The Test Individual is crucial for almost everything and anything a Family Trust wants to do.
Test Individual in a Family Trust Election
When you look at family trusts, everything rotates around the Test Individual. Whether you want to make a Family Trust Election, claim losses or stream franking credits.
Jonathan Ortner of Arnold Bloch Liebler in Sydney will outline how the Test Individual feeds into the definition of Family, Group and Family Group for a Family Trust.
Here is what we learned, but please listen as Jonathan Ortner explains all this much better than we ever could.
Access the episode through a free podcast app on your mobile phone to listen while you drive, walk, or work.
How it All Connects
Everything in a Family Trust pivots around the Test Individual. If you tried to draw all this, it would look like a spider web with the Test Individual in the middle.
The Test Individual defines who is part of the Family. The Family feeds into who is in or out of the Group and the Family Group. So you have Group, Family and Family Group. These three categories are the basis for everything else around the Family Trust.
So, choosing a Test Individual has far-reaching consequences.
Test Individual
It all starts with the Test Individual (‘TI’). The test individual will define who is in and who is out. Everything centres around the test individual for the definition of Family, Group and Family Group.
It is as if a circle is drawn around this person—a tiny circle to define Family, a slightly wider one for Group, and an even wider one for Family Group.
Anybody can be the Test Individual. There is only one condition: They must be alive when you make the FTE; if they are no more, bad luck. You have to choose somebody else, i.e. somebody alive. This is spelled out in ATO ID 2014/3.
Once the FTE is in place, whether the Test Individual is alive or dead no longer matters. The FTE lives on, even if the Test Individual doesn’t.
The Test Individual doesn’t have to be alive for an Interposed Entity Election (‘IEE’). The IEE links to the Family Trust and not to the Test Individual. Hence, the Test Individual can be alive or long gone by the time the IEE is made.
Family
Family is the lowest denominator. If you are part of a Family, you are automatically also part of the Group and Family Group. But not vice versa.
“You can choose your friends but you cannot choose your family” | Harper Lee in To Kill a Mockingbird
Every test individual has a Family, even if it is just them and nobody else.
A family only includes natural people but no other entities. No companies. No partnerships. No trusts.
Family is defined in s272-95 Sch 2F ITAA 1936. It includes the Test Individual and their spouse as well as both their:
1 – parents
2 – grandparents
3 – siblings
4 – children
5 – nephews and nieces
6 – children
7 – lineal descendants of nephews, nieces and children
8 – spouses of anybody listed above
Per s272-95 (2), you don’t cease to be a family member merely because of the death of another family member. This is especially relevant for widowed spouses.
Not included in the Family are:
1 – uncles and aunts
2 – great-grandparents and beyond
3 – former spouses
4 – parents of other family members
5 – grandparents of other family members
6 – siblings of other family members
7 – any companies, trusts and partnerships.
So, the Family is a tight circle around the Test Individual and their spouse.
Group
You must pass the Family Control Test for a valid FTE or IEE. To pass, your Group must control the trust for a valid FTE, and your Group must control the entity for a valid IEE.
So, the Family Control Test is all about the Group. Your Group consists of the
1 – Test Individual’s Family
2 – legal and financial advisors to any group members
3 – Family Trusts with an FTE specifying the same Test Individual
Family Group
Family Group is defined in s272-90 Sch 2F ITAA 1936. You need to stay within the Family Group to avoid Family Trust Distribution Tax (‘FTDT’).
Distributing to members outside your family group incurs FTDT at a 45% tax rate. Hence, don’t.
A Family Group consists of individuals and entities. Entities enter the Family Group either by default or through an IEE.
The Family Group includes:
Individuals
1 – Family (s272-95 ITAA 97);
2 – former spouses of family members (s272-95);
3 – children of family members before a relationship breakdown
Entities
4 – Family Trust itself that made the FTE
5 – Family Trust with an FTE specifying the same Test Individual
6 – Company or Partnership that made an IEE before the distribution
7 – Company, Partnership or Trust giving the Family (or a Family Trust with the same TI) fixed entitlements to all its income and capital
8 – deceased estates of family members (within time limits)
Certain funds, tax-exempt bodies and institutions without living beneficiaries can also be part of a family group.
Children
When you trace relationships to define a Family group, treat stepchildren, adopted children, and ex-nuptial children as ‘natural’ children (s960-255). This s960-255 ITAA 1997 is important. We will refer to it a few more times.
