Duels for the family jewels

Trusts are designed to protect assets but it can be a bit rich when the kids want out, writes Barbara Drury.

Trusts are designed to protect assets but it can be a bit rich when the kids want out, writes Barbara Drury.

Family trusts are a time-honoured way for successful individuals to put a fence around their wealth and protect it from outside threats and prying eyes. But it seems that such a trust can't protect a family from itself.

In recent months some of Australia's wealthiest families have been displaying their dirty laundry in full view of the neighbours. The mining magnate, Gina Rinehart, is resisting an attempt by her children to have her removed as trustee of the multibillion dollar family trust. And the billionaire retailer, Solomon Lew, is fighting legal attempts by the estranged spouses of two of his children to get a share of the $621 million family trust.

These fights over the hereditary silver are proof that the trusts are assailable (more on that later) but that does not mean they are not a valuable wealth-management tool.

In fact, Australians with far less wealth than Rinehart or Lew are embracing them in ever greater numbers. In 2009, 660,000 trusts lodged tax returns with the Australian Tax Office, a 50 per cent increase in less than a decade.

The main advantages of family trusts (see box) are to protect family and business assets, not just during a lifetime but beyond the grave, and to reduce tax, in that order.

A family trust specialist, Bernie O'Sullivan of Bernie O'Sullivan Lawyers, says many of his clients are professionals who set up family trusts to protect themselves from future litigation.

"In the event they are sued, money transferred into a family trust no longer belongs to them. Rather, it belongs to the trust so it is out of reach of potential creditors," he says.

But let's not forget the tax benefits.

One of the key ones is that the trustee can distribute income earned on assets inside the trust to other family members, taking full advantage of each member's tax status and $6000 tax-free threshold.

Capital gains generated by the trust are distributed to the beneficiaries as income. This might be from the sale of assets or distributions from managed investments inside the trust.

The beneficiaries pay tax on the income and can claim the normal 50 per cent discount if the asset was held for more than 12 months.

"Provided the trust deed allows, you can stream different types of income to different beneficiaries," O'Sullivan says.

For instance, you can distribute capital gains to a beneficiary who can offset them against existing capital losses, distribute income to beneficiaries on low marginal tax rates, or distribute income with franking credits to the family member who can benefit most from them.

"The trustee has full discretion whether to distribute income and capital, to whom and in what proportion," O'Sullivan says. "If they choose not to distribute income, it will be taxed to the trustee [inside the trust] at the top marginal tax rate."

This is rarely ideal, O'Sullivan says, as trusts would usually be better off distributing "excess" income to a corporate beneficiary, which pays tax at the company rate of 30 per cent.

Another benefit of family trusts is that they allow assets to be passed from one generation to the next and capital gains tax to be deferred for up to 80 years. But this can cause problems for beneficiaries when the "vesting" date arrives and the trust is pregnant with unrealised capital gains.

The HLB Mann Judd Sydney tax partner, Peter Bembrick, says when the trust vests, "all assets have to be passed on to the beneficiaries". "Capital gains tax is more likely to be a problem if it has been holding assets for a very long time," he says.

Or if the trust is sitting on billions of dollars of iron ore assets. The dispute at the heart of the Rinehart family feud is Gina's unilateral decision, as trustee, to extend the life of the family trust by more than half a century from its original vesting date late last year. Three of her four children want their share of the trust's assets now but Rinehart argues the capital gains tax bill would bankrupt them.

In practice, many family trusts with more modest fortunes wind up early and by the second generation, family members will often go their own way.

"When you have three siblings, all with their own families or divorced, they often want to take their share and go their separate ways," Bembrick says. "You have to balance the costs of taking assets out of the trust structure with the benefits of each person being able to control their own affairs."

REGULATORY CHANGE

The vexed issue of the distribution of capital gains is one reason behind the federal government's planned reform of the taxation of trust income.

Bembrick says recent court decisions, including the Bamford versus Commissioner of Taxation case that went all the way to the High Court in 2010, have highlighted gaps between ancient trust law and modern tax law, especially where the distribution of capital gains is involved.

This, plus the recommendations of the Henry Tax Review, is behind the federal government's planned reform of the taxation of trust income.

A consultation paper was circulated last November with the aim of "better aligning the concepts of distributable and taxable income".

While the government stresses that it was not proposing a "crackdown" on family trusts and that trusts are still a legitimate structure to conduct personal and business affairs, Bembrick says the uncertainty has led some people to think that family trusts are not worth the risk.

