Family trusts have been, and continue to be, a popular vehicle by which family and private businesses operate, whether to protect assets or appropriately tax plan.  After all, Australia has an estimated 450,000 trusts in operation. 

Over the past few years, the Federal Government has introduced legislation which has potentially affected the flexibility of trusts.  In particular, in the mid 1990s, fearing that a market was developing in relation to trafficking in trusts with losses, the Government introduced the quite onerous trust loss provisions.  As a result of the compliance burden that many families would endure under this legislation, the Government introduced the family trust election concept, a concept which has since found its way into a number of areas within the tax legislation.

Broadly, where certain considerations are satisfied, the trustee of a trust can elect for the trust to be a ‘family trust’. This requires the trustee to complete a family trust election form and nominate a test individual. The test individual nominated, in essence, defines the family group. This election needs to be completed by the time the trust income tax return is due to be lodged for a particular year.

Those operating through trusts need to consider whether to make a family trust election and, if so, be aware of the future ramifications that such an election can have.  This issue has recently come to light following a Tax Office audit, where a taxpayer receiving an otherwise clean bill of health, other than for the fact that it had not made a family trust election, resulted in a substantial amended assessment to the taxpayer.

Broadly, there are three situations in which a trust may wish to make a family trust election:

• Firstly, if the trust has tax losses which it will seek to recoup, a family trust election may be required; 

• Secondly, where non fixed trusts own 50% or more of the shares in a company which has tax losses, family trust elections may be required to be made by the trusts; and

• Thirdly, if the trust has acquired shares and seeks to distribute the dividend income and the associated franking credits to the trust’s beneficiaries, a family trust election may be required.

The timing in making a family trust election is absolutely crucial.  Failing to meet the election deadline can result in substantial additional tax being paid. 

What is often overlooked when making a family trust election is the potential sting that such an election possesses.

If we take a normal discretionary trust which usually has a wide and varying degree of eligible beneficiaries, a consequence of the trust making a family trust election is that future distributions will be restricted to a defined family group, which will invariably be narrower than the existing list of eligible beneficiaries of the trust. A consequence of making a family trust election is that any distribution outside of the defined family group will attract a tax known as the Family Trust Distributions Tax, a tax which is levied at the top marginal rate of tax. The concept of distribution not only includes a distribution of income and capital as usually understood but also includes the provision of property for inadequate consideration.  A typical example of the provision of property for inadequate consideration would be an interest-free loan. 

To further complicate matters, if the test individual dies, while the existing family trust elections made by existing trusts continue to be valid, no new trusts can make a family trust election and nominate the deceased person as the test individual.  The consequences of this is that the old trust and new trust will not be able to distribute income or capital to each other and will be required to transact with each other on an arms length basis.  This outcome is unsatisfactory in the context of a family group where trusts do distribute income and capital to each other as a matter of practice.

The family trust election concept has been introduced to alleviate some of the compliance burden which exists within the current tax legislation.  However those making family trust elections should not only look at the immediate consequences of making such an election but the potential future ramifications flowing from such an election.

Craig Holland is a tax principal specialising in family businesses at Deloitte.