In s960-255, you will find the following example: Frank is Clare’s stepfather. He has a biological sister called Angela. Per s960-255, Angela is Clare’s aunt, as if Clare were Frank’s natural child.
Spouses
s960-255 ITAA 97 treats anybody who meets the definition of spouse in s995-1 as if the individual were legally married to the other individual. Section 960-255 provides the following example:
George and Angelika are not legally married but live together on a genuine domestic basis in a relationship as a couple. They are, therefore, part of each other’s Family.
Step-Nieces and Nephews
Step-nieces and nephews are part of a test individual’s Family Group. If the test individual has a brother and this brother has step-children, these step-children would be included in the test individual’s Family Group.
However, the FTE rules do not clearly state this. Note 2 in s272-95 Sch 2F ITAA36 refers to s960-255 only with respect to (1)(a) – the subsection that covers ‘any parent, grandparent, brother or sister’. Note 2 does not refer to (1)(b), the section that covers ‘any nephew, niece or child’. And it does not refer to (1)(c) or (1)(d).
However, indirectly, the FTE rules do include step-nieces and nephews since s960-255 treats the step-child and step-parent relationship as a “natural relationship” for s272-95(1) of Sch 2F to the ITAA36. Hence, it should also be treated as such when traced in the other direction.
Let’s say Shane and Bob are brothers. Shane has a stepdaughter called Sharon. If Shane were the test individual, then s272-95 (1) would treat Sharon as Shane’s natural child. If you now make Bob the test individual, then—applying the same principle—Sharon should still be treated as Shane’s natural daughter and, hence, as Bob’s natural niece. Sharon would, therefore, be included in both Shane’s Family and Family Group and Bob’s Family Group.
The Commissioner outlined the same reasoning in Edited Private Advice 1012872697591.
Family versus Family Group
Whoever is in the Family is also in the Family Group, not vice versa. Former spouses are not included in the Family, but are included in the Family Group.
Neither included in the Family nor the Family Group are:
1 – uncles and aunts
2 – great-grandparents and beyond
3 – parents of other family members, unless included otherwise
4 – grandparents of other family members unless included otherwise
5 – siblings of other family members
6 – any companies, trusts and partnerships.
IEE
When you have a Family Trust with an FTE specifying the same Test Individual, you don’t need an IEE. The Family Trust is part of the Family Group by default.
That used not to be the case. Before 24 September 2007, you had to make an IEE to move such a trust into the Family Group.
However, with the insertion of subsection 272-90(3A) under the Tax Laws Amendment (2007 Measures No 4) Bill 2007, you no longer need to make an IEE for a trust with an FTE specifying the same Test individual.
But that doesn’t seem to be widely known yet. Many accountants and lawyers still make an IEE for trusts that have entered the Family Group by default. The problem is that an IEE can not be varied; it can only be revoked.
Example 1:
A company giving the Family fixed entitlements to all its income and capital
Let’s say you have Trust A. Trust A has made an FTE with Adam as their Test Individual. Adam owns 51% of Company A (outsiders hold the rest), which has made an IEE for Trust A.
So far, it’s all very straightforward. Adam is part of his Family. All three—Company A (due to its IEE), Trust A, and Adam—are part of Adam’s Family Group.
But now Company A acquires 100% of Company B. Company B has not made an IEE. Is Company B part of Adam’s family group?
Without an IEE, a company is – per s272-90(5) of Sch 2F – a member of the test individual’s family group where
• the test individual and
• one or more family members
have fixed entitlements directly or indirectly and for their own benefit, to all of the income and capital of the company.
Adam only holds 51% of Company A and hence doesn’t have a fixed entitlement to all of Company B’s income and capital. Company B is, therefore, not part of Adam’s family group.
There are two ways Company B can join Adam’s Family Group:
1 – Adam buys the remaining 49% of Company A. This makes Company B part of Adam’s Family Group since Adam is now entitled to all of Company B’s income and capital.
2 – Company B makes an IEE.
Example 2:
Family Trust with an FTE specifying the same Test Individual
In the example above, Adam sets up another Family Trust with an FTE specifying himself as the Test Individual. This trust would automatically join his Family Group, since the same Test Individual.
Summary
Identifying a Test Individual’s Family Group is not always easy.
You frequently have a modern family with step and de facto relationships. The FTE rules in Sch 2F to the ITAA36 are not easy to read. Despite having existed for over 25 years, there are not that many court cases about FTEs.
All this can lead to unexpected outcomes around family trust elections that feel wrong to everybody involved.
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Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature 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.