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Pros and cons of discretionary trusts at a glance:

1. Discretionary trusts allow for the accumulation of assets for beneficiaries
2. They give flexibility over capital and income distribution
3. Discretionary trusts also offer the potential for simpler reporting
4. They enable discounts on capital gains taxes
5. However, beneficiaries lack equitable or proprietary legal interest in property
6. You must also pay a family trust distribution tax
7. Discretionary trusts are also subject to regulatory burdens

With a discretionary trust, a trustee or trustees hold the property for the beneficiaries, and an appointor has the ability to hire and fire the trustee. Therefore, the appointor has ultimate control over the wealth in the trust.

Many Australian businesses are carried on in discretionary trusts. This is especially true of family businesses.

The beneficiaries of discretionary trusts are usually immediate and extended family members, other family companies and charities. They don’t all have to be included at the establishment of the trust; they can be added later as needed. In a discretionary trust, beneficiaries have no interest in the trust property unless the trustee exercises its discretion to distribute to them. 

The trustees can decide to distribute income or capital among the beneficiaries as they see fit. They’re not held to predetermined arrangements or agreements. This offers a great deal of flexibility, but might seem too nebulous for some stakeholders.

What works well for one business may not be the best choice for another business, which is why it’s important to weigh the pros and cons of a discretionary trust structure for your unique situation.

 

Pros of Discretionary Trusts

Discretionary trusts can be attractive options for several reasons, and they suit some businesses and organisations better than they suit others. The following are several pros of discretionary trusts.

Allowance for Accumulation of Assets for Beneficiaries

Unlike some other business structures, discretionary trusts allow for the accumulation of assets for beneficiaries. These assets, along with the capital of the trust, can be distributed to the beneficiaries without incurring significant taxation consequences.

Flexibility Over Capital and Income Distribution

Just as discretionary trusts offer ways to accumulate assets for beneficiaries, they also have an element of flexibility over how capital and income are distributed. The trustee or trustees of the trust could use their discretion to change the allocation of funds to certain beneficiaries without having to make any major changes.

The Potential for Simpler Reporting

Because discretionary trusts restrict and specify the trust beneficiaries, you may be able to simplify some of your reporting, such as the claiming of tax losses, debt deductions and franking credits. This is because in many cases, beneficiaries of discretionary trusts cannot take advantage of franking credits attached to share dividends received by the trust and passed to beneficiaries.

Discount on Capital Gains

Another tax-related benefit to operating your company as a discretionary trust is that the trust is entitled to a discount on capital gains made on the disposal of assets held by the trust for longer than 12 months. People who hold shares are also eligible for this capital gains discount, but the discount does not apply to companies that hold shares.

 

Cons of Discretionary Trusts

Unfortunately, there are also several cons to discretionary trusts. Some of these cons weigh heavier for some businesses than for others, depending on a number of factors such as size, income, losses, and assets.

 

Beneficiaries Lack Equitable or Proprietary Legal Interest in Property

The flexibility that can be so helpful in some cases can also be a liability in other cases. Since the trustee or trustees can use their discretion to change allocations, beneficiaries don’t have certain legal interests in the trust property. 

Therefore, beneficiaries can’t necessarily count on receiving their “share” of the assets because allocations could be changed on a whim. And in fact, a recent court case shows that even the trustees’ decisions can be overturned. 

In Kennon vs Spry, the High Court found that assets in discretionary trusts are liable to being used in property settlement agreements. In other words, the Court has the ability to effectively “dismantle” complex discretionary trusts. In this case, discretionary trust assets formed part of a property pool in family law proceedings. The Court “reversed” several complex amendments to the trust, which had removed the husband and wife as trust beneficiaries.

 

Family Trust Distribution Tax

Family trust distribution tax applies when a distribution is made outside of the “family group.” The “family group” is designated by making the election, so it’s highly important for trustees to make the election and choose the appropriate “test individual” for the family group. Keep in mind that a reasonable salary, wage or benefit such as superannuation is not considered to be a distribution.

 

 

Regulatory Burdens

Running a discretionary trust adds compliance obligations, and these additional obligations can be distractions for business owners. If you’re a business owner who likes to pour all of your efforts into growing your organisation, you may become frustrated with the compliance responsibilities associated with a discretionary trust.

 

Weighing the Pros and Cons of Discretionary Trusts

For businesses that are operated by two or more independent people (not members of the same family), discretionary trusts are less common and less appropriate. This is because independent parties generally want to know exactly who will receive what in order to make wise investment and business decisions. 

If flexibility is important to you, a discretionary trust may be the best option. It provides asset protection in that it can prevent a beneficiary’s creditors from accessing key assets. Therefore, if a business goes bankrupt, creditors won’t be able to touch any property held in the discretionary trust. 

Also, the trustees maintain complete control over income and capital distribution. If the net income is distributed by the end of each financial year, taxes may be minimised.

Depending on the complexity of your discretionary trust, the establishment and administrative costs could be more expensive than some other business structures. It would be wise to seek professional advice regarding the costs of a discretionary trust that suits your business.

 

You may also like this video which unpacks and explains discretionary trusts in simple terms.

 

Conclusion

A discretionary trust is a common business structure in Australia because it offers several important taxation advantages. It’s also well-suited for family businesses because it maintains a high degree of flexibility and protection for beneficiaries. 

However, not all businesses are good candidates for discretionary trusts. In some cases, taxation is more burdensome with a discretionary trust than with another business structure. Business owners may also find that the obligatory compliance is more than they want to manage.

How do you know which structure is right for your business? Contact one of our business advisers to learn more about discretionary trusts and other business structures that will best suit your Australian business. Reach out to Altus for trusted advice and guidance.