Introduction

Discretionary trusts, also frequently known as family trusts, serve as effective mechanisms for both asset management and safeguarding. They provide considerable adaptability in determining the timing and methods by which beneficiaries gain access to both income and assets. This inherent adaptability renders them a highly suitable option for families seeking to effectively handle wealth, lessen tax obligations, and ensure the protection of trust assets. This article offers crucial insights for individuals aiming to grasp the potential of a discretionary trust as a valuable tool in estate planning, delivering both financial security and reassurance.

What are Discretionary Trusts?

Discretionary trusts, also known as family trusts, are a type of trust where who will benefit from the trust isn’t set in stone. Instead of specific beneficiaries having a guaranteed share, the trust document lists a group of possible beneficiaries. The trustee then has the power to decide which of these people will receive income or assets from the trust, and how much they will get.

In this type of trust, those who could potentially benefit are initially called “objects of the trust” until the trustee decides to distribute funds to them. They don’t automatically own any part of the trust’s assets, but the trustee must consider them when making decisions about distributions. This flexible approach allows trustees to adjust to changing situations and the different needs of the beneficiaries. This can be useful for protecting assets and planning taxes effectively.

Even though discretionary trusts are flexible, it’s important that the trust document clearly outlines who the possible beneficiaries are. If it’s not clear, the trust could be invalid. These trusts are often used for planning estates, managing family businesses, and handling investments because they can protect assets and help with tax-efficient distribution of wealth.

Key Attributes of Discretionary Trusts

Discretionary trusts possess several important attributes that make them useful for various purposes. These key features are outlined below:

Different Forms of Discretionary Trusts

Discretionary trusts are not all the same; they can be structured in various ways to serve different purposes. Here are some common types:

• Discretionary Family Trusts: Frequently used for managing a family’s combined wealth and assets, these trusts empower trustees to allocate both income and capital among a wide group of possible beneficiaries. Typically, these beneficiaries are family members. Family discretionary trusts can also provide tax advantages. For instance, they can facilitate the transfer of tax credits linked to dividends and the carry-forward of tax losses, provided that a specific election related to family trusts is made.
• Testamentary Trusts: These trusts are established through a person’s will and become operational after their death. They are commonly utilized in estate planning because they offer flexibility in how a deceased person’s assets are distributed and can provide tax benefits. These types of trusts can also safeguard assets for beneficiaries, especially those who are minors or who might need help managing their finances.
• Child Maintenance Trusts: These trusts have a specific purpose: to provide for the financial support of children when parents separate. They assist in managing and distributing funds for the children’s benefit. Additionally, they can offer tax efficiencies by distributing income to children, who are likely to be taxed at lower rates.
• Special Disability Trusts: These trusts are set up to meet the care and living needs of individuals who have a severe disability. They come with specific benefits related to social security and tax. Often, these trusts are established by close family members and must comply with strict rules about how the trust’s money can be used.

Advantages of Using a Discretionary Trust for International Estate Planning

Discretionary trusts come with several advantages, making them a desirable option for planning estates that involve international aspects. Here are some of the primary benefits:

