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The use of family trust elections is very common among discretionary trusts.
Family Trust Elections
Given the prevalent use of family trust elections (FTE) among discretionary trusts, the term ‘family trust’ is often, in practice, used interchangeably with the term ‘discretionary trust’.
However, a trust only becomes a family trust for tax purposes through an FTE. So, a deed might refer to the trust as a family trust, but it isn’t a family trust for tax purposes until it makes an FTE per s272-75 of Schedule 2F ITAA36.
Paul Mackenroth of Cleary Hoare in Brisbane will walk you through the rules around family trust elections. Here is what we learned, but please listen to the episode, since Paul explains this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a podcast app on your mobile phone.
Family Trust Elections
In theory, fixed and non-fixed trusts can both make family trust elections. But in practice, it is usually only non-fixed (generally discretionary) trusts that make an FTE.
There is no one-size-fits-all. Family trust elections might benefit one but harm another. So you need to weigh up the minus and plus before you decide.
Minus
The main drawback of a family trust election is the potential application of family trust distribution tax (FTDT). Whenever the trustee distributes to a person outside the applicable family group, FTDT applies.
The ATO updated its views on FTDT in TD 2017/20. And effectively widened the net when FTDT may apply.
Plus
There are seven good reasons to make a family trust election.
# 1 Franking Credits
A discretionary trust can only claim franking credits if it has an FTE. This applies to any franked dividends on shares it acquired after 3pm on 31 December 1997.
# 2 Deductibility of Tax Losses and Bad Debt
The trust loss provision prevent the transfer of losses or deductions to persons who did not bear the economic loss.
To achieve this, the trust loss provisions deny the deduction unless the trust passes certain tests. The trust loss provisions sit in Schedule 2F ITAA36 and apply to revenue losses as well as certain debt deductions. With an FTE, a family trust only needs to pass a modified version of the income injection test.
# 3 Unit Trust
When a discretionary trust with an FTE owns units in a fixed (unit) trust, it can assist the fixed trust to pass the 50% stake test.
The 50% stake test requires the same individuals to have (directly or indirectly) fixed entitlements to more than 50% of the income and capital of the trust. With an FTE, Schedule 2F treats the discretionary trust unit holder as an individual for trust loss purposes.
An “alternative test’ may instead apply where other non-fixed trusts (i.e., that are not family trusts) hold fixed entitlements to at leat 50% of the income or capital of the fixed trusts.
# 4 Continuity of Ownership Test
If a discretionary trust owns shares in a company with tax or capital losses or bad debt, making an FTE may enable the company to pass the ‘continuity of ownership test’ (COT).
For the purpose of satisfying the COT, a family trust is taken to hold its interest as an individual for these purposes, meaning there is no need to trace past the family trust.
# 5 No Trustee Beneficiary Reporting Rules
Closely held trusts (including discretionary trusts) are subject to the trustee beneficiary reporting rules. But not if the trust made a FTE. An FTE will exempt the trust from the TB reporting regime.
# 6 Small Business Restructure Rollover
To access the small business restructure rollover, there must be no material change in the ‘ultimate economic ownership’ of an asset. Where a discretionary trust has made an FTE, transfers of assets to or from the family trust will not result in a material change in the ultimate ownership of the asset, provided that ownership remains with individuals within the same family group.
# 7 Practical Approach
The Commissioner might allow a practical approach that allows assets retain their pre-CGT status. Otherwise, he definitely wouldn’t.
Making an FTE
You make an FTE in writing and in the approved form per s272-80(2) Sch 2F ITAA36. Each year, the ATO releases an updated form to use for making, varying or revoking an FTE.
A trust can only have one FTE at a time. It can make the FTE at any time, provided it meets the requirements in s272-80.
To make a valid FTE, the election must specify the primary individual, the income year from which the election is to take place. And the trust must pass the family control test at the end of the income year.
You can make an FTE (or IEE) retrospectively.
Primary Individual
The test individual’ is the individual whose family group is used for the election.
A FTE limits the beneficiaries to which the trust can make distributions. So it is crucial to get this right. To specify the most appropriate primary individual in the election.
The identity of the primary individual will determine whether FTDT arises for distributions made outside the individual’s ‘family group’.
