Setting up a family trust is useful only at certain times.

Family trusts have been the subject of some public spats between Australia’s wealthiest families. But how do they work, and can anyone start a trust?

The richest Australian, Gina Rinehart, has been embroiled in a lengthy court battle with her children over a family trust for over 10 years. Then there are the Murdochs, whose family trust is front and centre of its succession saga.

What is a family trust?

A family trust is an agreement in which a person or entity agrees to hold assets on behalf of another person or entity. It’s a type of discretionary trust, which means the trustee or trustees—generally the parents—can choose how to allocate the income distributions.

Generally, trusts distribute their income annually to beneficiaries, who are then required to pay tax; the trust is not usually taxed directly.

The beneficiary is a person or company, usually a family member such as a spouse or child, entitled to the trust’s income or capital. Beneficiaries tend to be taxed on the trust’s net income based on their share of the income.

There are several practical, commercial and financial reasons for distributing trust income in a particular way. Income is often distributed to family members with the lowest taxable income who will incur the least tax. However, it’s not always that simple.

What is the purpose of a family trust?

A family trust allows flexibility in managing investment portfolios, family wealth, the ability to run a business and lower tax bills.

The main reason is to reduce taxes. When you’ve children, you can distribute the income to use up your tax-free thresholds.

If your trust has an asset earning your money, you can distribute that to everyone in your family to use up that $18,200 tax-free threshold. So, if you’ve got three kids, that’s $60,000 tax-free. Another reason is to protect assets from creditors and legal disputes.

The assets of a family trust are administered and controlled by the trustee and not by the individual beneficiaries. This can provide excellent asset protection advantages in certain circumstances, such as if a family member is sued.

Family trusts are also helpful for estate planning purposes. Through a family trust, the ownership of assets such as a share portfolio or a holiday house can continue uninterrupted even when a key family member passes away. The family member doesn’t own the asset; the trust does. Consequently, the assets don’t form part of the individual’s estate.

When is a family trust a good idea?

A family trust can be worthwhile for those who want to invest a substantial amount and have either maxed out their super contributions or want more accessibility than super provides. Family trusts may also be more sensible for people with certain occupations than others, particularly those at a higher risk of being sued.

For example, individuals in the medical profession, financial services, and those who provide advice may be at a greater risk of litigation. They may want to add a layer of protection around their assets. Family trusts are also helpful for younger investors because they are a flexible investment vehicle.

Unlike super contributions, which are locked away until you reach retirement age, family trust assets are available to the family at any time. The main limiting factor is the capital gains tax payable on accrued capital gains when trust assets are distributed as cash. It’s also an attractive option for families who want to ensure their assets stay within the immediate family.

When is it not worth setting up a family trust?

The most basic rule of a family trust is that you need to have assets to put in it. The decision on whether to set up a family trust is more about personal circumstances and financial objectives than a fixed amount to invest. Other important considerations include the cost of running the trust and the level of asset protection required.

For example, the additional accounting fees and yearly tax returns may not be worthwhile. With investment portfolios, enough investment income should be generated to make income splitting between spouses worthwhile.

How does trust work?

Scenario 1: Without the help of the family trust.

Judy earns $160k a year. The same year, she sells her investment property and receives $800k after tax. Judy reinvests the proceeds from the sale and receives $40k a year. Therefore, her taxable income for the year is $200,000. Assume her effective tax rate is 32% (considering the tax-free threshold). So, she pays $ 64,000 in taxes.

Scenario 2: With the help of the family trust.

Judy earns $160k a year. The same year, she sells her investment property and receives $800k after tax. Judy establishes a family trust and invests the proceeds from the property sale. The trust generates $40,000 per year in income. The $40,000 is distributed equally to her two adult children, John and Rehana, who are studying and not earning a living.

John and Rehana pay no tax, considering there are no tax thresholds, low-income offsets or Medicare levy limits. Judy’s taxable income is now $ 160,000. She pays $47k in tax. The effective tax rate, in this case, is 29%. The tax is lower due to the lower taxable income, a lower tax rate threshold, and a lower Medicare levy on a lower taxable income.

Judy saved $ 17,000 in tax for the financial year by setting up a family trust and distributing part of the income to the children.