• Building Up Assets for Beneficiaries: Discretionary trusts allow assets, including capital, to grow over time within the trust structure. These accumulated assets can then be distributed to beneficiaries in a way that minimizes tax implications. This is especially useful for preserving wealth across generations and for long-term estate planning strategies.
• Flexibility in Distribution: A key benefit of discretionary trusts is their adaptability in how income and capital are distributed. Trustees have the authority to adjust these distributions among beneficiaries as their needs and situations change. This can be done without needing to make amendments to the original trust document itself, providing significant ongoing flexibility.
• Simpler Reporting Processes: By clearly defining and limiting who the beneficiaries are, discretionary trusts can lead to simpler tax reporting procedures. For example, managing tax losses, claiming deductions for debt, and handling tax credits related to dividends can become more efficient under this type of trust structure.
• Reduced Capital Gains Tax: Discretionary trusts are eligible for a reduction in capital gains tax when assets held for more than a year are sold. This tax benefit applies to the trust itself and can also be passed on to the beneficiaries who receive distributions, effectively lowering the overall tax owed on capital gains.
• Tax Efficiency: These trusts offer various tax benefits. Notably, income can be directed to beneficiaries who are taxed at lower rates, which helps to minimize overall tax liabilities. Additionally, there may be opportunities to utilize tax concessions available to small businesses, further enhancing tax efficiency.
• Customizable Trust Agreement: The document that establishes the discretionary trust, known as the trust deed, can be specifically tailored. This means it can be designed to fit the unique requirements of the individuals setting up the trust and those who will benefit from it. This customization adds another layer of flexibility to estate planning and asset management.
• Protection for Assets: Discretionary trusts provide a level of protection for assets. Because beneficiaries do not have a guaranteed right to the trust’s property, these assets are less vulnerable to potential creditor claims. This protection can be strengthened further by using a company as the trustee, which can shield the trust’s assets from personal liabilities that beneficiaries might face.
• Straightforward Dissolution: Compared to some other business structures, discretionary trusts are relatively easy to wind up or dissolve. This makes them a practical choice for estate planning, as it simplifies the process of finalizing and distributing assets when the time comes.

Disadvantages of Discretionary Trusts for Protecting Assets

While discretionary trusts have many advantages, it’s important to be aware of their potential downsides. Here are some key disadvantages to consider:

• Uncertainty for Beneficiaries: Those who may benefit from a discretionary trust do not have a guaranteed right to specific assets or income from the trust. The trustee has the power to change how distributions are made, meaning beneficiaries cannot be certain about what they will receive. This lack of guaranteed benefits can create problems for beneficiaries who are counting on the trust for their financial security.
• Possible Legal Challenges: While the adaptable nature of discretionary trusts is often seen as a strength, it can also create some challenges. For example, the courts can sometimes get involved in how these trusts are managed, particularly when family law issues arise. Consider the case of Kennon vs Spry. In this instance, a high court made a decision that included assets held within a discretionary trust as part of a divorce settlement. This court ruling essentially went against the trustee’s intended decisions and the established structure of the trust itself. This example shows that even with a discretionary trust, court actions can sometimes impact how the trust operates.
• Family Trust Distribution Tax: In a family discretionary trust, if distributions are made to individuals or entities outside the defined “family group,” these distributions can be taxed at the highest possible income tax rate. It is therefore very important for trustees to make the correct selections and identify the appropriate “test individual” to avoid this high tax rate.
• Significant Paperwork and Rules: Managing a discretionary trust involves dealing with a considerable amount of regulation and compliance tasks. This includes complex tax reporting and calculations for employee income tax. This can create a heavy administrative burden, especially for business owners, and increase the costs of running a business.
• Losses Can’t Be Easily Used: If the trust experiences financial losses, these losses cannot be transferred to other entities, like companies. Instead, these losses remain within the trust and can only be used to reduce future profits earned by the trust itself. This can restrict options for tax planning.
• Complex Rules for Losses: The tax regulations concerning trust losses are complicated and can make managing the trust more difficult. Understanding and correctly applying these rules often requires careful consideration and advice from financial or legal experts.
• Risk of ‘Resettlement’ and Taxes: Making changes to the trust deed, such as altering the terms or adding new beneficiaries, could be seen as legally creating a new trust, known as a “resettlement.” This event can trigger taxes like capital gains tax and stamp duty, which can be expensive.
• Trustee’s Liability: Trustees can be held personally responsible for the debts and obligations of the trust if the trust’s assets are not enough to cover these liabilities. This represents a significant risk, particularly if the trust is involved in business activities that carry financial risks.
• Higher Land Taxes: Discretionary trusts do not qualify for the same land tax exemptions that are available to individual property owners. As a result, holding properties within a trust can lead to higher land tax costs.

These disadvantages show that while discretionary trusts can be beneficial, they also involve complexities and potential risks for asset protection and estate planning. It is crucial to get advice from legal and financial professionals to effectively navigate these challenges.

