Family Trust Distribution Tax: What it is and how to avoid it

Whilst many discretionary trusts set up to benefit spouses/children/other family members may have "Family Trust" in their name, they are not truly 'family trusts' for taxation purposes until they make a Family Trust Election (FTE).

Making an FTE entitles a trust to access a range of useful tax/reporting concessions, and should be considered by trustees who only make distributions to members of a closed family group. The trade-off is that when distributions are made outside the family group, the punitive family trust distribution tax (FTDT) is imposed.

What is an FTE and what effect does it have?

The FTE identifies a 'specified individual' who forms the point of reference for defining the family group, which generally includes the specified individual, their spouse, their parents, their grandparents, their siblings and their spouses and nephews and nieces and their spouses and lineal descendants. Where these family members have an entitlement to all of the capital and income of a particular company or partnership, that company or partnership can also be a member of the family group.

An FTE can only be made if the trust passes the family control test at the end of the specified income year, meaning that only the individual specified in the relevant FTE or members of their family/their advisers are in control of the trust. An FTE can't be made for a trust that has previously had an FTE revoked.

Why make an FTE?

Carry forward losses: the main reason to make an FTE is to simplify the use of carry forward tax losses. The trust loss tests are ordinarily quite cumbersome and complex. However once an FTE is made, only one of the trust loss tests (the income injection specified) applies, and only in a modified way.

The other reasons can be just as important, but are somewhat more complex:

• Simplified loss tracing for companies: if a family trust (with an FTE) owns shares in a company, that company can treat the family trust as a single notional entity when tracing as part of its own loss testing. This means that there is no need for the company to trace past the family trust when testing the company's ownership structure during a loss period.

• Access to franking credits in family group: ordinarily a beneficiary of the trust who does not have a vested and indefeasible interest in shares owned by the trust will not be a 'qualified person' to receive any of the franking credits paid on those shares. However with an FTE, the members of the family group are deemed to be qualified persons for the purpose of receiving franking credits.

• Other benefits: trustees have the benefit an exemption from complying with the trustee beneficiary reporting rules, and family groups can more easily access special rules relating to small business restructure CGT roll-overs.

How does an FTE give rise to FTDT?

• Once an FTE has been made, if any distribution is applied to an entity outside of the family group, FTDT is payable on the distribution by the trustee at the top marginal rate of tax applying to individuals plus Medicare levy. This could happen, for instance, where the family loses the right to 100% of the income and capital of a company (which may be due to the issue of shares to an external third party) yet the trustee still distributes to that company.

Can I vary who the specified individual is? Should I?

Given the highly punitive FTDT, it is always prudent to consider who the most appropriate specified individual will be before the FTE is made, as there is little flexibility to vary who this individual is thereafter.

The specified individual can be varied once, but only once, and subject to certain conditions. One of those conditions is that the new specified individual has to have been a member of the family group at when the original FTE was made.

In the event that the specified individual becomes isolated or estranged from the other members of the family group, then a once-off variation to the specified individual could be considered.

Do you still need the election? Can it be revoked?

Once the election has been made, it can only be revoked in limited circumstances. This is why it is very important to consider the possibility that the trustee may want to distribute to entities outside of the family group in the future, even if the trustee is not doing so now.

An FTE can be revoked where:

• the family trust is a fixed trust; or
• where the FTE was not required for recouping tax losses, deducting bad debts or accessing franking credits.

An FTE revocation generally must be made within four years of the initial FTE being made.

The revocation should be made in the trust's tax return for the income year from which the revocation is to be effective. You must be sure of the revocation at the time of initial lodgement - a tax return that has already been lodged can't be amended simply to include an FTE revocation that was previously left out.

Once a trust has had its FTE revoked, it can never make an FTE again.

More Cleardocs information on related topics

You can read earlier ClearLaw Articles on a range of topics, including the following topics which you may find relevant:

• Trusts holding residential land in NSW must amend their trust deed by 31 December 2020 or risk foreign surcharges applying;
• Discretionary trusts: recent developments in "foreign person" rules for duty and land tax purposes; and
• Testamentary trusts: Changes to taxing of distributions to minors.

Order related document packages

• Discretionary (Family) Trust Minutes & Resolutions
• Discretionary Trust - excluded beneficiaries
• Change of Trustee Discretionary Trust

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Revenue Practice Group.