Passing Control of a Discretionary Trust to the Next Generation

Discretionary trusts have long been the go-to vehicle for advisors when setting up a structure for their clients. The principal reasons for this are clear – discretionary trusts give a high level of flexibility and control over both administrative issues and distribution of income while also providing asset protection benefits and access to tax concessions^[1].

Given this rise in popularity, it is only natural that we are now starting to see the transition of businesses and assets held by discretionary trusts to the next generation. As the disposal of the assets themselves would trigger a taxing event, clients are keen to pass these assets to their children via passing control of the discretionary trust instead.

However, the very qualities that made a discretionary trust appealing at the time of its establishment can create a number of problems when trying to meet the expectations of both the outgoing and the incoming generations.

The following examples endeavour to draw out the most common problems and discuss possible solutions to them.

Example 1

Mr and Mrs Smith conduct their manufacturing business through a discretionary trust. The beneficiaries of the trust are Mr and Mrs Smith, their relatives, and associated companies and trusts. The trustee of the trust is Smith Co Pty Ltd, a company which Mr and Mrs Smith control. Mr and Mrs Smith are joint appointors of the trust.

The trust has unpaid present entitlements owing to Mr and Mrs Smith.

Mr and Mrs Smith want to retire and pass the business to their two sons, while realising the value that they have built up in a tax effective manner. However, they wish to retain some level of control until they are satisfied that their sons are capable of running the business themselves.

As there is significant value in the goodwill, they don’t want to trigger any tax liability on a disposal of the business to their sons so instead want to pass the business via passing control of the trust.

The following issues arise in this scenario.

Control

As the trust has a corporate trustee, it is easy to transfer control of the trustee to the sons by appointing the sons as directors in place of Mr and Mrs Smith and transferring to them all of the shares in the company.

Alternatively, Smith Co Pty Ltd could be removed as trustee and a new trustee which the sons control appointed. However, as the trust carries on a business, from a commercial viewpoint the preferred option is to simply pass control of the existing trustee so as to not disturb existing arrangements with suppliers, financiers, customers contracts, employees and so on^[2].

Mr and Mrs Smith will also need to appoint the sons as joint appointors of the trust in place of themselves.

The above assumes that Mr and Mrs Smith are willing to relinquish complete control. As Mr and Mrs Smith want to retain some control, however, it is not as straight forward. One option is for control of the trustee company to pass to the sons with Mr and Mrs Smith retaining their role as appointor of the trust and therefore having the ability to remove the existing trustee and appoint a new trustee if they wish.

Alternatively, the sons could be appointed as directors of the trustee company in addition to Mr and Mrs Smith, with Mr and Mrs Smith retaining their shares and role as appointor of the trust until they are willing to pass complete control to the sons.

In either situation, however, the sons are likely to want some protection against Mr and Mrs Smith exercising their powers as appointor or shareholders to take control of the trust away from the sons other than in certain agreed circumstances. This is commonly done through either a shareholders agreement or other document such as a family constitution.

Where Mr and Mrs Smith retain their position as directors of the trustee company, the agreement between the parties will also need to address how decisions of the trustee company regarding various issues, including exercise of distribution powers, can be exercised^[3].

Distribution of income

As the sons and their relatives and associated entities would already qualify as beneficiaries of the trust, distributions of income and capital can be made between them and their entities without the need to amend the trust deed or alter the beneficiary class.

However, it would be recommended that an agreement be put in place in relation to distributions specifying what control each of the sons and Mr and Mrs Smith have over determining to who and in what amount income and capital is to be distributed.

This agreement can take the form of a shareholder agreement or company constitution or can be inserted into the trust deed itself in the form of “distributor provisions”.

Payment of UPEs

To the extent that the trust has cash or surplus funds, these can be applied towards payment of the unpaid present entitlements and the trust can then borrow further funds to use as working capital in the business.

However, if there are insufficient funds in the trust to pay out the entitlements in full, a funding dilemma arises.

