Avoid a tax headache from trust rule changes

A lot of family businesses use discretionary trust structures. These have been popular as they provide both a level of risk management, separating the business from your personal assets and are also quite tax efficient.

A discretionary trust allows the trustee to appoint the income of the trust (this is typically the profit of the business) to any of its beneficiaries in the proportions that it determines from year to year.

The entitlement of the beneficiary is not fixed, rather it is a decision of the trustee each year. Normally the trustee is either the key person in the business or a company controlled by this person.

In a typical family situation, mum and dad may be the trustees or directors of the trustee company. Using this structure business owners have the flexibility to distribute income in the most tax efficient way. None of this has changed.

A common technique employed by a lot of trusts was to appoint some of the income to a related company. Normally, this was done where the other beneficiaries had received income for the year that would take them past the 30 cent in the dollar tax rate and by appointing this excess income to a company allowed the family to limit its immediate tax cost at 30 cents in the dollar.

It was also common for trusts to appoint this income to the company but perhaps not pay all or any of this income over to the company. It created a debtor and creditor relationship between the company and trust which is called an unpaid present entitlement.

This simply means that the company is entitled to the money but it has not been paid at the time.

Apart from limiting the amount of tax payable, the main reason for employing this technique was because often the profits of the business had not fully realised into cash.

Most businesses find that some of their profits can be tied up in stock, debtors or other working capital.

The profit has been made. It is just not cash in the bank at the end of the financial year. And practically you can’t pay out profits that haven’t turned into cash.

Sounds sensible to most of us but the Tax Office don’t see it that way. Last year it announced that where there is an unpaid present entitlement between a trust and a company beneficiary that continues past the financial year, they will treat this as a loan from the company back to the trust.

The implication of this is that it could trigger Division 7A of the Tax Act and cause the amount to be deemed a dividend.

In most cases you will want to avoid this situation. Income appointed by a trust to a company after December 16, 2009 is affected by these new rules. So it could affect your 2010 income tax return.

Many small businesses have used this strategy as a way of managing their tax and cashflow position and dealing with the differences between their accounting profits and available cash.

There are still a number of options available to you in how you manage this situation. It’s important to have a talk with your accountant if you operate your business through a trust and have used a related company as a beneficiary.

There are some things you will need to do this year and some of your strategies may need to change. Get it done now to avoid a tax return headache.

Greg Hayes is a director of Hayes Knight and specialises in taxation and business planning advice.