SMSFs versus Trusts

Background

The concept of a trust arose in Britain in the Middle Ages. Knights used them to enable their affairs to be managed by a friend during long absences. Trusts were also used to put assets beyond the reach of creditors.

There are many types of trust but the basic elements are simple enough: One party (the ‘settlor’) transfers assets (the ‘trust capital’ or ‘corpus’) to another party (the ‘trustee’) to hold on behalf of another party or parties (the ‘beneficiary’ or ‘beneficiaries’).

Once established, any party may make further contributions to trust capital and the trustee may transact on behalf of the trust in the same manner as a natural person or company. Trustees can buy or sell assets, enter into contracts, borrow money and litigate, just like you and I.

Managed share funds are a form of trust—known as a ‘unit trust’—where the interest of the beneficiary is represented by a unit capable of being traded. Superannuation funds (including SMSFs) are also a form of trust, although a somewhat peculiar one, given they are heavily regulated by Federal legislation. Deceased estates, charitable trusts and nominee arrangements (for instance, child bank accounts) are other commonly used forms.

Family (discretionary) trusts

Somewhat forgotten in the rush to self managed super is the ‘discretionary trust’. Referred to colloquially (and in the Tax Act) as ‘family trusts’, they have traditionally been used in the planning of families’ financial affairs.

Family trusts can offer both asset protection and tax planning opportunities. Assets held by a family trust can, in some instances, be shielded from creditors of the individual beneficiaries.

At the end of each tax year, the trustee distributes the trust income to beneficiaries, as it sees fit (this is the ‘discretionary’ part). This allows the overall tax burden to be minimized by, for instance, distributing ordinary income to those beneficiaries with lower marginal tax rates and directing capital gains to beneficiaries with capital losses.

If the trust itself has losses they can’t be distributed. As with SMSFs, they get carried forward to deduct against income of future years. One catch with trusts is that franking credits received in a year of losses (ordinary, not capital) are lost—they can’t be carried forward and distributed down the track.

The typical family trust set up looks something like Diagrams 1 and 2. There are a few critical points to note:

1. Settlor. The role of the settlor is simply to establish the trust. They can’t be a beneficiary of the trust and will generally have no ongoing involvement. Typically, the settlor will be a family friend that will establish the trust with a nominal sum (say $10).
2. Trust deed. A family trust will be governed by a document—executed by the settlor and trustee—known as the ‘trust deed’. The trust deed will identify beneficiaries, set out any limitations on the trustee’s powers and generally provide the rules by which the trust is to operate.
3. Corporate trustee. As with SMSFs, it is not critical to have a corporate trustee, but they do help to keep things clean and simple—cutting down on mix-ups with non-trust assets, reducing admin arising from an individual trustee change and minimising the risk of personal liability in certain cases.
   The shareholders (and directors) of a corporate trustee will typically be a group of family members (or an entity controlled by them). But, unlike a SMSF, they don’t have to be.
4. Beneficiaries. The definition of beneficiaries will typically be drafted widely to give maximum flexibility—immediate family, distant relatives, unborn children and future spouses might all be included, since the beneficiaries can’t be easily changed down the track. Remember, being a beneficiary doesn’t give you anything unless the trustee decides to make a distribution to you.
   Note also the inclusion in our diagram of a corporate beneficiary (which might also be the corporate trustee). A corporate beneficiary (which pays the company tax rate of 30%) can be a useful ‘catch-all’ where you don’t want to allocate income to beneficiaries on high marginal tax rates. Be aware that at some point (hopefully, in the distant future) the income of the corporate beneficiary will need to be paid out as a dividend and tax paid at the shareholders tax rate (after offsetting franking credits).
   Ignoring the potential future tax liability, the effect of a corporate beneficiary is to cap the maximum marginal tax rate on trust income at 30%.

That, in a nutshell, is a family trust. But in this modern world of SMSFs why would anyone use one?

SMSF versus family trust

The question of SMSF versus family trust is largely a matter of tax benefits compared with flexibility.

The tax benefits of SMSFs—deductions for contributions and low fund tax rate—are very attractive. But they come with a regulatory sting. They’re difficult to manage, are restricted in their activities and include a high risk of future political meddling.

Family trusts generally won’t offer the same level of tax benefit but they provide more flexibility and are simpler to manage. A trustee, acting for a trust, can do pretty much everything an individual might do and, without a regulator in the background, management is simpler and ‘stuff up’ risk is reduced.

A more detailed comparison of individuals, family trusts and SMSFs is contained in Table 1.

In Why a SMSF may not be for you we looked at those cases where establishing a SMSF makes sense. When might you consider setting up a family trust?

The case for a family trust

Firstly, family trusts and SMSFs are not an either/or proposition. They each have their place and many people (your author included) use both.

