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Warning: ATO crackdown on tax avoidance in family trusts

Fail to use your trust structure properly and you could be taxed up to 47%.

Compilation image of crowd of people crossing the street and ATO tax logo to signify family trusts
A family trust has several tax benefits, but the ATO says some are crossing the line. (Source: Getty) (Samantha Menzies)

The Australian Taxation Office (ATO) is shining a spotlight on how family trusts are distributing their income to beneficiaries after finding some trusts are avoiding tax.

The issue is that, in many cases, trust beneficiaries are avoiding tax by structuring distributions so that it appears beneficiaries on low or tax-free brackets are receiving distributions when, in reality, the income is going to other higher-income-earning beneficiaries.

Read more from Mark Chapman:

What is a family trust?

A trust is a structure that allows a person or company to hold an asset - cash, property, shares or businesses - for the benefit of others. The person who controls the asset is the ‘trustee’ and those who benefit are the ‘beneficiaries’. Discretionary trusts (sometimes known as family trusts) are the most common type of trust used in Australia.

How are family trusts taxed?

The income of a trust is taxed in the hands of the beneficiaries of that income, based on their share of the income of the trust at the end of each tax year. That means each beneficiary records their share of the income of the trust in their personal tax return and pays income tax on it at their marginal rate. In normal circumstances, the trust itself doesn’t pay any tax at all.

If a particular beneficiary is under a “legal disability” (such as those under 18, those who are mentally incapacitated and those who are bankrupt), the income will be taxed to the trustee at the relevant individual rates (which may be higher than usual, since the law imposes punitively high tax rates on some income paid to under-18s). That beneficiary may then need to declare the income in their tax return and claim a credit for the tax paid by the trustee.

For income to which no beneficiary is “presently entitled”, tax will generally be payable by the trustee at the highest marginal rate of 47 per cent (including the Medicare levy). If a trustee resolution setting out the respective entitlements of the beneficiaries is not prepared by June 30, no beneficiary will be “presently entitled” and the higher tax rate will be applied to the trustee.

Businessman checking money, Australian dollars, in the envelope
When it comes to filing your tax, it's important you follow the rules. (Source: Getty) (Getty Images/iStockphoto)

How is the ATO cracking down?

When they are used carefully and responsibly, there should be no tax issues with family trusts. However, consider this situation:

The Trustee of the Dodgy Family Trust elects to make a trust distribution to Johnny Dodgy, who has just turned 18 and has very little taxable income. However, the cash isn’t actually paid to Johnny but is instead diverted to Jeff and Jean Dodgy - his parents, who earned $500,000 each from the family business - ostensibly to reimburse them for the cost of providing private schooling to Johnny when he was under 18.

The result is that Johnny Dodgy is “presently entitled” to the distribution and pays tax at a relatively low rate on the distribution (but doesn’t actually receive anything) and his parents, who are higher-rate taxpayers, actually receive the cash and pay no tax at all (other than covering Johnny’s minimal tax bill).

What steps is the ATO taking?

This all-too-common situation has raised the ire of the ATO who have promised to invoke anti-avoidance legislation (s100A) to combat it. Section 100A applies to a trust distribution where a trust makes a beneficiary (Johnny, in this case) presently entitled to the income of the trust and the present entitlement arose out of a “reimbursement agreement”.

The beneficiary in these circumstances will be deemed to not have a present entitlement to the trust income and the trust distribution will be invalidated. In effect, the cash will be treated as if it remained in the trust, which means the trustee will be subject to tax, at a rate of 47 per cent.

The term “reimbursement agreement” is very broadly defined. There does not need to be an agreement in writing and the agreement does not need to provide for a “reimbursement”. It means an agreement to provide a benefit to or for a person (the parents, in this case), other than the presently entitled beneficiary (Johnny).

As noted, where s100A applies, the ATO has the power to assess the trust distribution to the trustee of the trust, rather than the beneficiary made presently entitled to the income, at the top marginal rate of tax (47 per cent) – which could prove very expensive tax planning for the trustees.

So, watch out how you use your family trust if you want to avoid this situation – always take tax advice before structuring trust distributions.

Understanding the tax involved with companies and trusts can be confusing. Read H&R Block’s tax guides online to help you gain an understanding of the tax involved.

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