Discretionary Trusts Explained: Key Facts and Benefits

Managing wealth and planning for your family's future involves navigating a complex landscape of legal and financial structures. One of the most powerful and flexible tools available in Australia is the discretionary trust, often referred to as a family trust. If you're seeking to protect your assets, optimise your tax position, and ensure your wealth is managed according to your wishes, understanding how a discretionary trust works is essential.

This guide provides a comprehensive overview of discretionary trusts, explaining what they are, how they function, and the significant benefits they can offer. We'll walk you through the key features, the setup process, and common pitfalls to avoid. By the end of this post, you'll have a clear understanding of whether this structure is the right fit for your financial goals and family's needs, giving you the confidence to take the next steps in securing your legacy.

What is a Discretionary Trust?

A discretionary trust is a legal arrangement where a person or a company (the trustee) holds assets on behalf of a group of people (the beneficiaries). The defining feature is the trustee's "discretion" to decide which beneficiaries receive income or capital from the trust, and how much they receive.

Unlike other types of trusts where beneficiaries have a fixed entitlement, in a discretionary trust, no single beneficiary has an absolute right to any portion of the trust's assets or income until the trustee decides to make a distribution to them. This flexibility is the cornerstone of its utility in wealth management and estate planning.

Key Features of Discretionary Trusts

Understanding the components of a discretionary trust is the first step to appreciating its power. Every trust has several key roles and elements:

• The Settlor: This is the person who initially establishes the trust by providing a small sum of money (the "settled sum"). Once the trust is created, the settlor typically has no further role. To avoid legal complications, the settlor should not be a beneficiary.
• The Trustee: The trustee is the legal owner of the trust's assets and is responsible for managing them according to the rules set out in the trust deed. The trustee can be an individual or a company (a "corporate trustee"). A corporate trustee is often recommended for better asset protection and easier succession planning.
• The Appointor (or Principal): This is arguably the most powerful role. The appointor has the authority to hire and fire the trustee. This provides a crucial layer of control, ensuring the trustee always acts in the best interests of the beneficiaries.
• The Beneficiaries: This is the group of individuals or entities who can potentially benefit from the trust. A trust deed usually defines beneficiaries as a broad class, such as "the children and grandchildren of John and Jane Smith," along with their spouses, related companies, and other trusts.
• The Trust Deed: This is the legal document that sets out the rules for the trust. It defines the powers and obligations of the trustee, identifies the beneficiaries, and outlines how the trust will be managed. A well-drafted trust deed is critical for the trust to function effectively and achieve your goals.

Benefits of Using a Discretionary Trust

For high-net-worth individuals and families, discretionary trusts offer a unique combination of advantages that are hard to replicate with other structures.

Asset Protection

One of the primary reasons for establishing a discretionary trust is asset protection. Since the assets are legally owned by the trustee and no single beneficiary has a fixed claim on them, they are generally shielded from creditors or legal claims against an individual beneficiary. For business owners or professionals in high-risk occupations, this separation can provide invaluable peace of mind, knowing that family assets are protected from business liabilities.

Tax Flexibility and Optimisation

Discretionary trusts are highly effective for tax planning. Each financial year, the trustee can decide how to distribute the trust's income among the beneficiaries. By distributing income to beneficiaries with lower marginal tax rates (such as adult children at university or a non-working spouse), the overall tax paid by the family unit can be significantly reduced. This flexibility allows you to adapt your tax strategy year after year as your family's circumstances change.

Wealth Transfer and Estate Planning

A discretionary trust provides a structured and private way to manage and transfer wealth between generations. Unlike a will, which becomes a public document upon probate, a trust deed remains confidential. Assets held in a trust do not form part of a deceased individual's personal estate, so they are not subject to the potential challenges and delays of the probate process. The trust can continue to operate seamlessly after the death of the primary individuals, with control passing to the next generation according to the rules of the trust deed.

Flexibility for Changing Family Circumstances

Life is unpredictable. A discretionary trust's inherent flexibility allows it to adapt to changing family needs. For example, funds can be directed towards a child who needs support for education, a family member starting a business, or a beneficiary with special needs, all at the trustee's discretion. This adaptability ensures that your wealth can be used where it is most needed over the long term.

