Trusts are one of the most talked-about (and misunderstood) investment structures in Australia. But are they really worth it?

In this episode, Mark and Shani break down what family trusts are, how they work, and the scenarios where they can help reduce tax and protect wealth.

• What a trust is and how it distributes income

• The tax benefits (and limitations) of using a family trust

• Why minors can’t benefit from trust income like you think

• Trust setup and maintenance costs in Australia

• Who trusts actually suit (and who they don’t)

• Alternatives like joint ownership & company structures

• Why professional advice is crucial before setting one up.

You can find the full article here.

You can find the transcript for the episode below:

Shani Jayamanne: For the past five years, we’ve released a weekly podcast to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis backed by the work of hundreds of researchers and professionals at Morningstar.

Mark LaMonica: We’ve shared our journeys and you’ve shared back. We’ve listened to what you’re after and created a companion for your investing journey, Invest Your Way. Invest Your Way is a book that focuses on the investor instead of the investments. It’s a guide to successful investing with actionable insights and practical applications.

Jayamanne: You’re able to pre-order the book through the links in the episode description.

LaMonica: Thank you for your continued support and we look forward to helping you invest your way.

Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

LaMonica: For long time listeners of the podcast, we have not talked about this in a while, but you are fairly obsessed with this place called Dickson Noodle House in Canberra. And we went there once.

Jayamanne: We did, but you didn’t order the Laksa.

LaMonica: You were not as obsessed with the Laksa at that time. But you went there twice this weekend.

Jayamanne: I did.

LaMonica: And you had to go to Canberra for sad reasons, which we won’t get into. But you did get to go to Laksa twice and you said that you spoke to the owner for 45 minutes.

Jayamanne: I did. Yeah, we became besties. So much to the point that he said that I can call ahead now and he’ll freeze the Laksa for me so I can bring it back in commercial quantities to Sydney.

LaMonica: Commercial quantities.

Jayamanne: Yes.

LaMonica: Well, there we go. So this is exciting. It’s important to build relationships to get what you want out of life.

Jayamanne: Exactly.

LaMonica: All right. Well, exciting news for Shani. Another thing about your time in Canberra that was where you were going to uni. And after uni, you started your career as an accountant.

Jayamanne: No, everyone thinks I’m an accountant because I talk a lot about tax.

LaMonica: Yes. And mostly the people that think you’re an accountant are your family.

Jayamanne: Yes.

LaMonica: Okay.

Jayamanne: There’s no real like, I don’t know, when you’re Sri Lankan, there’s really three paths that you can go down. You can become a doctor or a lawyer or an engineer.

LaMonica: What about a cricket player?

Jayamanne: That’s very rare. So I feel like accountant is the closest real job to what I have. So I think that’s where it comes from.

LaMonica: Okay. Well, you’ve embraced this and you do write a lot about tax. You spend a lot of time on the ATO website.

Jayamanne: You make me sound like a really boring person, Mark.

LaMonica: I don’t think you’re boring at all. What is this? You’re importing Laksa into Sydney. You’re going to the ATO website. I mean, what is more fun than this? You wrote an article during one of your trips to the ATO website. You researched and wrote an article about trust. So why don’t you tell us a little bit about this?

Jayamanne: So I actually went to see an accountant and I think a large part of making sure that your finances are in the best shape they can be, is ensuring that you do engage with professionals when you need to. And my husband and I were both getting into high marginal tax rates and it was forward planning to see if there’s anything we can do now or going forward to ensure that we’re structured correctly.

LaMonica: And what did your fellow accountant say to you?

Jayamanne: He asked if we were going to have kids.

LaMonica: I know. That’s very personal.

Jayamanne: Yeah. No, my parents are actually quite happy with just Priscilla, surprisingly, but he did.

LaMonica: And Priscilla is your dog.

Jayamanne: Yes. But he did ask that for a reason and that’s because it’s more common than many of us think families with high household incomes to set up trusts.

LaMonica: And a trust is a good way to use your kids to minimize your overall tax. So we’ll go through obviously a lot of the details here, but basically what you can do is you can distribute income from the trust and you can distribute it to all the individuals in your family, including your kids. And so tax is a large drag on returns, but of course in most circumstances you can’t avoid paying taxes. So there are however different rates of taxes owed by different types of entities. So that’s what we’re going to talk about today, trust. So income earned by you as an individual might be different to tax owed on income that’s earned by a trust, which might be different to tax earned by a company structure. So there’s all these different structures. They all have different tax obligations and different tax rates.

Jayamanne: Mark’s not completely correct that you can distribute to your children and have a good tax rate, but we’ll get into that. But one of the structures is a discretionary trust and trust structures help redistribute income and tax amongst multiple people. So what you see as the most common set ups of this is for families where income from investments can be distributed to lower income earners. So would you help me with an example, Mark?

