Legal Tip 188: How to Fund a New Discretionary Trust

Discretionary trusts are generally started with just $10 or $20. Mostly trusts are established for a trustee to hold shares or property for the benefit of a beneficiary, so how does the trustee get the deposit or money to do this?


There are basically just 3 options to consider:

a) Gift

A gift is an irreversible transfer from one person to another.

It is better than a loan for asset protection against bankruptcy because if the gift giver goes bankrupt generally the gift will not be available to creditors (but the claw back laws need to be considered).

Gifts to discretionary trusts may not be ideal though because when you die the gift will not form part of your assets and cannot be passed via your will.

If the gift giver is borrowing money to gift to a trust the interest will not be deductible.

Gifts should be documented with a deed.

b) Loans with interest

A loan can be made with interest accruing. However, interest is income to the receiver. Interest may be deductible to the trust if it is using the borrowed money invest, s 8-1 ITAA97.

The interest rate could at market, under market rates or higher than market rates. Each has different consequences.

But a person cannot contract with themselves, so you could not lend to yourself if you are the trustee.

Generally, someone borrowing money to lend to the trustee should consider charging interest to the trust. This interest would need to be at least the same interest that the bank is charging you. But the question you should be asking is if the bank has a first mortgage security over real property and charges say 4% to you, if you lend to the trust at 4% without security would this be a market interest rate? Are there any Part IVA consequences?

A loan should be documented with a written loan agreement which would be either a contract or a deed.

c) Interest free loans

Many like to make interest free loans to trusts because there are no direct tax consequences and the loaned money would generally come back to the lender at death and therefore form part of their estate and can then pass into a testamentary discretionary trust.

But a major issue with loans is the various state limitations acts. This could cause a loan to become unenforceable if there has been no activity with a loan for 6 years (NSW law). So, a loan made say 7 years ago which is interest free and no transactions have happened will not be recoverable if the borrower refuses to pay back. You might think that you are not going to sue a related trust, but you must remember that if you set up a trust you are just in control temporarily. If you lose capacity, go bankrupt or die the control of the trust will pass to someone else.

Interest fee loans should be documented in the same way as loans with interest.


Which method should you use?

You should all get specific legal advice from a lawyer, but as a guide:

a) If you have cash and are concerned about bankruptcy a gift might be worth considering

b) If you are not concerned about bankruptcy and have cash, then an interest free loan may be worth considering

c) If you are borrowing and on-lending the money to the trust a loan with interest may be worth considering.


If you do make a loan you must adhere to the terms of the loan for it to be effective.

Originally posted at
How to Fund a New Discretionary Trust – The Structuring Blog

 

A trust could also issue units if its a unit trust or some other forms of units if its a hybrid trust. eg a Hybrid Discretionary Trust. The units are typically issued for a nominal sum eg $1 each. And can later be "traded" to exchange the asset with another investor or redeemed through the trustee who may issue new units to a new investor. Even a hybrid discretionary trust may be able to do this. This broadens the ways a discretionary trust MAY access funds. And until the HDT issues units it can essentially be a discretionary trust !

Many people think that hybrids are incorrect and no longer permitted but that isnt correct. A hybrid trust can be a great structure if all the tax consequences are known and planned for. The rights of unitholders would be based upon the terms of the trust and the terms governing the issued units.

eg

- Fixed rights to redemption or fixed rights to income
- Trustee discretion for redemption
- Other restrictions on redemption
- Rate or type of return
- Ability to demand capital

One obvious benefit of a HDT issuing units may be that the unitholder may be able to personally borrow funds and avoid the issues of loss quarantining that may occur if the trustee borrows. (Subject to the new ALP rules)

The second major benefit is the ability to use the refinance principles. Simply explained this means Dad can seek to have his units redeemded. Mum boorows to invest and new units are issued. Mum buys units from trustee who then uses those funds to repay Dad. There is no test for what Dad does with Mums money. Dad could buy a boat and Mum may have a deductible loan. This is no different to the position if the trust was a Stockland Property Trust or a related party trust.

This can be combined with or as an alternative to gifts and loans.

The importance of legal advice is essential. Hybrid trusts may leave a unitholder exposed without asset protection in the manner of a discretionary trust.

 

This can also be a mistake. There may be very sound reasons to settle a trust with more than a nominal sum. The key reason people choose nominal sums is stamp duty.

The stamp duty on a $100,000 settled sum is how much ??
A : This will vary.

 

Nil if cash - in most states. nsw $500

It would be very impractical for a settlor to give over $100k to a trustee to hold on trust for others with them or their children not being able to benefit.

 

Great post Terry. Very useful summary.

