If your family trust receives franked dividends or has tax losses, the trustee should consider the option of making a family trust election (FTE) in order to access certain tax concessions.
In particular, the making of an FTE will enable the trustee to pass franking credits on to beneficiaries and more easily offset prior year losses against the trust’s taxable income.
The fact alone that your trust is described as a ‘family trust’ in the deed of settlement is not enough to ensure that it will be treated as such for tax purposes; the Australian Taxation Office (ATO) will only recognise a trust as constituting a family trust where the trustee has made an FTE.
While the making of an FTE will enable the trust to access tax concessions, there is a catch – where distributions are made outside of the ‘family group’, the trustee will be hit with family trust distribution tax (FTDT) at the rate of 47% (comprising the top marginal rate plus Medicare Levy).
What is a family trust election?
An FTE is a choice that is made by the trustee of a trust to specify an individual (the ‘test individual’) as the individual whose ‘family group’ is the subject of the election.
The test individual will be the reference point for defining the ‘family group’ for the purposes of the election. The individual who is specified must be alive at the time that the election is made, and the trust must pass the ‘family control test’ – this test is discussed in greater detail below.
A trust will constitute a family trust at any time when an FTE is in force. The election must be made in the ATO approved form, and will generally take effect from the commencement of the income year specified in the election. The specified income year must have actually ended before an FTE is made; this is necessary because an FTE can be made only if the trust passes the family control test at the end of that year.
The ability to make an FTE will be most beneficial for trusts which receive franked dividends or have revenue losses, for the reasons detailed below. The trustee must weigh up the advantages of obtaining concessional tax treatment with the risk of incurring FTDT if a distribution is made to a beneficiary outside of the family group; accordingly, an FTE may not be appropriate in all instances.
Trust receives franked dividends
Where a trust receives franked dividends, an FTE will enable beneficiaries to access franking credits.
Generally, franking credits may only be streamed to a beneficiary of a discretionary trust if the beneficiary does not receive greater than $5,000 in franking credits from all sources during the income year, or alternatively, the trustee acquired the shares prior to 31 December 1997.
Where a beneficiary has total franking credit entitlements of $5,000 or more, the ‘holding period rule’ must be satisfied which requires that the beneficiary holds the shares ‘at risk’ for at least 45 days (90 days for preference shares). As the beneficiary of a discretionary trust generally cannot satisfy the holding period rule, they will be denied the benefit of the franking credits. However, a trustee who makes an FTE can personally satisfy the 45-day holding period test and pass the franking credits to beneficiaries.
Trust has revenue losses
In order to deduct losses from prior income years, trusts must satisfy several complex tests known as the income injection test, 50% stake test, pattern of distributions test and control test. Each test is difficult in its application, particularly when applied to discretionary trusts. If a trust makes an FTE, the trust will only need to satisfy a modified version of one of the trust loss tests, the income injection test.
Who should be the test individual?
The crucial aspect of an FTE is the identity of the test individual. The ‘family group’ surrounding this individual will then set the range of beneficiaries to whom the trustee can make distributions without triggering FTDT.
Broadly, the family group of the test individual includes:
- the test individual and their spouse;
- the parents, grandparents and siblings of the test individual or the test individual’s spouse;
- any nephew, niece or child of the test individual or the test individual’s spouse and any lineal descendants of these people;
- the spouses of any of the above individuals;
- former spouses of the test individual or a family member who are no longer family members due to the breakdown of a marriage or relationship, or due to the death of the test individual or a family member.
Not all family members of the test individual will form part of the family group (such as aunts, uncles and cousins). It is important to keep this in mind, in order to ensure there is no inadvertent exposure to FTDT.
Can I change my test individual?
Yes – the identity of the test individual can be varied once, subject to satisfying strict requirements. Variations can only be made until the end of the fourth income year from the year specified in the original election.
The family control test
A trust must satisfy the family control test in order to make an FTE. This test will be satisfied at the point in time when some or all of the following people control the trust:
- the test individual and/or members of the test individual’s ‘family’;
- a professional legal or financial adviser of the family;
- the trustees of one or more family trusts, where the same test individual is specified in the FTE and the individual together with family members have more than a 50% stake in the income or capital of the trust.
A group constituted of the above persons will be considered to have control of the trust where, broadly, the group has the power to control or obtain the beneficial enjoyment of the income or capital of the trust, or to remove or appoint the trustee.
The composition of the ‘family’ which applies for the purposes of the control test is similar to the test individual’s ‘family group,’ however the former spouse of the test individual is not a member of the ‘family’ but remains a member of the family group.
The option to make an FTE requires careful consideration and will be most relevant where trustees wish to stream franking credits to beneficiaries, or where the trust has revenue losses.
It is important to remember that where an FTE has been made, this does not necessarily mean that trust distributions can be made to every person within the family group; the trustee must refer to the trust deed to ensure that each person comes within the definition of the beneficiary class.
The risk is that where a trustee makes an ineffective distribution to an individual outside of the beneficiary class, the trustee will generally be assessed at the rate of 47% (including Medicare levy) on the amount of the purported distribution to the non-beneficiary.
Other factors which may impact upon an effective distribution from a family trust is, does the trustee have the power to determine what is “income” in any given year. Does the trustee have the power to stream income and finally does the trust include those person you want to distribute to as beneficiaries.
If you have any questions regarding FTEs or the operation of your family trust or you require advice as to whether it may be beneficial to make an FTE in your particular circumstances, please contact one of Rigby Cooke’s experienced lawyers.
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