LaMonica: I don’t do trust, you just said that I am wrong about using your children to minimize taxes. But let’s use an example where there are four people in a trust. There are two high income earners on the highest marginal tax rate and two individuals that are over 18 who are full time students with no income. So the investment income distributed out of the trust goes to all of those trust members and overall that would result in a lower overall tax burden. Which to me means you are using your children to lower your tax burden.

Jayamanne: If they are over 18.

LaMonica: They’re always your children.

Jayamanne: Okay. So there are a few scenarios where trust makes sense. These include a single income household with two adults or a situation where children or elderly parents are dependents and reliant on your income. If the dependents are over 18 and in a lower tax bracket, a trust may be a way to share the tax burden and lower the overall taxes paid on any earnings. And there are some nuances to this and you don’t have complete freedom to distribute income, how you please. So trusts have to distribute income in the same year that the income was earned. It can’t be carried forward. If there’s undistributed income from the financial year, tax is paid at the highest marginal tax rate. And although it can distribute income, a trust can’t distribute any losses. So the only way that these losses can be distributed is by offsetting them against gains and these losses can be offset in the same year or carried forward to offset against future income. With capital gains, trust can still utilize a 50% CGT discount after holding an asset for 12 months.

LaMonica: However, nothing in life, Shani. You can’t get anything in life for free, right? So same thing with trust. So they do require admin and they do cost money. So you have to file a separate tax return and the obligations need to be managed. There’s rules and responsibilities that are set out in the trust deed that need to be followed as well.

Jayamanne: And who wants more rules and responsibilities, Mark?

LaMonica: Not me, Shani. But we do need to talk a little bit about the ATO, of course, and their view of trust. They figured out how they might actually be used. So one thing to note is that the distribution of income is not really tax effective to minors. So anyone under 18, and that’s the distinction Shani was making when I said kids. So you do have to be over 18. So they have different tax treatments if somebody is below 18. And they’ve been set up to discourage minors from taking on trust distributions to lower overall tax burdens. So for beneficiaries that are under 18, you’re paying the top marginal tax rate of 45% if somebody receives more than $1,308 in a financial year. So when the beneficiaries are over 18, and they’re on lower marginal tax rates or not earning income, that’s when you can utilize a trust to lower the overall tax rates that would apply to two people.

Jayamanne: So let’s go back to logistics for a moment. Along with not being able to distribute any losses, a trust also can’t distribute franking credits if the trust receives them. If the trust contains Aussie equities that issue franking credits, it may be worth considering a family trust election or an FTE. Now we’re not going to spend a lot of time on an FTE, but a quick summary is that it’s an election for a trust that sets boundaries on who can be in the trust. And for those boundaries, you get concessions.

LaMonica: So these boundaries about who are included restrict the members to family. So it can include spouses, parents, grandparents, siblings, children, nieces, nephews, and the spouses of everyone I mentioned. So what do you get in exchange for this restriction, Shani?

Jayamanne: What you get for this election is that it’s primarily used to take advantage of benefits that are not available to a discretionary trust without the election. And these benefits are distributing franking credits and the losses. But if you violate the conditions, the ATO will try to make you sorry for it by making you liable for family trust distributions tax, so a penalty.

LaMonica: So Shani said at the beginning of this episode, to really maximize your outcomes is important to have experts involved where it’s appropriate. And if you have a structure like that, we definitely classify an expert as appropriate to help you out with it. So have a tax professional, not Shani, a real one, a tax professional heavily involved in the management of the trust. And of course, that’s going to cost you some money. So we should talk a little bit more about that. We obviously want the cost of the trust to be less than the tax benefits that you receive. So how much does one of these things cost, Shani?

Jayamanne: So costs really do depend and it depends on the complexity of the trust. Trust require attention. So you pay for the services of a lawyer during the initial set up and any amendments to the trust in the future. But you also have an accountant or a tax professional that’s doing the annual filing and any maintenance. So Mark, maybe you can go through a general guide of costs.

LaMonica: We’re going to separate this between setup and maintenance. So you found something called the McEwen Investment Services, which is where you got this guidance. So the cost to establish your trust is between $1,000 and $2,000 and maintaining the trust is around $1,500 to $2,500 a year.

Jayamanne: So just looking at these numbers, you can see you do need a really large base of assets to justify the cost for a trust as well as the right circumstances with the beneficiaries of the trust.

LaMonica: All right, we need to talk about an important caveat that we’ve missed. And that is the type of income that can be distributed. So not all income is equal in the eyes of the trust. So importantly, your salary cannot be split via trust. So it’s a limited to business investment income.