Another issue comes to my mind in deciding whether to loan or gift. Say you put money into a trust, but are thinking of maybe upgrading your PPOR, and hence may want to use the funds for that purpose in the future.

Is this readily achievable if you have already gifted the money. While the trust could distribute the money back to the beneficiaries (and hence have it used towards a upgraded PPOR), that distribution would be all taxable as income in the hands of the beneficiary (I am assuming a ‘capital return’ to a beneficiary from a trust is just normal income in the hands of the beneficiary???). So, not very tax effective.

Maybe this can be solved (in the case of money gifted to the trust) by the trust simply lending the money back to one of the beneficiaries (who in turn uses it to contribute to an upgraded PPOR).

Lastly, regarding the issue of enforceability if there is no activity, this does not strike me as a particular problem, largely because banking apps are so good, you can easily set up a direct periodic debit from one account to another. So, easily addressed (IF you have been made aware of the issue).

 

Distribution of capital from a discretionary trust is not taxable unless assets are realised triggering a CGT event. s 99A(2) from memory.

 

s98B(2)(a) ITAA36
INCOME TAX ASSESSMENT ACT 1936 - SECT 99B Receipt of trust income not previously subject to tax

 

Thanks Terry. So, return of capital or ‘corpus’ not assessable income (unless a CGT event has occurred). Makes sense. Not sure why I thought otherwise now I think about it. Ah, the flexibility and effectiveness of trusts!

 

Thanks for this Terry. Is a return of capital from a trust normally just actioned through a standard letter from the trustee prepared by the accountant.

 

accountants shouldn't be preparing trustee documents!

The method would usually be by trustee resolution but subject to the trust deed.

 

It may depend on the trust financial records too. If the trustee has borrowed substantial funds from "Dave" then the trust may merely repay this liability. Some of the distribution may include income in which case the limits of an annual resolution to distribute income needs to comply with the deed. Get it wrong and it could pose a problem. Many deeds dont consider a interim income distribution. In which case an advance to a beneficiary to be later repaid by a distribution of income is another option.

 

Hi Terry, thank you for the informative post.

You mentioned under b) Loans with interest that 'a person cannot contract with themselves, so you could not lend to yourself if you are the trustee.'

Does this also apply for interest free loans?

In other words, if I am the trustee the only way to contribute money (coming from my savings) to the trust is by gift?

 

You can't contract with yourself at law because you cannot sue yourself. this would include lending yourself money

but the courts of equity might recognise someone moving money to a trust with the intention of the trust giving that money back at some point. But best to avoid the issues by simply having yourself and someone else lend money to yourself as trustee.

 

Does this include if it's a corporate trustee where you are sole diector? Or techinically that's lending/contracting with a separate entity/company and not to yourself.

 

A company is a separate legal entity to its directors and shareholders.

 

Hi Terry

I have a question i have not been able to find info on, and that is if i receive money into my personal account from a discretionary trust, can i move that into my family trust, without being personally liable, if the trust distributing the money to me declares my trust as the benificiary, in their return.
That would then aloow me to move the money into my trust and distribute to my family members (at their tax rate) rather than me paying all of the tax?

Thank you

 

Maleko

The question asked is confusing. As you asked it...No.

A distribution by Trust A makes the beneficicary "presently entitled" and subject to tax whether the funds are paid in cash or credited as a entitlement. The trustee resolution is the typical creation of that income entitlement...not when its paid. In the scenario you explain it may mean YOU and family are each taxed on the same income. eg Trust B would also have income.

I would be seeking tax advice.

 

Thank you Paul.

Apologies if my question was unclear.

I meant to say- My trust compant is a beneficiary of the trust making the distribution. I am aldo a beneficiary, in my personal capacity.

My trust bank account is not set up yet, hencewhy i wanted to receive the money into my personal account, temporarily, before moving it into my trust.

The trust making the distribution to my personal account would declare my trust as the beneficiary.

That way the money paid into the trust could be distributed and taxed, versus taxed by me alone.

 

Still makes no sense. Two trusts neither with a bank account ?
Definately one for your tax adviser

 

Trust A dustributes --> into a Personal Bank Account --> Moves to Trust B bank account

Trust A declares Trust B as the beneficiary in their reporting, i.e. that Trust B received the distribution.

Holder of Personal Bank Account therefore not taxed.

Trust B makes its ditribution (from money transferred in, from the personal bank account.

Beneficiaries of Trust B declare the income and pay tax.

The question is whether the distributuon into the personal bank account, temporarily, and then into the Trust account B is legal, and as no tax implications for the personal bank account holder.

Regards
Marc