Are Family Trusts Dead? Federal Budget post-mortem

The recent Federal Budget announcements have cast a shadow over traditional wealth management strategies in Australia, prompting a critical re-evaluation of investment structures. Specifically, the proposed introduction of a 30% minimum tax on family trusts from 1 July 2028 signals a significant transformation for Family Offices, Investors, and Business Owners. While the initial reaction might lead some to question the future of trusts, the short answer is “No, family trusts are not dead.” However, it is undeniable that if these changes are implemented as proposed, the attractiveness of trusts for tax planning will be substantially diminished.

The precise legislative details underpinning this announcement are yet to be published, meaning draft legislation is still forthcoming. Nonetheless, the mere announcement necessitates a proactive examination of current investment structures, particularly those holding passive assets such as investment properties or share portfolios. Prudent planning demands readiness for these impending changes.

Capital Five Partners offers this article as general guidance to help our clients understand the potential ramifications. It is crucial to remember that definitive action should only be taken after receiving proper legal and financial advice, thoroughly considering the medium- and long-term impacts of these proposed reforms on your specific circumstances.

Based on the information currently available, we can draw several key immediate conclusions:

Discretionary Trusts are not obsolete but will be significantly less appealing for tax planning purposes. Their utility for other critical objectives, however, remains robust.

The fate of Testamentary Trusts under these new rules is presently unclear. We must closely monitor legislative developments regarding potential carve-outs before advising on changes to existing estate planning strategies.

The long-standing practice of utilising corporate beneficiaries (often referred to as “bucket companies”) for income distribution from a discretionary trust will, under the proposed framework, cease to be a viable tax-effective strategy.

Topic 1: Are Discretionary Trusts dead?

The Short Answer

No, Discretionary Trusts are not dead. While their appeal for tax planning will be significantly reduced, their value in other crucial areas of wealth management remains. These trusts continue to offer compelling advantages that extend beyond mere tax optimisation, ensuring their enduring relevance for many families and businesses.

The Impact of the 30% Trust Tax

Historically, one of the most compelling advantages of discretionary “family” trusts, particularly for passive income generation, has been their unparalleled flexibility in distributing income. This flexibility allowed trustees to allocate income among various beneficiaries – such as a low-income spouse, adult children pursuing full-time education, or other family members with minimal taxable income – who typically possessed lower marginal tax rates. By strategically distributing income in this manner, families could significantly optimise their overall tax outcomes, often achieving a substantially lower effective tax rate on their income compared to other conventional structures. This income-splitting capability has been a cornerstone of Australian tax planning for decades.

The proposed 30% minimum tax on family trusts is specifically designed to curtail this long-standing tax advantage. While the intricate details of the legislation are still awaited, the core intent is abundantly clear: income generated by a family trust is intended to be taxed at a minimum rate of 30%. This new threshold will directly impact existing arrangements where family trusts distribute income to beneficiaries who would otherwise pay significantly less tax than 30%. For instance, distributions to a low-income spouse or a full-time university student, who might historically have paid marginal rates well below 30%, will now be subject to this higher minimum threshold, thus eroding the historical tax efficiency of such distributions.

Companies for Passive Assets?

Given this looming change for trusts, a natural question arises: will proprietary companies become the preferred vehicle for owning passive assets? To answer this, we must first understand the current tax landscape for companies.

Currently, companies in Australia face different tax rates depending on their size and income type. Small to medium businesses, defined as those with an aggregated turnover under $50 million, benefit from a company tax rate of 25% on their trading income. Larger entities, or those exceeding this turnover threshold, are subject to a 30% tax rate. However, it’s important to note that, from 1 July 2018, capital gains realised by companies are expected to be taxed at the 30% rate, irrespective of turnover.

One of the key mechanisms that makes companies attractive for tax purposes revolves around franking credits. Profits are initially taxed at the company level. When these after-tax profits are subsequently distributed to shareholders in the form of franked dividends, the franking credits attached to these dividends effectively represent the tax already paid by the company. Shareholders then include the grossed-up dividend (the dividend amount plus the franking credits) in their assessable income and pay tax at their individual marginal tax rate, with the franking credits offsetting the tax already paid by the company. This system generally prevents double taxation of company profits.

An Illustrative Example

To truly grasp the implications of these proposed changes, let’s consider a practical example involving $100,000 in passive investment income. This income could be net rental income from an investment property or interest income received from other entities. Our analysis will compare the tax outcomes for both a proprietary company and a discretionary trust after the proposed 1 July 2028 implementation date. For simplicity, we’ll assume the primary individual beneficiary/shareholder is on the top marginal tax rate of 47%, which comprises a 45% income tax rate plus the 2% Medicare Levy.

Scenario 1: Proprietary Company

Under the company structure, the process unfolds as follows: Income Earned by Company: $100,000

Company Tax (assuming a 25% rate for a small business): $100,000 x 25% = $25,000 Net Profit Available for Distribution: After company tax, $75,000 remains, which can be distributed as a fully franked dividend.

