HLB Mann Judd: Family trusts – will they survive?

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Family trusts have a worthwhile and legitimate role to play in planning for Australians’ financial security and retirement needs, but the proposed Labor changes would significantly impact on their use, says accountants and financial advisers HLB Mann Judd Sydney.

Jonathan Philpot, HLB Mann Judd wealth partner, says that trusts are a useful and practical structure that are used by families for many valid reasons.

“There has been a lot of talk lately about how family trusts are only used by the very wealthy as a way of avoiding paying their fair share of tax.

“While trusts can be a tax-effective effective way of managing financial arrangement, they are certainly not a tax avoidance mechanism as tax is still paid on distributions.

“Trusts are used by families for many reasons including building wealth, protecting their assets, adding to retirement savings, and looking after other family members, especially those who may not be able to look after themselves.

“In particular, we are seeing an increased interest in family trusts following the government’s ongoing changes that limit the amount of money people can save for their retirement through superannuation.

“Trusts have a useful role to play as a safe, reliable and tax-effective alternative to the superannuation system and over the last few years we have seen an increase in the number of family trusts as a result of the superannuation changes.

“If the proposed changes are implemented, superannuation will become even more important given the now sizeable tax advantages it provides.  Maximising concessional contributions at a younger age will become a much more necessary strategy,” Mr Philpot said.

Peter Bembrick, tax partner at HLB Mann Judd, said that trusts are a tax-neutral structure, with all income distributed to individuals who then pay income tax on the money they receive.

“It is incorrect to refer to trusts as a way of avoiding tax; this isn’t the case as tax is paid by beneficiaries at their own marginal tax rate.  They are better described as a tax-effective structure for holding assets and distributing income to beneficiaries.

“Labor has proposed introducing a minimum tax rate, of 30 percent, on distributions from a family trust. Therefore if a distribution is made to someone whose marginal tax rate is already above 30 percent (for example, someone who already earns more than $37,000, or those under 18 years old who receive more than $417 a year from the trust) the higher marginal tax rate will automatically apply.

“If the changes are implemented, there is little doubt that the increased tax liability associated with family trusts will mean they are less likely to be used, as a vehicle for building wealth, for many families.

“Of course, the changes depend on whether Labor comes into government, and whether it will actually implement the proposed changes; unfortunately the result is that many people are now left in limbo wondering what their best option will be,” Mr Bembrick said.

Mr Philpot added that while family trusts have been used for hundreds of years and will continue to play a useful role as a structure to hold assets in, they will be negatively impacted by the proposed changes.

“Many people will find other structures are more suitable to their needs if the changes come into effect.

“Whether family trusts will continue to be used as the primary structure to build up wealth will now depend on individual tax positions, the potential beneficiaries, ages and whether asset protection is required,” Mr Philpot said.

Example 1

A family who has built up wealth of $1 or $2 million (outside of the family home) would now need to consider whether to invest in the lower earning spouse’s name, or jointly.

Philpot and Bembrick say that under Labor’s proposed changes a family trust may no longer be the best option for them.

“The decision between these two options will be based on taxable income levels and age.

“However given that most people will not build up these levels of wealth until late in their working lives, a jointly held portfolio will in many cases be the best approach, as once they are both no longer working, splitting retirement income equally for the remainder of lives will result in significant tax savings.”

Example 2

For a family with between $2 and $5 million, however, a family trust could still result in a better tax outcome than other options, particularly if there are a few years during which other trust beneficiaries (such as children studying at university) have no other taxable income at a time when both parents are high income earners.

Mr Philpot says the trust also provides some advantages with estate planning and being able to pass assets to the next generation without triggering capital gains tax.

“In addition, a trust allows people to withdraw money, perhaps with little tax consequences and then invest in own names.  This is a useful strategy for retirees who could withdraw at least $1 million from the trust and invest in their own names to take advantage of the lower income tax brackets for individuals.”

Example 3

A family with wealth of over $5 million would be better placed considering investing through a company, with family members (e.g. the two parents) as direct shareholders of the company, and not using a family trust at all.  This means they could receive dividends at the individual tax rates at a time of their choosing.

Mr Bembrick says the disadvantage of losing access to the discount on capital gains is made up for by the 30 percent tax rate that will likely result in a lower average tax rate than the other structures.

Mr Philpot notes that with family wealth exceeding $5 million there will generally be less need for large-scale withdrawals from the portfolio, rather the focus is more likely to be on continued growth in the portfolio value, with the earnings available to pay out as dividends being sufficient to meet the family’s cash flow needs.