What is a closely held trust?
A closely held trust is a trust whose control and benefit sit with a small group of people, usually members of one family or a tight-knit group of business partners. In Australian tax law the label has real consequences: it decides whether the trustee must collect tax file numbers, withhold tax from distributions and report certain distributions to the ATO.
If you operate through a family discretionary trust or a small unit trust, there is a good chance the ATO already treats you as a closely held trust, whether or not anyone has used the term. This article covers:
- What a trust is: the legal relationship underneath the label
- The closely held tests: how the ATO decides whether a trust is closely held
- The two ATO rule sets: what the label triggers for trustees
- A worked example: how the rules play out for a family business
- Common misconceptions: what owners often get wrong
- Getting help: where lawyers and accountants fit in
The trust underneath: a relationship, not a company
A trust is a legal relationship in which a trustee holds property, such as business assets, shares or cash, for the benefit of other people called beneficiaries. The trustee controls the trust and must act in line with the trust deed and the law. A trust is not a separate legal entity like a company: it does not own assets in its own right, and it is the trustee who enters contracts, holds bank accounts and can be sued.
The trusts that small businesses most often use, and that are most often closely held, come in two forms:
- Discretionary trusts: the trustee decides each year which beneficiaries receive income or capital, within the class named in the deed. These are commonly called family trusts.
- Unit trusts: beneficiaries hold fixed units and distributions follow unit holdings. These suit unrelated business partners who want a fixed allocation method.
Many owners appoint a company as trustee, called a corporate trustee, to separate their personal affairs from the trust's affairs and to simplify governance and succession. That separation is not complete protection for the people behind the company. Under s 197 of the Corporations Act 2001 (Cth), a director of a corporate trustee can be personally liable for a trust liability if the company cannot discharge it and is not entitled to be fully indemnified out of trust assets, for example because of a breach of trust or because it acted outside its powers.
The tests that decide if a trust is closely held
"Closely held" is not a special type of trust that you register or set up. It is a classification that tax law applies to ordinary trusts, and the consequences flow from that classification. The core definition sits in s 102UC of the Income Tax Assessment Act 1936 (Cth), and the ATO summarises it as the "20/75 test".
A trust is a closely held trust if either of these applies:
- The small group test: an individual, or up to 20 individuals between them, has fixed entitlements to 75% or more of the trust's income or capital, directly or indirectly and for their own benefit
- The discretionary trust test: the trust is a discretionary trust, meaning it is not a fixed trust within the meaning of the trust loss rules in Schedule 2F of the Act
Two details make the first test easier to satisfy than it looks. An individual and all of their relatives are treated as a single individual, so a family group counts together even if it has more than 20 members. And a trustee of a discretionary trust that holds a fixed entitlement in another trust can be treated as an individual holding the entitlement for their own benefit. The practical result is that most family discretionary trusts are closely held trusts as a matter of law from the day the deed is signed.
Unit trusts are assessed on the same basis. The trust loss rules in Schedule 2F use the same small group test to work out whether a fixed unit trust is widely held or closely held, so a unit trust held by a small group of unrelated investors will be closely held if the group holds 75% or more of the income or capital between them.
There are exclusions. Under s 102UC, a trust is not closely held if it is a unit trust whose units are listed on the ASX, or if it falls within certain excepted trust categories in Schedule 2F. For the two ATO rule sets, the ATO's exclusion table also carves out complying superannuation funds, pooled superannuation trusts and approved deposit funds, and treats deceased estates differently depending on how long the estate has been in administration. Employee share scheme trusts and law practice trusts are excluded from the TFN withholding rules in some circumstances.
Why the label matters: two ATO rule sets
Once a trust is closely held, two special sets of rules can apply: the trustee beneficiary reporting rules and the TFN withholding rules. They apply in different circumstances, and both sit on top of the ordinary obligation to lodge a trust tax return.
TFN withholding
Under Subdivision 12-E of Schedule 1 to the Taxation Administration Act 1953 (Cth), a trustee of a closely held trust must withhold tax from a distribution to a resident beneficiary who has not quoted their tax file number (TFN) before the payment is made or the entitlement arises. The ATO requires the trustee to withhold at the top rate of tax, register for PAYG withholding for closely held trusts, pay the withheld amounts to the ATO and lodge the annual reports. Withholding does not apply where the amount for the income year is below the regulatory threshold of $120, or where the beneficiary is a non-resident, a tax-exempt entity, under a legal disability, or a trustee beneficiary covered by a correct trustee beneficiary statement.