The test individual will also determine who is an ‘outsider’ for the purposes of the income injection test contained within the trust loss provisions.
Only one individual can be specified as the primary individual and that person must be alive when the election is made, refer to ID 2014/3. However, if the primary individual dies after an FTE has been made, the trust remains a family trust and the family group continues to be determined by reference to the deceased primary individual. As such, the life expectancy of potential primary individuals should be considered.
Varying the Primary Individual
Once a primary individual has been specified in an FTE, that person remains the primary individual for as long as the trust exists, unless one of the following two exceptions applies:
# 1 Once-Only
The primary individual can be varied once only (subject to four-year time limit, starting from the beginning of the income year specified in the election), if the following conditions apply:
The new primary individual was a member of the original primary individual’s family when the FTE commenced; and
The trust (and any entities that have made an interposed entity election (‘IEE’) in relation to the trust) has not made distributions of income or capital outside the new primary individual’s family group during the period the FTE has been in force Refer to s272-80(5A) and (5B).
# 2 Marriage Breakdown
The primary individual may be varied (at any time) if control of the family trust passes to a new primary individual (alone or together with their family members) as a result of an order, agreement, or an award of a kind mentioned in S.126-5(1)(a) to (f) of the ITAA 1997 arising from a marriage breakdown (e.g a court order under the Family Law Act 1975). Refer to s272-80(5C)
Family Control Test
A trust cannot make an FTE (or an IEE) unless it passes the family control test.
To pass the test, one of a number of specified groups must hold ‘control’ of the trust. These groups include the primary individual, one or more members of the primary individual’s family or the primary individual and one more members of the primary individual’s ‘family’. Refer to s272-87.
Subject to the exception for retrospective FTEs, once a trust passed the test for the specified income year, it doesn’t need to pass it in each subsequent year to continue being a ‘family trust’. Refer to s72-80(4) and s272-80(10).
Retrospective
You can make an FTE retrospectively if the trust passes the family control test in each of those earlier years and it only made distributions of income or capital to the primary individual or members of their family group in all those earlier years. Refer to s272-10(4A) for more details.
Varying the FTE
To vary an FTE, the variation generally must be made in the trust’s income tax return for the income year from which the variation is to be effective.
However, if the trust is not required to furnish a return in the relevant income year, the variation must be made in approved form, specifying the income year from which the variation is to be effective, and given to the ATO within two months of the end of the specified income year (unless further time is allowed by the Commissioner). Refer to s272-80(8).
When making an FTE, an income year must be specified from which the election commences to apply. However, if the family control test has not been met at all times during the specified income year, the election will apply from the day in the income year when the trust passed the family control test for the remainder of that income year. Refer to S.272-80(10).
Revoking the FTE
Once you make an FTE, it is generally in place for the life of the trust. You can only revoke it in two circumstances:
# 1 Fixed Trust To Outsider
When a fixed entitlement to income or capital of the trust passed to an individual other than a member of the family group (e.g., upon sale of some or all of the units in a unit trust), the trustee can revoke the FTE per s272-80(6)
# 2 FTE Not Required
You can revoke an FTE (subject to a four-year limit) if you didn’t use the FTE to claim tax losses or bad debts, or access franking credits. Refer to s272-80(6A) and (6B).
Once a trust revokes an FTE, it cannot make another election. Refer to s272-80(11). You can make an FTE retrospectively, but you can’t revoke it retrospectively. Refer to s272-80(9).
Family Trust Distribution Tax
A family trust election is not a one-size-fits-all solution. There is always the looming danger of ‘family trust distribution tax’ (FTDT).
FTDT effectively limits the range of beneficiaries the trust can distribute to. And it does that by taxing the trustee on distributions outside the family group. The FTDT is applied at the highest marginal tax rate plus medicare levy. So currently 47%.
FTDT is payable by the trustee of a family trust if the trustee distributes income or capital to an entity outside the family group. FTDT is also payable if an entity with an IEE distributes income or capital outside the family group. You find a lot more details in ss271-15 to 271-30 Sch 2F ITAA36.
A corporate trustee director is jointly liable along with the trustee for any outstanding FTDT.
So unless there is a specific reason for an FTE, avoid making an FTE. A specific reason might be to claim tax losses or pass franking credits to trust beneficiaries or any of the other 5 benefits listed above.