"It is vital that the reforms lead to a system that is workable and provides certainty to beneficiaries and trustees of family trusts," Bembrick says.

"There's a popular perception that family trusts are just a way to rort the tax system but that does not appear to be the approach Treasury is taking.

"I don't think they are in danger of disappearing."

But tax isn't the only area where trusts have not kept up with the times.

O'Sullivan says the protection offered by family trusts from a family law perspective is not as good as it once was. He says the Family Court is increasingly willing to consider treating an individual's interest in a family trust as being part of the property of their marriage.

"In recent times there have been more cases where people get divorced and there is very little marital property. In such cases, the Family Court might be more inclined to look to the family trust, if one exists. But there are ways of structuring a trust that offer greater protection," he says.

COSTS

Family trusts are not necessarily expensive to set up but the experts agree that you need to be well off to make the most of them.

O'Sullivan says it costs in the order of $600 to set up a family trust, plus ongoing fees associated with lodging an annual return. Additional costs kick in if you decide to have a corporate trustee. "In total, ongoing costs can amount to $1000 a year or more," he says.

"Rarely would someone establish a trust for assets of only $100,000 but it's not uncommon to get started with that if it is expected to grow quickly."

Regardless, O'Sullivan says anyone thinking of establishing a family trust, streaming income or distributing to corporate beneficiaries should always seek advice from their accountant or lawyer before doing so, as complex tax and succession-planning issues can arise.

A senior adviser at Donnelly Wealth Management, Russell Lees, normally only recommends a family trust where assets exceed $400,000.

"If a client's capital is reasonably high, we would consider a family trust and self-managed super and shuffle assets from the trust into super," he says.

"If a client is in their 30s or 40s, perhaps with their own business, they can't get access to money in super so they can use a family trust as an entity to hold money outside super.

"Trusts are a complicated beast. The holdings are more long-term and it doesn't dissolve at death, as super does. Even with a testamentary trust, you have to ask, 'is it worth it to direct $300,000 to a beneficiary?"'

The advantages of setting up any trust needs to be weighed up against the added cost and complexity of using the structure. You need to be satisfied that a trust will have real financial benefits for your family and not just provide a rich seam of fees for your advisers.

Protect assets from professional liability

Melda Donnelly started her family trust more than 20 years ago when she and her then-husband were building careers and raising a family. Being risk averse, she wanted to protect family assets from professional liability.

"I was, and am, a company director and ran a business running investor education conferences for 18 years," she says. "I had a very strong view that I didn't want the family wealth to be at risk.

"The question for me was how does one create, protect and pass wealth on while also playing my part in passing on my financial knowledge? My father [financial planning pioneer] Austin Donnelly inculcated that concept in my mind."

Being her father's daughter, Donnelly also has testamentary trusts set up as part of her will, with powers of attorney in place. She has a self-managed super fund to provide for her retirement. "If I manage that wisely I won't have to sell assets in the trust," she says.

The trust's beneficiaries are Donnelly's two adult daughters and any future grandchildren.

"I involved my children all along, knowing what the trust's assets are, where they are and why they pay tax on distributions," she says. "I used to get both girls to write cheques for the trust for pocket money so they knew where money went."

After selling her business Donnelly is no longer involved operationally but she is still a company director of a listed company in London and a company in Sydney.

"For those of us in the professional world, there is more litigation and more onus on directors," she says. "The answer is to be a good director, a good corporate citizen and to do the best you can to protect your family wealth."

Types of trusts

A family trust is a discretionary trust set up to hold and protect assets or to conduct a business for the benefit of the family. The term discretionary refers to the ability of the trustee to determine who gets what, provided distributions are made to people who qualify as beneficiaries.

The trustees are usually mum and dad or a company of which they are the owners and directors. Their children and grandchildren are usually the beneficiaries.

The maximum length of the trust, called the vesting date, is normally 80 years.

A testamentary trust is similar to a discretionary family trust but it is only activated after you die, according to terms set out in your will. Whereas a will transfers assets straight to your beneficiaries, a testamentary trust passes assets to a trustee who holds them in trust for beneficiaries. The trustee then decides how beneficiaries will receive income and capital gains from the trust.

Testamentary trusts can be used to maintain social security benefits for your beneficiaries, to ensure that assets pass to your children if your spouse remarries or to provide for children with disabilities. They can also be used to fence off an inheritance from estranged partners of adult children or to control the flow of income to a spendthrift.

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