If the sons borrow money and lend it to the trust to fund the pay out, they will only be able to deduct interest on the borrowing to the extent that the amount of the unpaid present entitlement had previously been retained by the trustee and used in the gaining or producing of the assessable income of the trust.^[4] If any part of the funds representing the unpaid present entitlements have been applied by the trust to produce exempt income or for private family purposes, interest on the borrowing will not be deductible.

The same problem applies if the trust borrows the money required to pay out the entitlements directly from the bank rather than from the sons.

Realisation of asset value

Another issue is how to realise the value of Mr and Mrs Smith’s interest in the assets of the trust without triggering a taxing event. Often, this is done via a revaluation of the relevant asset with the increase in value credited to an asset revaluation reserve and distributed out as a corpus distribution. However, to the extent that borrowings are required to fund the pay out of the distributions, interest on the borrowing will not be deductible.

Further, as the trust conducts a business, the majority of the value of the business will be in goodwill. As goodwill is not able to be revalued, this strategy cannot be used to extract the goodwill value. Mr and Mrs Smith may therefore not be able to realise the value of their interest in the goodwill.

Conversely, from the sons’ perspective, they are inheriting a valuable asset which has no cost base and are therefore taking on an inherent tax liability for which they may wish to be compensated. Generally, this issue will only arise where the outgoing controllers are able to realise the value of their interest in the assets of the trust^[5]. Where the outgoing party is unable to realise this value, as will likely be the case with Mr and Mrs Smith, then no compensation for the low cost base would be required as the incoming party gets the full benefit of the asset.

If a compensating adjustment is required to be made, this could potentially be done via an adjustment to the amount distributed to the outgoing party as a corpus distribution to reflect the tax liability that is being inherited by the incoming party or alternatively through the forgiveness of amounts owed by the trust to the outgoing parties.

Example 2

Mr and Mrs Brown are married with three children. They control a discretionary trust which holds three investment properties, all of which have unrealised capital gains. The beneficiaries of the trust are Mr and Mrs Brown, their relatives and associated companies and trusts.

Mr and Mrs Brown want to pass one property to each of their children. The children want the properties to remain in a discretionary trust environment so as to retain the ability to distribute income from the property amongst their family members and related entities.

In the past, the simple solution would have been to split the trust. There are various means by which this could have been done, with the end result being three separate trust estates, each comprising one of the properties. The children could then each take control of one of the trusts.

However recent scrutiny of these arrangements has cast doubt about whether this does, in fact, create separate trust estates or simply a trust and sub-trust arrangement and, if it does create separate trust estates, whether this triggers both income tax and stamp duty consequences. For this reason, a trust split is not always a feasible option.

Alternatively, each child’s property could be transferred out of the trust, for example via a vesting, to a trust controlled by that child. However this will trigger a capital gains tax liability that will need to be funded and which may not be able to be streamed to Mr and Mrs Brown. Further, if the property is distributed to a trust, stamp duty will be payable on the distribution^[6].

So a solution must be found which allows each child to control their relevant property while retaining all properties in the one trust.

Control

If the trustee of the trust is a company, each of the children will need to be appointed as directors and shareholders of the company. If Mr and Mrs Brown were the trustees of the trust, then either the children will need to be appointed as trustees in place of them or a new corporate trustee in which the children are all directors are shareholders will need to be appointed.

As each child will want to control the decision and activities of the trustee in relation to the relevant property allocated to him or her, an agreement will need to be entered into to deal with this, for example a shareholders agreement if the trustee is a company, or a family constitution or similar if there are individual trustees. Potentially these provisions could also be drafted into the trust deed for added protection if desired.

The children will also need to be appointed as appointors. All children will need to be appointed jointly to ensure that none of the children can take control away from the others.

Entitlement to income

As the properties are all retained in the one trust, distribution of income needs careful consideration. Given that the trust fund is essentially being administered in three separate parts (one for each property), separate accounts will need to be kept in respect of each part to determine how much of the income (if any) is attributable to each of the properties.

Specific terms setting out who is entitled to determine how the income is distributed can be drafted into an agreement such as a shareholders agreement^[7].