How a Discretionary Trust Works: A Step-by-Step Guide

Let's break down the annual lifecycle of a typical discretionary trust:

1. Assets are Acquired: The trust acquires income-producing assets, such as shares, property, or a business. These assets are legally held in the name of the trustee.
2. Income is Generated: Throughout the financial year, the assets generate income (e.g., dividends, rent, business profits).
3. Trustee Determines Distributable Income: At the end of the financial year, the trustee calculates the trust's net income available for distribution.
4. Trustee Exercises Discretion: Before 30 June each year, the trustee must pass a resolution deciding which beneficiaries will receive income and in what proportions. This decision is documented in writing.
5. Income is Distributed: The income is then legally distributed to the chosen beneficiaries, who will declare it in their personal tax returns and pay tax at their marginal rates.
6. Trust Lodges Tax Return: The trust itself lodges a tax return, but if all income is distributed, the trust typically pays no tax. Any income not distributed is taxed in the hands of the trustee at the highest marginal rate, creating a strong incentive to distribute all income.

Setting Up a Discretionary Trust: Legal and Tax Implications

Establishing a discretionary trust requires careful planning and professional advice. Here’s what’s involved:

• Engage Professionals: You will need a lawyer to draft a tailored trust deed and an accountant to advise on the tax implications and set up the necessary registrations, such as a Tax File Number (TFN) and an Australian Business Number (ABN).
• Choose the Structure: You'll need to decide on the key roles: who will be the trustee, appointor, and beneficiaries. Using a corporate trustee is often the preferred approach for asset protection and administrative ease.
• Draft the Trust Deed: Your lawyer will draft a trust deed that reflects your specific wishes and complies with Australian law. This is not a place to cut corners with off-the-shelf documents.
• Settle the Trust: The settlor provides the initial settled sum to the trustee, and the trust deed is signed and dated. The trust is now legally established.
• Stamp Duty: Depending on your state or territory, stamp duty may be payable on the trust deed. It's crucial to meet these obligations to ensure the trust is valid.
• Open a Bank Account: The trustee will open a bank account in the name of the trust to manage its finances.

Common Mistakes to Avoid

While powerful, discretionary trusts can be complex. Here are some common errors to avoid:

• Failing to Distribute Income: Not making a valid resolution to distribute income before 30 June can result in the trustee being taxed at the highest marginal rate.
• Poorly Drafted Trust Deed: A generic or poorly written deed can limit the trustee's powers, create ambiguities, or fail to provide adequate asset protection.
• Blurring Lines Between Personal and Trust Assets: The trustee must keep trust assets strictly separate from their personal assets. Mixing them can compromise the trust's legal integrity.
• Wrong Choice of Trustee or Appointor: Appointing the wrong individuals to these key roles can lead to disputes or mismanagement. Careful consideration of who holds control is vital.
• Ignoring Land Tax Rules: Each state has different rules regarding land tax for trusts. It's important to understand these to avoid unexpected liabilities.

Discretionary Trusts vs. Other Types of Trusts

It's helpful to understand how discretionary trusts differ from other common trust structures:

• Unit Trusts: In a unit trust, beneficiaries (unitholders) have a fixed entitlement to the income and capital of the trust, proportional to the number of units they hold. This structure lacks the tax flexibility of a discretionary trust but is often used for joint ventures between unrelated parties.
• Testamentary Trusts: A testamentary trust is created through a will and only comes into effect after the person's death. It can be discretionary in nature but is specifically part of an estate plan. It offers significant tax advantages for income distributed to minor children.
• Bare Trusts: This is the simplest form of trust, where the trustee holds assets for a beneficiary who has an absolute entitlement to them. The trustee has no active duties other than to transfer the assets when instructed.

Your Next Steps

A discretionary trust is a cornerstone of sophisticated wealth management in Australia, offering unparalleled benefits for asset protection, tax planning, and estate management. Its flexibility allows you to protect your family's wealth while adapting to their changing needs for generations to come.

However, setting up and managing a discretionary trust is not a DIY task. It requires expert legal and financial advice to ensure the structure is established correctly and managed in a compliant manner.

If you believe a discretionary trust could be the right solution for you, the next step is to speak with professionals who specialise in this area. Mahler Advisory can help you navigate the complexities, understand the implications for your specific situation, and provide the peace of mind that comes from knowing your family's future is secure.

Contact us to schedule a free consultation and explore how a discretionary trust can benefit you and your family. Our team of experienced professionals is here to provide tailored advice and support every step of the way. Reach out now for personalised guidance and peace of mind.

Disclaimer: This blog post provides general information only and does not constitute legal or financial advice. Consult with a qualified professional for personalised advice. Laws and regulations regarding trusts are subject to change. The information in this post is based on Australian law and may not be applicable in other jurisdictions. We are not liable for any actions taken based on the information provided in this blog post. Case studies and examples are for illustrative purposes only and do not guarantee specific outcomes.