The risk of getting this wrong is real. If the trustee pays a distribution or creates an entitlement before the beneficiary's TFN is on file, the trustee can face failure to withhold penalties without having the money in hand to pay them.
Trustee beneficiary reporting
Division 6D of the Income Tax Assessment Act 1936 (Cth) contains the trustee beneficiary reporting rules. Where a closely held trust distributes a share of its net income to a trustee beneficiary, usually a company or another trust, the trustee may be required to make a trustee beneficiary statement about that share. Where the share is distributed without a correct statement, trustee beneficiary non-disclosure tax can apply, and for a corporate trustee the liability can extend to the directors who took part in the decision. The ATO also applies separate rules to circular trust distributions. For non-resident trusts, the reporting rules apply but TFN withholding does not.
There is also a routine annual duty that applies regardless of TFNs: the trustee must complete the statement of distribution in the trust's tax return, reporting total payments made to, and unpaid entitlements created in, each beneficiary, even where every beneficiary has quoted their TFN.
A worked example: the Kumar family trust
The Kumar family runs a wholesale food business through the Kumar Family Trust, a discretionary trust with a corporate trustee. The beneficiaries are Ravi and Meena Kumar, their adult daughter Priya, and an investment company that holds part of the family's assets.
Each year the trustee resolves how the trust's income will be distributed. Ravi, Meena and Priya have quoted their TFNs to the trustee, so their shares of the income can be paid without withholding. The investment company has not quoted a TFN. At year end the trustee resolves that the company is entitled to $40,000 of the trust's net income. Because the company has not quoted a TFN, the trustee must withhold from that entitlement at the top rate of tax unless a correct trustee beneficiary statement removes the obligation, then pay the withheld amount to the ATO and report it.
Now suppose Priya's share is $60,000 and she has not quoted her TFN. The trustee must withhold at the top rate from her entitlement as well. If the trustee resolved her entitlement and paid it out without withholding, the trustee would face failure to withhold penalties, and the money would already be sitting in Priya's bank account. Distributions below the $120 threshold for the income year are the only ones that escape withholding entirely.
Common misconceptions
Several beliefs about closely held trusts are wrong in ways that matter in practice:
- Setup myth: a closely held trust is not a special trust you set up or register. The label is applied by tax law to structures you would otherwise call a family trust or a small unit trust. If you already have a discretionary trust, you almost certainly have a closely held trust.
- Family trust election: a family trust election is a different mechanism: a formal election under the trust loss rules that confines the trust's distributions to a family group. It does not switch off the TFN withholding rules. Under the ATO's exclusion table, a family trust with a valid election in force is excluded from the trustee beneficiary reporting rules, but distributions to beneficiaries outside the family group can attract family trust distribution tax, and TFN withholding still applies to the trust.
- Corporate trustee protection: a company as trustee keeps the trust's affairs separate from the personal affairs of the owners, but s 197 of the Corporations Act 2001 (Cth) can make directors personally liable for trust liabilities where the company has breached the trust or acted outside its powers and cannot be indemnified out of trust assets. Asset protection also depends on the group's contracts, guarantees and how assets are actually held.
- Family only: a unit trust with up to 20 unrelated investors is closely held if those investors hold 75% or more of the income or capital between them.
Getting help: where lawyers and accountants fit in
Because the label carries obligations from day one, the practical work happens at setup and then repeats every year:
- Drafting the deed: a lawyer prepares the trust deed so the trustee's powers, the beneficiary class, and the variation and succession clauses match how the business will actually run, including who can appoint and remove trustees
- Setting up the corporate trustee: a lawyer handles the company registration, constitution and director appointments so the company can validly act as trustee
- Tax settings: the accountant puts in place TFN collection and reporting processes, works out whether a family trust election or interposed entity election is worthwhile, and prepares the annual distribution resolutions and the statement of distribution in the trust tax return
- Changes over time: when the business changes, a lawyer prepares a deed of variation or appoints a new trustee, and checks the original deed's variation power before anything is signed
The question to answer before the deed is signed
Before you settle a trust, decide who will control it and who will benefit from it. If that group is small, and for most family businesses it is, the trust is closely held under tax law and the two ATO rule sets apply from the start. The real question is not whether the label fits, but whether your TFN collection, distribution resolutions and annual reporting can keep up with it, and whether the directors of your corporate trustee understand the exposure s 197 leaves in place.