Leaving aside for a moment some potential ‘tax magic’ with family trusts (more on this later) family trusts win out over SMSFs in the following situations:

1. Restricted activities. SMSFs are restricted in their activities in a number of ways; They can’t buy certain assets (for instance, residential property used by a related party); They can’t freely borrow; And investments have to comply with the ‘sole purpose test’. A family trust can buy art that will hang on your wall, or a property the kids will use for university. A SMSF can’t.
2. Highly regulated activities. SMSFs are allowed to undertake certain activities with restrictions. You can, for instance, buy property in your SMSF but you won’t be allowed to develop it or lease it to family members. These rules are not static either; the restrictions could increase with time. If you simply can’t be bothered with the hassle of trying to monitor what can and can’t be done with a SMSF, a family trust may make more sense.
3. Change of law risk. This is a question of personal perspective but, depending on your age and circumstances, it is one of the strongest arguments in favour of a family trust over SMSF—or, at least, not putting all your eggs in the ‘SMSF basket’.
   If you are in or close to pension phase, changes to super laws aren’t a great problem—you can withdraw your funds if you don’t like them. But for those further from pension age it is a far greater risk.
   We have put the case that SMSFs are very much on the political agenda. This means that nasty changes—for instance, higher tax rates, capped benefits, further restrictions or prohibitions, mandatory investments or levies—could appear at any time. Trust laws could also change but most likely this would be to simply tax them as companies. Besides, unlike ‘locked up’ super, trust capital can be distributed whenever the trustee chooses.
   SMSFs are fine and we don’t want to alarm you. If your portfolio contains shares, bonds and cash, your main risk is likely to be higher rates or capped benefits. But if you have a penchant for the alternative—art, leveraged property, derivatives—think long and hard about this issue. The Cooper Review has already placed you on the agenda for adverse change.
4. Lower marginal rate taxpayers. The 15% tax rate of SMSFs is of most benefit to those on a high marginal tax rate. But for those on lower tax brackets the benefit may not be that great and, with smaller balances, may be largely eroded by the fixed costs of running a SMSF.
   Let’s consider the example of a single income family receiving an inheritance of $200,000. Initially at least, they might be better off with the funds in a family trust where income could be distributed to the non-working spouse (who would pay no tax if they had no other sources of income).
5. Unwinding. A family trust is easier to unwind than a SMSF if your circumstances change. The hardest bit is closing down the corporate trustee. If the corporate trustee is to remain on foot then a family trust need not be shut down at all. Unlike a SMSF, it can sit dormant without cost.
   Of course, as with SMSFs, you need to take account of the type of investments being made. Real estate, in particular, is never easily transferred due to the need to pay stamp duty. Even simple assets, like term deposits, can be difficult to transfer quickly thanks to break costs.

These are some common situations where a family trust might have more appeal than a SMSF. But there is a more specific scenario where a family trust can have lower tax and more flexibility.

Family trust ‘magic formula’

In Year-end tax strategies we mentioned the changes to marginal tax rates which took effect from 1 July 2012. They added to the attractiveness of family trusts.

Consider a two income family consisting of husband and wife and a couple of kids. Let’s assume there are two sets of parents—self funded retirees living from a tax-free pension income. Even if both husband and wife are in the 38.5% tax bracket, the family investments may be able to generate over $80,000 per annum tax free.

How so?

Fortunately (from this perspective) tax free pension recipients still get the usual tax brackets, including tax free threshold (TFT), and the low income tax offset (LITO). The TFT is now $18,200 and the LITO is $445. Taking both into account, an individual can receive $20,542 of income before they need to pay a cent of tax. Multiply by four and this family’s trust could distribute $82,168 of income to the two sets of parents before a cent of tax would need to be paid.

Of course, there’s no need to stop there. The kids can receive $416 each tax free and the parents-in-law can each receive another $16,458 each, which will only suffer 19% tax.

All up, that’s a grand total of almost $150,000 in income with an average tax rate of less than 10%—or the original $80,000 tax free. Either way, this is a lower tax cost than a SMSF, without restrictions on contributions, investments or withdrawals.

Of course, we have picked the ideal scenario for this example. In practice, your parents or parents-in-law may have other sources of taxable income, aged pension criteria to consider, or you may not get along with them enough to want them involved in the family’s financial affairs.

The key principle to remember is: If you can allocate income to beneficiaries who haven’t used their TFT (or have a low rate), you may be able to get similar or greater tax benefits than a SMSF, without the inflexibility.

And if, down the track, you want to avail yourself of the SMSF’s 0% pension mode tax rate?

If you have enough non-concessional contributions caps to play with (and the rules remain unchanged), it shouldn’t be a problem. Members are currently allowed to make $150,000 in annual non-tax deductible contributions to super and (if under 65) to use the ‘bring-forward rule’ to make three years contributions in one hit. So a husband and wife, using the bring-forward rule and making no other contributions, could potentially shift $900,000 in funds in one year.

If you’re warming to the idea of a family trust, how do you go about it?

Setting up a trust

Fortunately, setting up a trust (and corporate trustee/beneficiary if necessary) is a straightforward task. Most accountants or lawyers will have standard documentation available and do all the work at a reasonable cost (not much more than $1,000 all up). Or, as with SMSFs, there are online services that will provide the necessary documents to those sufficiently expert.

If you have a focus on asset protection you really should engage the services of a lawyer. This is a highly specialised, complex area of the law.

Even if this is not your aim, we recommend involving a lawyer or accountant, at least at the establishment phase. Committed DIYers may want to keep the records, prepare the accounts and lodge the tax returns to keep costs down, but setting up a solid template from day one is money well spent.

Final thoughts

SMSFs make great sense in the right circumstances. But they are not always the best option. If you have a SMSF, you may find the family trust a useful addition to your investing arsenal. If you don’t have a SMSF, a family trust might be a sensible alternative.

This is a big topic and the possibilities are almost endless so, as always, we await your questions.