Legal Tip 327: Trusts Mistakenly Distributing Income to Non-Beneficiaries

Discussion in 'Legal Issues' started by Terry_w, 4th Feb, 2021.

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  1. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    Only a beneficiary of a trust can benefit from the income and/or capital of the trust. With discretionary trusts the beneficiaries are those people and companies nominated in the deed.

    By distributing to a person or company that is not a beneficiary the trustee will be breaching their duties as trustee and personally liable for the loss. But, perhaps even worse, the tax consequences could be very expensive.

    Example

    Homer has set up the Simpson Family Trust with himself as the trustee. The beneficiaries are Homer, Marge and relatives by blood and marriage of either of them.

    Aunty Patti is not earning any income and living on a cash inheritance, so Homer starts distributing income of the trust to Patti - $30,000 per year.

    This goes on for 10 years until the ATO audit the trust.

    On a close look at the deed, it turns out that Patti was not a beneficiary of the trust and never had been a beneficiary.

    The wording of the deed will mean that no valid distribution of the trust income had been made so the trustee will have been taxed on that income at the top marginal tax rate.

    Over the years $30,000 x 10 means $300,000 has been mistakenly given to Patti.

    Homer, as trustee, owes the ATO $135,000 in tax plus he is personally liable to reimburse the trust $300,000 which he will probably try to recover from Patti.



    Some trust deeds might have what are called ‘default beneficiaries’ which means if the trustee does not make someone entitled to the income of the trust the default beneficiaries can get that income.

    This can save being taxed at the top marginal tax rate if things go wrong, but



    Example 2

    Continued from above, there is a default beneficiary clause – Grandpa Simpson is the default beneficiary. When he finds this out, he realises that he is legally owed $300,000 by Homer. He can sue Homer to recover this money and can even get at Homer’s personal assets if the trust does not have enough.



    Make sure beneficiaries of a trust are actually beneficiaries.
     
  2. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    Beneficiaries may also be limited from those on apparent reading of the deed by :
    - Amendment. Common to exclude non-resident beneficicaries in NSW for example. And it isnt attached to the original deed. Older parents are often excluded by amendment.
    - A Family trust election which will nominate a test individual which will limit benefciaries
    - Events occuring after the deed was settled eg remarriage, divorce, death etc
    - Clauses not understood by trustee on reading. eg Perpetuity rules which may affect a trust to trust distribution

    The most fatal of the lot however is often - accountants. I have seen many instances where an accountant distributes as part of their trust tax services and doesnt actually check the deed. eg Grandchildren are the only beneficiaries and the parents are not able to receive income.

    The ATO will commonly consider the trust terms, written resolutions and other records to determine if a distribution was validly made. Their approach tends to result in double taxation as the incorrect beneficiary and the trustee would both be assessed
     
  3. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    A Family Trust Election doesn't change the beneficiaries of the trust. It just means extra tax if the income of the trust, or captial, is distributed outside the family group - as defined by the ITAA36 act
     
  4. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    No it wont "change" the beneficiaries. But it can restrict (for tax purposes) where the deed is more expansive that the FTE. Especially on remarriage etc eg new wife may not be covered by the FTE (irrevokable too) but seems a deed beneficiary. Joe the trustee reads the deed and just assumes its OK. However several months later the tax adviser notes a concern. Doesnt invalidate a distribution but imposes some altered tax outcomes on the trustee. The tax system imposes penalties on the defect. A potential shortfall since the trustee may have fully distributed rather than net of tax withheld.

    Distributions made under tax law inconsistent with the FTE and test individual rules can include
    - Losses are lost
    - Franking credits lost
    - Family trust distribution tax (47%) may mean the trustee has a trust shortfall and late payment and reporting penalties
    A distribution also can include capital and not just income.

    And even then its not uncomon to find "new wife" or family injects new trust capital and seeks to use a expanded "family". A thorough mess.
     
  5. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    A FTE restricts who the trustee can make presently entitled without having to pay Family Trust Distributions Tax. It doesn't restrict the trustee other than this.