Distinctions Between Discretionary Trusts and Other Trust Types for Wills and Estate Planning

Steps to Set up a Discretionary Trust

Setting up a discretionary trust involves a number of essential steps. Each of these is important to ensure the trust is legally sound and works effectively. Below is a step-by-step guide to help you through the process:

• Choose Your Trustee: The responsibility of managing a discretionary trust’s assets falls to the trustee, who must act according to the instructions in the trust document. Trustees can be individuals, either a single person or multiple people, or they can be a corporate trustee, which is a company. Using a corporate trustee can be beneficial as it can reduce the personal legal risks for individuals acting in this role and simplify the trust’s administration, particularly when there are changes in trustees, because the company, as the registered asset owner, remains constant.
• Create the Discretionary Trust Deed: This document is the foundation of the trust. It’s a legal document that spells out all the key rules for how the trust will operate. Important elements within the trust deed include:
  • Beneficiaries: Clearly stating who is eligible to benefit from the trust.
  • Trustee Authority: Specifying the powers the trustee has when it comes to managing the trust’s assets and making decisions about distributing income and capital.
  • Financial Provisions: Addressing important financial aspects, such as how the trustee will be paid for their services and how taxes and other expenses related to the trust will be handled.
  • Trustee Changes: Describing how new trustees can be appointed and how existing trustees can be removed from their role.
• Formally Establish the Trust (Settlement): The settlor is the person who sets up the trust initially. Typically, this is someone who is not connected to the people who will benefit from the trust. This separation is usually done for tax reasons. The settlor’s role involves signing the trust deed, which is the legal document that establishes the trust, and providing a small initial amount of money to start the trust – often just a symbolic sum, like $10. Once this is done, the settlor generally has no further role or involvement with the trust’s ongoing operations.thumb_upthumb_down
• Trustee Agreement and Signing: Trustees must formally accept their role to officially begin managing the trust. This involves signing the trust deed, indicating their agreement to be bound by all the terms within it. Typically, this process includes a meeting where the appointment is officially acknowledged.
• Stamp Duty Requirements: Setting up a trust might involve a tax called stamp duty, but this depends on the specific rules of the location where the trust is established. In some areas, there is a fixed stamp duty fee for creating a new trust, and this fee must be paid within a certain timeframe after the trust is set up. If the payment is late, there could be extra charges like interest. Even if no stamp duty is required in a particular location, the trust document might still need to be officially registered with the local tax authority to formally acknowledge its existence.
• Obtain Business and Tax Numbers: A trust needs to obtain certain identification numbers for business and tax purposes to operate correctly. Specifically, it’s necessary to get a business registration number and a tax identification number. Applications for these can be made online through the relevant business registration service, or support can be sought from an accountant to assist with the application. The process of receiving these numbers can take up to about a month.
• Set Up a Trust Bank Account: It’s important to establish a bank account specifically for the trust. This account should be opened under the name of the trustee, clearly indicating that they are acting in their capacity as trustee for the trust. When opening this account, the bank might ask for certain documents to verify the trust’s legitimacy. These documents could include the trust’s business registration number and a certified true copy of the trust deed itself. The first deposit made into this new account should be the initial settlement amount that was used to establish the trust. After this initial deposit, the account will be used for all other financial activities related to the trust, such as receiving contributions and managing transactions.
• Trust Commencement: After completing these setup steps, the trust is officially ready to be used. At this point, it can receive additional funds, take out loans, and make investments, all according to the rules and permissions outlined in the trust document.thumb_upthumb_down

Conclusion

Discretionary trusts provide a distinctive combination of adaptability, safeguarding of assets, and tax advantages. These features position them as a useful instrument in planning for the future of your estate. However, it is important to remember that they also involve specific obligations and intricate aspects that need careful attention. If you are thinking about establishing a discretionary trust, it is essential to get professional advice. This will help you confirm that the trust structure is appropriate for your family’s particular situation and financial objectives. For tailored advice and assistance, please reach out to Samoa Offshore Legal today.