Interposed Entity Election
Trusts, like companies and partnerships, are able to make an IEE. The IEE will include them in the family group of a family trust’s primary individual. Refer to s272-85(1).
But for various reasons, a trust it is usually better off to make an FTE (specifying the same primary individual as the other relevant family trust) rather than to make an IEE.
Family
To determine a primary individual’s family group, you first define their family per s272-95 and then their family group.
Family consists of the primary individual and all of the following: any
- parent, grandparent, brother or sister of the primary individual or primary individual’s spouse;
- nephew, niece or child of the primary individual or the primary individual’s spouse;
- lineal descendant (e.g., grandchild, great-grandchild, etc..) of a nephew, niece or child refer to in (b) above; and
- spouse of the primary individual or the spouse of anyone referred to in (a), (b) or (c)
Spouse includes de facto spouse. It doesn’t matter whether the spouse of the same sex or a different sex. Child includes the children of such relationships.
The definition of a primary individual’s family under the trust loss provisions excludes certain relatives, such as a former spouse (i.e., where divorced), a step-brother or step-sister (i.e., where there is no common parent), a former step-child (i.e., as a result of a divorce), an uncle, aunt, or cousin; and a great-grandparent
A person doesn’t cease to be a family member merely because of the death of any other family member. Refer to s272.95(2).
However, if a widowed spouse remarries, they will cease to be a family member. But they will continue to be part of the primary individual’s ‘family group’.
Family Group
The family trust election is all about the primary individual’s family group.
This family group per s272-90 includes the primary individual’s family. That is why you started with the family in the first place. But the family group goes beyond that.
The family group also includes:
- A former spouse or a former step-child. So a person who was a spouse or who was a step-child of either the primary individual or of a member of the primary individual’s family before a breakdown in marriage.
- A widow/widower who has remarried . So a person who was a widow or widower of either the primary individual or of a member of the primary individual’s family and who has a new spouse that is not a member of the primary individual’s family
- The trust subject to an FTE, so the family trust itself.
- Other family trusts with the same primary individual specified in their FTE
- An entity (i.e., a company, partnership or trust) that has made an IEE in respect of the primary individual
- A company, partnership or trust in which the primary individual, or family members of the primary individual, or another family trust which has the same primary individual, or any combination of these persons have fixed entitlements, directly or indirectly, to all of the income and capital of the company, partnership or trust.
- If the primary individual and all the members of their family have passed away, the deceased estates of the primary individual and their family members
- Certain tax-exempt entities or deductible gift recipients
Example
There are two discretionary trusts. And both have Bob as trustee. Trust A has made an FTE nominating Bob as primary individual. But trust B hasn’t made an FTE or an IEE. And trust B owns a bucket company that hasn’t made an IEE either.
As trustee of trust A Bob distributes $100m of trust income to the bucket company. Not a good idea. The bucket company is outside Bob’s family group, even though it is wholly owned by a trust that Bob acts as trustee for. So the distribution from trust A to the bucket company will result in an FTDT liability.
How to fix this? How can we make the bucket company part of Bob’s family group and hence avoid FTDT? There are two options.
# 1 Trust B makes an FTE
Trust 2 can make an FTE specifying Bob as the primary individual. As the fixed entitlements to all of Bucket Pty Ltd’s income and capital would then be held by a family trust with the same primary individual as Trust A, Bucket Pty Ltd will automatically be part of Leon’s family group as per s272-90(5). This is generally the preferred option in this scenario.
# 2 Bucket Company makes an IEE
The bucket company makes an IEE to be included in Bob’s family group per s272-90(4).
While the distribution from trust A to the bucket company would be within Bob’s family group, any subsequent distribution by the bucket company outside of Bob’s family group would result in FTDT. If trust B does not also make an FTE with Leon as its primary individual or doesn’t make an IEE to be included in Leon’s family group, FTDT would be payable (by trust A) if/when Bucket Pty Ltd pays a dividend to trust B in the future.
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Disclaimer: Tax Talks does not provide financial or tax advice. This applies to these show notes as well as the actual podcast interview. All information on Tax Talks is provided for entertainment purposes only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 24 September 2024
Tax Talks spoke to Paul Mackenroth - Senior Associate at Cleary Hoare - for more details.
