Some of the key issues associated with the distribution of trust income from a discretionary trust are listed as follows. However, it is important to be aware that this process will inevitably be different from one trust to another. This is because each trust presents a unique set of circumstances, in terms of the type of income derived by the trustee and the profile of the beneficiaries, along with its own, unique, trust deed.
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Understand what is being distributed and why
A trustee must distribute trust income each year in order to avoid adverse tax outcomes arising. If trust income is not distributed, the net (taxable) income of the trust is assessed to the trustee at the top marginal tax rate (referred to as a ‘trustee assessment’) or, if the deed contains a ‘default beneficiary’ clause, the default beneficiaries are assessed. The two important concepts to be familiar with here are trust income and net (taxable) income.
If trust income is distributed to a trust beneficiary (or beneficiaries), each beneficiary will pay tax on the net (taxable) income of the trust, based on their proportionate share of the trust income (as adjusted for streamed amounts). However, in the case of streamed capital gains and/or franked dividends, beneficiaries are assessed based on their share of the franked dividend or capital gain streamed to them.
- Consider how trust income is defined in the deed (if at all)
Trustees should review the trust deed and make note of how income is defined (if at all). If the deed contains an income definition, it is important to ascertain whether it is ‘hard-wired’ or whether the trustee has some discretion as to what amounts will form part of trust income.
If the trustee does have such discretion, it is important to ascertain the nature of that power and any requirements that apply in relation to exercising that power. Any necessary action should then be taken no later than 30 June (or earlier if required under the trust deed). If trust income is not defined, it is generally the case that amounts will form part of the trust income where they are properly regarded as income according to ‘ordinary concepts’.
Further to the above, consider whether the way in which trust income is calculated is likely to result in ‘notional’ amounts (e.g., franking credits) being included in trust income, as this may result in an adjustment to trust income for tax purposes.
- Does the trust have at least $1 of trust income?
Although there is no specific requirement to quantify trust income prior to year-end, it is recommended that a trustee at least have some idea of the amount. This may necessitate the preparation of draft accounts. Consider whether the trust has at least $1 of trust income and, if not, whether action can be taken to ensure there is at least $1 of trust income.
- Who are the trust beneficiaries?
In most cases, identifying trust beneficiaries will not be contentious. However, be cautious where there has been a marriage, divorce or death to ensure distributions are not made to a ‘non-beneficiary’. A distribution to a non-beneficiary may result in there being no beneficiary having been made presently entitled to that trust income. Alternatively, the amount may be dealt with under a default beneficiary clause.
- The profile of the beneficiaries
Before making any trust distribution, it is important that trustees consider the profile of potential beneficiaries. This is important to enable tax-effective distributions to be made and also to consider if there are special rules that need to be adhered to if distributions are made. For example:
- Are any of the beneficiaries non-residents for tax purposes? This is relevant for a number of reasons, for instance, non-residents generally cannot utilise franking credits and may not be eligible for all or any of the CGT 50% discount on a capital gain.
- Is a trust distribution to be made to a bucket company? If so, regard should be had to the rules that apply in respect of bucket company Unpaid Present Entitlements (UPEs). These rules basically ensure that the trust pays in one way or another for the use of company funds.
- Is a trust distribution to be made to a tax-exempt entity (e.g., a charity, religious institution or sporting club)? If so, it is important to be mindful of the ‘pay or notify rule’ and the ‘benchmark percentage rule’. These are anti-avoidance rules that basically ensure this type of entity is not used to shelter taxable income.
- What is the marginal tax rate for each beneficiary? This will require an estimate of beneficiary income (e.g., salary) in some circumstances.
- Do any beneficiaries have capital losses (if the trust has derived a capital gain) or revenue losses
- Resolving to distribute trust income
Trust income is generally distributed by way of an appropriately worded income distribution resolution, pursuant to the terms of the trust deed. Three key issues that often arise in this regard concern the timing, format and documentation of the resolution.
- Timing – For tax purposes, a trustee must distribute trust income prior to midnight on 30 June of an income year (or earlier, if required under the deed). As a result of this deadline, trustees (and practitioners) will generally need to undertake preliminary work prior to 30 June.
- Format – Issues may arise if the trustee distributes fixed dollar amounts and trust income or net (taxable) income is later amended (e.g., as a result of an ATO review). For this reason, trustees often distribute percentage amounts, or they may distribute any excess income to a ‘balance beneficiary’.
- Documentation – Best practice is for a formal written resolution to be prepared, signed and dated by 30 June (or earlier if required under the deed). Alternatively, a circulating resolution can be utilised whereby each trustee/director will sign and date no later than 30 June. If this is not achievable, and a meeting or ‘verbal resolution’ will be relied upon (trust deed permitting), contemporaneous documentation should be created, which can then be used as the basis for preparing minutes at a later time.
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