Tax with Max: Taxing family trusts

Summary: If you receive income under a family trust structure, the following questions and answers address how the ALP's proposed tax on trust beneficiaries would work.

Key take-out: In most cases trust beneficiaries will be worse off by having to pay a flat 30 per cent tax rate instead of receiving the first $18,200 tax free, as is currently the case for individuals.

Question: Is there any proposal to enable franking credits to apply to the profit and tax distributed to beneficiaries? Let us assume that two people are beneficiaries of a trust which earns $35,000. Under the ALP proposal the tax payable is $10,500 and the amount after tax is $24,500. If these individuals have no income other than the trust distribution they would currently pay no tax. However, under the new proposal they would each pay an effective tax rate of 30 per cent or $5,250. What amount do they include in their tax return, before or after-tax amounts? How in heaven's name is this equitable?

Answer: My understanding of how the new policy would work is similar to the way non-residents are taxed. In your situation you would each need to show $17,500 at item 13 on your individual tax return. The ATO would then calculate tax payable, on the basis that all income must be taxed at least at 30 per cent or $5,250. In addition, where applicable, the Medicare levy would be payable.

Question: I would like to clarify the ALP's recent policy on the taxing of discretionary trusts.

In an example shown on the ALP website, detailing how the new policy will work, they provide an example of how an individual who receives $70,000 would be paying $21,000 under its policy. I cannot work out how the ALP arrived at this figure and I am not clear on what the ALP does with the Medicare levy in all of this?

Answer: In the example you referred to $210,000 is distributed to three beneficiaries ($70,000 each) of a family trust, which results in $63,000 in tax payable. The fact sheet also states that this results in an increase in tax of $15,900 for all beneficiaries compared with the current tax rules.

Tax on $37,000, of a $70,000 distribution, at the 30 per cent rate is $11,100. Tax on the remaining $33,000 at the relevant marginal tax rate of 32.5 per cent is $10,725, making a total tax payable under the new ALP policy of $21,825.

Under the current marginal tax rates that apply to distributions from family trusts the tax on $37,000 is $3572, with the balance of $33,000 having tax payable of $10,725, making a total tax payable of $14,297. On the basis of these calculations a distribution of $210,000 to three beneficiaries results in extra tax payable of $22,584, and not the $15,900 quoted in the ALP example.

In addition to the income tax payable, as is the case currently, a Medicare levy of 2 per cent would also be payable.

Question: It is my understanding that a passive investment company would only pay 30 per cent on investment income it earns, whereas under the ALP policy a beneficiary could pay a lot more if they had any amount of “normal” income before receiving the “distributed income”. So, does this mean that a beneficiary would be taxed more than an investment company?

Answer: Under the ALP policy a beneficiary of a family trust receiving income would pay more tax than an investment company as they do now. Currently, when the income exceeds the $37,000 income level individuals pay tax at the higher marginal rate of 32.5 per cent.

At this time an individual pays no tax up to $18,200, and then 19 per cent on income between $18,200 and $37,000. If that individual had shares in an investment company that paid 30 per cent company tax, and received fully franked dividends from the company, the income would be taxed at their applicable marginal rates with the franking credits reducing the overall tax payable.

Question: I would be interested to know how franking credits will be treated under the ALP's policy of taxing income distributions from family trusts. Presumably if it's a fully franked dividend from an investment it will cancel out the tax if it is an adult dependent, but there will be no additional credit. Is that correct?

Answer: One of the things I have been able to confirm from the shadow treasurer's office is that all other rules relating to distributions from family trusts, such as retaining the benefits of franking credits when a trust receives fully franked dividends, will remain.

For example, if a family trust had shares in an investment company, which paid a fully franked dividend of $25,900 that was distributed to one adult beneficiary with no other income, that distribution would bring with it an $11,100 franking credit.

In addition to confirming that the benefit of franking credits will be retained, Chris Bowen's office confirmed that the 30 per cent tax will apply to the net taxable income distributed by trusts to individuals.

In the example, the individual would need to show $37,000 in total income distributed to them, made up of both the cash dividend and the franking credit. Tax on the $37,000 would be $11,100, with the franking credit equalling the tax payable.

In this situation the beneficiary would be worse off under the ALP's policy of taxing trust distributions by $7,528. This represents the tax refund that is currently generated, before Medicare levy, being the difference between $3,572 payable under the current marginal tax rates and $11,100 franking credit received.

Question: Small business owners will not be the only ones affected by the ALP policy, but an equally unintended consequence is the inability to utilise the senior tax offset. My wife and I get no tax benefit from the use of our family trust but we have an income producing property funding our retirement that was purchased in a family trust in the 1980s.

If we transfer the property to ourselves would this incur substantial legal and stamp duty charges plus crystallising a capital gains tax event when we would be unable to pay the tax without selling the property into a flat market?

Answer: What is not understood about the new policy is whether the usual tax offsets will apply to the 30 per cent tax on family trust distributions. Unless the ALP really wants to punish beneficiaries of family trusts, the usual offsets of the low income tax offset in the senior Australians tax offset should still apply.

If you decided to transfer the property from the trust to yourselves legal fees would be payable but, depending on which state you live in, no stamp duty could be payable. This is because some states do not levy stamp duty when there is no change in the beneficial ownership of a property, which should be the case when transferring property from a trust to beneficiaries.

As to whether capital gains tax would apply to any gain made on the property, this will depend on whether the ALP builds into their policy of taxing trust distributions an exemption from income tax if people transfer property from a family trust into their personal names as a result of the new tax.