Discretionary trusts continue to be the preferred investment and trading vehicles for most family groups and business owners due to their tax effectiveness, flexibility and ability to preserve wealth. Whilst establishing a trust can be simple, some fail to consider long term strategies to maintain and maximise asset protection opportunities.
Most often, issues can arise where:
- income of the trust is appointed or distributed to ‘at risk’ individual beneficiaries; or
- valuable assets are held in a trust which operates a business and, as a result, are exposed to potential trading risks.
While the trustee of a discretionary trust usually has total discretion in relation to how they distribute income and capital overtime, they must apply or distribute all of the net income of the trust before the end of each financial year. If not, the trustee risks being assessed for tax on that income at the top marginal rate.
For this reason, most trustees choose to appoint the net income to individual members of the family group. However, due to cash flow constraints and working capital or investment requirements, the income is often made available in the form of an unpaid present entitlement (UPE) as opposed to actual cash payment. From a beneficiary’s perspective, it is noted that:
- tax is paid on the UPE at the individual’s marginal tax rate; and
- the UPE is an asset that will (particularly as they increase over time) be problematic for those ‘at risk’ individuals who may be exposed to risk from external factors such as bankruptcy or family law disputes.
For existing UPEs, trustees and beneficiaries can manage unintentional exposure by taking steps to reduce or eliminate the value of UPEs owed to individual beneficiaries, as part of an ongoing strategy to ensure maximum asset protection is achieved. A more common approach has been for trustees to apply or distribute the net income of the trust to corporate beneficiaries instead of individuals, particularly where there is a desire to access the corporate tax rate. Unfortunately, given the ATO’s view on the application of Division 7A to UPEs owed to private companies (which may result in unintended tax consequences), this is no longer a preferred solution.
For those with little or no appetite to constantly monitor UPEs every year, an alternative solution may be to implement a business licence. Business licencing can be attractive for those who operate a business through a trust, but wish to access the corporate tax rate without material tax or duty implications. It is achieved by having the trust make all components of its business available to a private company under a written licence agreement. The agreement allows that company to carry on the business in return for payment of a licence fee to the trustee.
The result being that business profits are derived in the company (as opposed to the trust) where they can be retained and taxed at the corporate rate, rather than the trustee having to apply or distribute that income to beneficiaries of the trust and manage UPEs on a year by year basis.
An effective business licence agreement also ensures ownership of the assets under licence remain with the trust, including any improvement to those assets (such as goodwill). From an asset protection perspective, this means that operational risk is moved into the company and away from valuable assets in the trust.
While this strategy maximises asset protection, it is not likely to be a long term solution to manage UPEs to private companies. Where a trust is no longer suitable for its intended purpose, it is worth considering options available to restructure or move business operations into a corporate environment permanently.
As with all matters involving trusts, legal advice should be sought to ensure that effective solutions are considered and implemented appropriately.