Jayamanne: That’s right, Mark. If it included salary, it would be a much more attractive proposition for many households. So let’s sum up who a trust might suit. If you have a high marginal tax rate and will maintain a high marginal tax rate for the foreseeable future and generate considerable passive income that will justify the cost of the trust. If you have children over the age of 18 that have little to no income, for example, uni students, you have retired parents that are on low marginal tax rates and can receive extra income at this lower rate. You have a non-working spouse or they are on a lower marginal tax rate. And you’ve got passive income that you’re generating. So Mark, you derive a considerable amount of passive income. I don’t know why you’re here, to be honest. Have you ever thought of a trust?

LaMonica: I have not. So I’m in a similar situation as you, Shani. I do not have any children and have no plans to have any children. So the only thing that I’ve thought about with a trust is, of course, I have no beneficiaries for when I pass away. So I always think of setting up trust to, in a funny way, I think, control how income can be spent by people who inherit money from me.

Jayamanne: What is money for, if not to have fun with?

LaMonica: Well, exactly. But this is going to force them to spend the money in fun ways.

Jayamanne: Like what’s a fun way?

LaMonica: Like you could write into the trust documentation that this money can only be spent on overseas trips.

Jayamanne: Oh, OK. Like fun as in like fun for them, not funny for you.

LaMonica: Well, no, I’ll be dead. No, but like fun, fun things like that. I mean, you can put anything you want into trust documentation. The money can only be spent on Tuesday at steak restaurants.

Jayamanne: All right. So do you want to talk about who they might not suit, Mark?

LaMonica: Well, me for one person, from both a maturity level and then I think just in general, my personal situation. But the obvious answer is that a trust does not suit you if the only income you have is employment income. As we said, that cannot be directed through a trust. Also, if your investment income is minimum and it’s minimal and it’s not enough to justify those flat fees that we talked about to establish and maintain a trust. If you are the sole income household, you have no beneficiaries to split this with to try to lower the tax rate. If you have children under the age of 18, that means, of course, that you cannot apply a lower tax rate if they’re not making income. If you don’t want to go through this burden, this yearly administrative burden, and you just want a simple tax structure. So I think those are all pretty good reasons. Now, Shani, you don’t fully fit into any of these camps. Are there any options that you’ve been thinking about or that you think are good for people or trust really the only thing that you can do?

Jayamanne: Yeah, I mean, I think it definitely depends on your circumstances, but you might be able to get similar benefits without the added complexity and the flat fees that are involved with a trust. The first and simplest approach is to just have joint ownership of assets. Doing so means that you’re able to split the tax burden from income between multiple owners. And it’s assumed by the ATO that the tax obligations will be split equally. The ATO allows you to deviate from the 50-50 split if you can prove ownership. So for example, if I contribute 30% of the initial capital to an investment and my husband contributed 70%, he can pay 70% of the tax obligation, which leaves me with 30%.

LaMonica: So one thing you mentioned at the beginning of this episode is you mentioned companies. So another structure out there. Now, you also wrote continuing your journey into tax articles. You’ve also written an article about company structures and who they may suit. And so we’ll put a link to that into the podcast notes. Where did you come up with after this conversation that you had with this accountant who asked about children?

Jayamanne: Look, my husband and I aren’t establishing a trust and we don’t have the passive income from investments to justify it. Nor do we have the right circumstances with our family unit to justify the distribution advantage. Instead, what I’ve chosen to do is focus on minimizing taxes in ways that are within my control.

LaMonica: And legal, hopefully.

Jayamanne: Yes, and legal. So investing in tax-efficient investments and minimizing turnover in my portfolio.

LaMonica: And I do think that that’s a really important point that as investors, when we pay tax, we obviously are earning income. So that’s a good thing that we’re earning income. So tax is part and parcel of being a successful investor. So trust may help some investors who derive considerable passive income from their investments. For others, it might just be worth it to keep a simple structure. Pay taxes at the individual tax rate and do what Shani’s doing, trying to come up with ways that you can minimize those taxes. If you are going to consider a family trust, you can see that there are complexities to it. It requires commitment from you once it’s actually set up.

So definitely speak to a tax professional to understand what you’re getting yourself into, like you spoke to a tax professional. All right. So that is the lesson from all of this. Be more like Shani. So thank you very much for listening. We really appreciate it.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

Invest Your Way

A message from Mark and Shani

For the past five years, we’ve released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.

We’ve shared our journeys with you, and you’ve shared back. We’ve listened to what you’re after and created a companion for your investing journey – Invest Your Way. Invest Your Way is a book that focuses on the investor, instead of the investments. It is a guide to successful investing, with actionable insights and practical applications.

The book is currently in presale which is an important time to build momentum. If anyone would like to support this project you can buy the book now. Thanks in advance!

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