Shareholder Tax: When this $75,000 dividend is distributed to a shareholder on the top marginal tax rate of 47%, the additional tax payable by the shareholder would be $22,000 (after taking into account the franking credit).

Total Tax: Summing the company tax and the additional shareholder tax: $25,000 + $22,000 = $47,000.

Scenario 2: Discretionary Trust (Post 1 July 2028) Let’s first recall the traditional approach and then apply the new rules: Traditional Strategy (Pre-1 July 2028): Historically, a discretionary trust generating $100,000 in passive income might have distributed this income strategically to multiple adult beneficiaries with minimal other income (e.g., adult children). This income-splitting strategy could collectively achieve a significantly lower overall tax burden for the family group, potentially ranging from $10,000 to $15,000 in total tax, depending on the number of beneficiaries and their respective tax-free thresholds and marginal rates. This flexibility was the trust’s primary tax advantage.

Post 1 July 2028 Impact: The new rules are designed to ensure that the tax paid on this trust income is at least 30%. Therefore, regardless of how the income is distributed to beneficiaries (unless a beneficiary is on a higher marginal rate), the total minimum tax payable would be $30,000 (I.e., $100,000 x 30%).

• • If the income is distributed entirely to a top marginal rate beneficiary (taxed at 47%), that beneficiary would still pay tax at their marginal rate, resulting in a total tax outlay similar to the company scenario, which would be $47,000.
• • Where the income is distributed to beneficiaries on different marginal tax rates, the total tax payable would fall somewhere between the minimum of $30,000 and the maximum of $47,000 (if all income went to a top marginal rate individual).

This illustrative example vividly demonstrates that the historical tax advantage of trusts, particularly through the strategic streaming of income to lower-rate beneficiaries, will be significantly diminished or, in many cases, entirely eliminated under the proposed 30% minimum tax regime. The tax efficiency that once made trusts so attractive for income splitting will largely evaporate.

Broader Considerations

While tax implications are undoubtedly paramount, it is essential to recognise that trusts offer a range of benefits beyond mere tax minimisation. Several other critical factors continue to make discretionary trusts an indispensable tool in wealth management:

Asset Protection: Both proprietary companies and discretionary trusts offer robust asset protection. However, a discretionary trust generally provides a superior level of asset protection. This is because, legally, no single beneficiary holds a direct “interest” in the trust assets; rather, they have a mere expectancy. This structure makes trust assets significantly more difficult for creditors, litigants, or spouses in family law disputes to claim, providing a crucial shield for wealth.

Flexibility: Trusts still offer unmatched flexibility in how income and capital can be distributed among a wide class of beneficiaries, and when those distributions occur. This dynamic adaptability contrasts sharply with companies, which are more rigid in terms of ownership structures and the rules governing dividend payments. Trusts allow for immediate adjustments to distributions based on changing beneficiary circumstances or tax laws, a level of agility not found in corporate structures.

Succession Planning: Discretionary trusts are highly advantageous for facilitating multi-generational wealth transfer. They allow the original wealth creators to retain significant control over assets for many years, even decades, guiding how family wealth is managed and distributed to future generations while potentially avoiding probate and ensuring continuity across different family members.

Compliance Burden: It’s important to acknowledge that both structures entail ongoing compliance costs, including accounting fees, annual reviews, and regulatory filings. While the specific nature of these costs may differ, neither structure is entirely free of administrative obligations. The complexity of compliance for trusts may slightly increase with the new tax rules as trustees navigate the 30% minimum tax.

Topic 2: Does the minimum tax apply to Testamentary Trusts?

The Short Answer

Currently, the answer is “Unknown.” The proposed legislation has not yet clarified whether Testamentary Trusts will be carved out from the application of this new minimum tax. This uncertainty means we must carefully monitor legislative developments before advising clients on significant changes to their existing estate planning strategies.

Testamentary Trusts

Traditionally, Testamentary Trusts, which are established through a Will upon an individual’s death, have been a cornerstone of comprehensive estate planning. They offer a multitude of benefits, including strong asset protection for inheritances, control over how distributions are made to beneficiaries over time, and, critically, significant tax advantages. One of the most notable tax benefits of a Testamentary Trust has been the treatment of income distributed to minor beneficiaries. Unlike typical family trusts, where income distributed to minors is generally subject to punitive penalty tax rates designed to discourage income splitting to children, income from a Testamentary Trust distributed to minors is typically taxed at adult marginal rates. This unique tax treatment has made Testamentary Trusts an incredibly effective tool for providing for minor children or grandchildren in a tax-efficient manner following the death of a testator.

