts it. The Commissioner has sought special leave to appeal this decision to the High Court.
Before proceeding with a disclaimer, it’s essential to evaluate the consequences. Depending on the terms of the trustee resolution and the trust deed, another beneficiary or the trustee may assess the relevant income.
Other Implications of FTDT
If a distribution cannot be disclaimed, several consequences arise from an FTDT liability. For instance, in the previous example, the tax loss that would have been utilised remains available to Trust 2 to offset future income.
More importantly, future distributions by Trust 2 and downstream entities, such as companies, partnerships, and trusts, should be considered non-assessable, non-exempt (NANE) income to the extent they are attributable to the initial distribution from Trust 1. Consequently, these future distributions should not be subject to tax again in the recipient’s hands. Thus, the imposition of FTDT might result in a timing difference rather than a permanent tax burden. However, the timing difference can be substantial and occur at an inopportune moment for the family.
The provision that deems future distributions as NANE income is not perfectly drafted and remains largely untested. For example, while a distribution from Trust 2 to a corporate beneficiary is expected to be NANE income, it is less clear whether a subsequent distribution from the corporate beneficiary to an individual shareholder, such as a dividend, will also be treated as NANE income for the shareholder. Nonetheless, this outcome aligns with the policy intention.
Preventing Unintended Tax Consequences
Growing families and their tax advisers must coordinate their tax affairs effectively to avoid unintended tax consequences. Communication plays a pivotal role in this process. In the absence of communication, unintended tax liabilities may arise.
Considerable thought must be given to making Family Trust Elections (FTEs) and Interposed Entity Elections (IEEs). Ordinarily, many families do not realise that their Perth tax accountant has prepared a family trust tax election when preparing the tax returns. However, the poor choice can have far-reaching, sometimes irreversible, impacts. The reflexive response of naming the family member instructing the tax adviser as the specified individual in an FTE should be resisted. The strategy behind making IEEs is crucial, given the restrictions on multiple IEEs. FTEs and IEEs should be periodically reviewed.
Once an FTE is made, it generally cannot be varied or revoked. An FTE can be varied to specify a new individual, but this is usually only permissible for an income year occurring within the period starting from the income year specified in the original FTE and ending at the end of the fourth income year thereafter. This provides a limited window for variation, and it may only be done once. The new individual must be a member of the original individual’s family group, and no income or capital should have been previously distributed outside this new individual’s family group.
Conclusion
In summary, while Family Trust Elections offer significant tax benefits, they require careful consideration of family dynamics and long-term planning. Failure to align the specified family group across trusts can lead to unintended tax consequences. Tax professionals must remain vigilant in advising families as they grow and evolve, ensuring that effective and compliant tax strategies are employed.
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