Alternatively, or in addition to the above, “distributor provisions” can be inserted into the trust deed giving each child the power to direct the trustee as to how the income from the relevant property is to be distributed.

However, the above only works effectively if all properties are producing net income. As there is only one trust estate, if one of the properties produces a loss, then it will reduce the income available for distribution from the other properties. Unfortunately there is no obvious solution for how to deal with this situation and advisors would need to consider how to deal with this depending on their client’s specific needs^[8].

Realisation of asset value

An issue arises if Mr and Mrs Brown wish to realise the value of their interest in the properties when passing them to their children. In this situation, it is relatively easy to revalue each of the properties and distribute any resulting revaluation, after taking into account any adjustment for unrealised capital gains being inherited by the children, as a corpus distribution to the parents. However, as outlined above, a funding issue arises if the parties have to borrow any money in order to pay out the distribution.

Example 3

Mr and Mrs Jones conduct a business through a discretionary trust. The trustee of the trust is Jones Co Pty Ltd, a company controlled by Mr and Mrs Jones, and the appointor is Mr Jones. The beneficiary class of the trust comprises Mr and Mrs Jones, their relatives and associated entities.

Mr and Mrs Jones have three children – two of whom work in the business and one who does not, and does not intend to, work in the business. Mr and Mrs Jones don’t have any other significant assets and on their death want all of their children to benefit from the business, not just the two that are working in it. Accordingly, under their will Mr and Mrs Jones leave their shares in the trustee company to their three children jointly. In addition, Mr Jones nominates all three children jointly to be appointor of the trust on his death.

Mr and Mrs Jones die unexpectedly leaving the children to administer the estate and carry on the business.

Control

As only two of the three children are working in the business, it is important to protect the interest of the non-working child. As the shares and role of appointor are left to the children jointly, this provides a level of protection provided all decisions are required to be unanimous. If decisions are required to be by majority only, then two of the children could outvote the third child, potentially cutting them out.  As the non-working child is unlikely to be a director of the trustee company, this would leave that child exposed.

In this situation, an agreement such as a shareholders agreement would be required to protect the interest of the non-working child and ensure that the other two children cannot cut the third child out. How far this goes would depend on the circumstances of the parties. For example, it may be appropriate to stipulate that some major decisions such as sale of the business or incurring significant liabilities cannot be made without the agreement of all three children, even though the non-working child would ordinarily not have a say in these decisions as he or she is not a director.

Distributions

As it is the intention of Mr and Mrs Jones that all children should benefit equally, measures must be taken to ensure that the non-working child’s entitlement to income is protected, given that he or she will not be a director of the trustee company and therefore would not otherwise be involved in decisions regarding distributions.

This could be addressed through the constitution of the trustee company or as part of a shareholders agreement by inserting terms stipulating that any decision of the trustee to do such things as to distribute income or corpus of the trust other than equally between the three children requires the consent of all of the children.

Alternatively, this could be addressed in the trust deed itself though the insertion of “distributor provisions” which give each child the power to direct the trustee as to how one third of the income and capital is to be distributed.

Pay out of non-working child

In the event that the children working in the business wish to buy out the non-working child, an issue arises as to how to do so. While the children jointly own the shares in the trustee company, these shares are of no value and therefore cannot be used as a means by which the non-working child could realise the value of his or her interest.

This poses the same problems as those encountered in example 1, namely how to create an entitlement to an amount of income or corpus assuming that the majority of the value of the business lies in goodwill which is unable to be valued or revalued, and if an entitlement is able to be created, how to fund the payment to the non-working child taking into account interest deductibility issues if money is required to be borrowed to fund the payment. How this can be achieved will need to be carefully determined based on the individual circumstances of the trust.

Conclusion

As can be seen from the above examples, the discretionary nature of interests in a discretionary trust, along with the desire to defer tax, can create a number of issues when transitioning these structures to the next generation. However with careful management of these issues they should not create any barrier to successfully passing control of a discretionary trust between generations.