Implications for Estate Planning Strategies (If Tts are Caught) Should Testamentary Trusts ultimately be caught by this proposed minimum tax, the implications for existing and future estate planning strategies would be profound and far-reaching: Diminished Tax Efficiency for Minors: A primary driver for many individuals incorporating Testamentary Trusts into their Wills has been the ability to distribute income tax-efficiently to minor children or grandchildren. If the 30% minimum tax applies, this significant tax advantage would be substantially diminished, if not entirely negated. The benefit of minors being taxed at adult rates, rather than penalty rates, would still exist, but the overall tax burden would likely be higher than current expectations, potentially eroding the value of the inheritance more quickly.

Review of Existing Wills: Individuals with current Wills that incorporate Testamentary Trusts would face an urgent need to review their estate plans. This review would involve a careful reassessment of the pros and cons of maintaining the Testamentary Trust structure in light of the altered tax landscape, potentially leading to significant revisions to ensure their estate planning objectives are still met.

Consideration of Alternatives: The potential erosion of tax benefits might necessitate a re-evaluation of traditional estate planning strategies. This could mean favouring direct bequests of assets to adult beneficiaries, establishing life interests (where a beneficiary has the right to income or use of an asset for life, but not ownership), or placing greater reliance on superannuation death benefit nominations, depending on the specific circumstances of the deceased’s estate and the overarching goals of the estate plan. Each alternative comes with its own set of advantages and disadvantages regarding asset protection, control, and tax implications.

Asset Protection Remains: It is crucial to underscore that while the tax advantage for Testamentary Trusts might be reduced, other compelling reasons for their establishment would still remain intact. Testamentary Trusts offer invaluable asset protection against potential claims arising from a beneficiary’s bankruptcy, divorce, or even against the beneficiaries’ own poor financial decisions. This protective shield, along with the ability to control the timing and conditions of distributions, ensures that Testamentary Trusts will continue to serve a vital role in estate planning, even with altered tax treatment.

Topic 3: Are Corporate Beneficiaries still viable?

Short Answer

No, under the proposed changes, the utilisation of corporate beneficiaries (or “bucket companies”) as a tax-effective strategy will no longer be viable.

Bucket Companies

Historically, distributing trust income to a corporate beneficiary has offered several significant advantages, making “bucket companies” a popular tax planning tool. Primarily, this strategy leveraged the lower corporate tax rate – which, for most corporate beneficiaries, was generally 30% (or 25% for small businesses in recent years) – compared to the top individual marginal tax rate of 47% (which includes the 2% Medicare levy).

This strategic approach allowed for two key benefits: Tax Deferral: Income could be accumulated and retained within the company at the lower corporate tax rate. This effectively deferred the payment of the higher individual marginal tax until such time as dividends were eventually paid out to individual shareholders. This deferral provided significant cash flow advantages, allowing funds to be reinvested.

Franking Credits: When profits eventually accumulated within the bucket company were distributed to individual beneficiaries as fully franked dividends, the franking credits attached to these dividends provided tax credits for the company tax already paid. This mechanism reduced the individual beneficiaries’ overall tax liability when the income was ultimately distributed, preventing double taxation and ensuring that the combined tax rate did not exceed the top individual marginal rate.

This strategy has been particularly attractive for growth-oriented businesses and property investors seeking to retain earnings for reinvestment, not just in property, but across various asset classes, without immediately triggering high individual tax rates.

However, the landscape changes dramatically from 1 July 2028. Under the proposed new rules, the mechanism that made bucket companies tax-effective will be dismantled. Specifically, corporate beneficiaries will not receive a credit for the minimum 30% tax paid by the trust on the income distributed to them. This means the income will first be taxed at 30% in the trust’s hands, and then, upon distribution to the corporate beneficiary, it will be subject to an additional layer of corporate tax (e.g., 25% or 30%). When these profits are later distributed as dividends to individual shareholders, they will be taxed again at their marginal rates, with franking credits only applying to the corporate tax paid by the bucket company itself, not the initial trust tax. This cumulative effect would result in an exceedingly high effective tax rate. For example, if a trust income is taxed at 30% in the trust, then another 25% in the company, and finally at 47% at the individual level (considering franking credits for the 25% company tax), the overall effective tax burden could soar to approximately 62.9% on the original trust income. Such a prohibitive effective tax rate renders distributing to bucket companies a non-viable and fiscally punitive strategy.

Conclusion: Staying Informed and Being Proactive is the Key

The proposed changes stemming from the Federal Budget are undeniably significant, marking a potential paradigm shift in how family wealth is structured and managed in Australia. The manner in which these announcements have been made, notably without accompanying detailed draft legislation, has naturally led to considerable confusion and uncertainty within the market.

In this rapidly evolving regulatory environment, it is more critical than ever for individuals, families, and businesses to stay informed and thoroughly understand the intricate details as they emerge. Proactive engagement with these changes is not merely advisable but essential for safeguarding wealth and optimising financial outcomes.

Capital Five Partners is committed to keeping our clients updated as the legislative detail becomes clearer. We will continue to monitor developments and communicate on developing strategies. Now is the time to engage in considered planning, not reactive decision-making.