Trusts are a very popular way for families to hold investments and carry on business because of the clear advantages of asset protection and income management. However the flexible nature of trusts also gives rise to compliance complexities. Family trust elections are an example of a trust compliance complexity. This article provides an overview of family trust elections, including the important impact family trust elections have on the transfer of family assets to the next generation.
What is a family trust election (FTE)?
A FTE is a tax legal mechanism to restrict distributions by a discretionary trust to a group of beneficiaries, which we identify as the ‘family group’. The restriction is enforced by applying a penalty tax to distributions made outside the family group. The penalty tax is the top marginal personal tax rate.
An FTE is made by a Trust with respect to a particular individual called the specified individual. The individual must be living at the time the election is made. The family group is then defined in respect of the specified individual.
Why do we have family trust elections?
It is the nature of discretionary trusts that trust beneficiaries have no ownership of the trust assets. Certain tax provisions, in particular laws around distributing franked income or carrying forward losses, require the ownership of an entity to remain the same over a period of time. This is tested by tracing through to ultimate individual owners. Discretionary trusts cannot satisfy these rules because there is no direct beneficial ownership to any individual. A family trust election ensures that the trust is controlled and operated for the benefit of a specific family group defined around a specified person, and so this mechanism connects the trust to a single person. This connection enables the trust to satisfy tax rules for distributing franked income and recouping losses.
Who is in the family group?
- The specified individual
- certain family members of the specified individual;
- other trusts that have an FTE with the same specified individual;
- entities that are wholly owned by individual family members or elected family trusts (with the same specified individual); and
- other entities that have made an Interposed Entity Election (IEE).
What is an interposed entity election (IEE)?
An IEE is an election that a family-controlled entity can make to be included in the family group. The election is made with respect to a specific trust that has an FTE. An entity that has an IEE is also restricted to making distributions to other members of the family group.
What are the consequences of making these elections?
The key consequence is that the distributions from the trust are limited to the family group and connected entities (significant tax penalties apply if the rule is breached). The benefit is that the trust can distribute franked income and recoup losses. These benefits, particularly distributing franked income, are a basic requirement of most trusts, so most trusts have made these elections. While it is useful for these benefits it is also important to understand the impact on succession planning.
What is the impact of making a family trust election on succession planning?
Imagine a family group made up of a company and a trust that have operated for 40 years by a husband and wife. The company has a lot of retained earnings and the trust has significant investments in listed shares. The company and the trust are covered by a family trust election. This is a typical story in one form or another!
Now at some stage the assets of the company and trust will pass to their three children. It is possible to keep the parents’ company and trust operating on behalf of the next generation, but in my experience this is not satisfactory because there are always legitimate competing interests across the next generation. Therefore we need to pass the assets into three new structures for the next generation.
The impact of the family trust elections is that when new trusts and companies are set up for the families of the three children, the new structures will need to be part of the original family group defined by the original family trust election of the parents. This means in practical terms that when the retained profits and listed assets are distributed to the structure of the next generation, that structure will be limited to distributing to the child of the parents, their spouse and children. This is manageable, but my point is that when succession planning is undertaken, it is important to understand the consequences of family trust elections.
For more information on establishing or reviewing your succession plan, or more specifically your family trust elections, please speak with your usual Mazars advisor or alternatively one of our specialists:
Author: Michael Jones
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