Discretionary trust or family trust and what to weigh before you set one up

You are a couple of years into running a profitable small business as a sole trader, or you are about to launch a family venture with a sibling, and your accountant has said the words “you should think about a trust”. The bank has started asking what structure the loan should go into, the tax bill has crept up two years running, and a supplier has mentioned putting the business relationship on a proper footing. This is the moment the structure decision gets made, and it is usually made once and lived with for decades. The question on the table is not really whether to buy a pre-packaged “discretionary trust” or “family trust”, because in most Australian small business settings those two labels describe the same underlying structure.

The two labels, and what actually differs

A discretionary trust is a trust under which the trustee has a discretion, exercised each year, to decide which beneficiaries receive income or capital of the trust and in what proportions. The trust is created by a trust deed, which sets out who can benefit, what powers the trustee has, how the trustee is appointed and removed, and how the trust can be changed or brought to an end. A discretionary trust has no fixed ownership interests; each beneficiary has a hope of receiving a distribution, not a right to a defined slice.

A family trust, in everyday Australian business language, is simply a discretionary trust whose beneficiaries are drawn from a family group. Nothing in the general law requires a special document or a special name for it. But in tax law the phrase has a narrower, more consequential meaning. Under Schedule 2F of the Income Tax Assessment Act 1936 (Cth), a trust is only a family trust for tax purposes if the trustee has made a family trust election (FTE) in the approved form, the trust passes the family control test, and the election specifies the individual whose family group applies. The ATO is explicit that a trust is not a family trust for tax purposes simply because the words “family trust” appear in its name.

So the comparison that matters for your decision is not discretionary trust versus family trust as two rival structures. It is a discretionary trust without an FTE versus the same trust with an FTE, and getting clear on which of those you are actually talking about is the first step. The factors below are the ones that should drive the call.

Who can benefit under the deed

The trust deed defines the class of beneficiaries, and this is the single most important drafting choice in the whole structure. In a typical family discretionary trust the class includes the family members you name plus related entities such as a company or another trust, and it is common to leave the class open enough to include future children, spouses and in-laws. A broader class gives the trustee more room to distribute to whoever is in the best position in any given year.

The everyday label matters less than the deed. Two businesses can both call their structure a “family trust” and have very different beneficiary classes, because one deed might confine benefits to a married couple and their children while another admits a much wider group. If you are weighing up who should be able to receive distributions, the question to put to your lawyer is not what the structure should be called, but what the deed should say about the beneficiary class, and how easily the deed can be amended later if circumstances change.

An FTE changes the practical significance of that class. Once an election is in force, distributions of income or capital to anyone outside the specified individual’s family group attract family trust distribution tax at the top marginal rate, which the ATO describes as capable of having severe consequences. So a deed that admits a wide beneficiary class is fine as far as the general law is concerned, but it is the election that determines who can actually receive money without a tax penalty.

What the election does to your tax position

The FTE is voluntary, but once made it is very difficult to undo. The trustee can make only one FTE for the trust, and it can only be varied or revoked in limited circumstances set out in the legislation and the ATO’s guidance. That makes it a one-way door, which is why the tax consequences deserve attention before you walk through it.

The attraction of an FTE is access to tax concessions. A trust with losses or deductions that cannot satisfy the ordinary trust loss tests can, as a family trust, use those losses under a concessional regime. An FTE can also assist a company that has a non-fixed trust as a shareholder to access a loss-tracing concession, and can help beneficiaries satisfy the holding period rules needed to access franking credits on shares held through the trust. For a trust that wants to carry forward losses or hold shares, an FTE can be genuinely valuable.

The price of those concessions is confinement. The election must specify an individual, and the trust’s distributions are then confined to that individual and their family group. If you think there is any realistic chance of bringing in an outside investor, an unrelated business partner, or a non-family beneficiary down the track, an FTE can foreclose that option or make it very expensive. The trustee must also pass the family control test at the end of the income year specified in the election, so the family must be able to demonstrate that it controls the trust.

Distributions that do stay within the family group are taxed in the ordinary way. A beneficiary who is presently entitled to a share of the trust’s income is assessed on that share at their own marginal rate, and the trustee is assessed on behalf of minors and non-residents. Where income is not distributed and no beneficiary is presently entitled, the trustee is taxed at the highest marginal rate. The ATO’s guidance makes clear that the tax treatment of trust income depends on present entitlement, which is determined by the deed and any trustee discretion, and that trust losses cannot be distributed to beneficiaries but can be carried forward. None of this is a substitute for your accountant modelling your actual numbers, but it is the framework within which that modelling happens.

Control: who really runs the trust

The trustee is the legal owner of the trust assets and the decision-maker on distributions. But in most discretionary trust deeds the appointor holds the real control, because the appointor has the power to remove and replace the trustee. A common structure has an individual or a couple as appointors, a company as trustee, and the family as beneficiaries.

Three control questions are worth settling before the deed is signed:

• Who is the appointor, and what happens on their death or incapacity? If the appointor dies without a succession mechanism in the deed, control can be contested, and families have litigated over exactly this. The deed should say what happens to the appointor power.
• Who is the trustee, and can they be removed? If a corporate trustee is used, control is exercised through the company’s directors and shareholders, which adds a governance layer on top of the trust.
• How are disagreements resolved? Where siblings or multiple branches of a family are involved, the deed should provide a mechanism rather than leaving conflict to be resolved in court.

These questions are the same whether you call the structure a discretionary trust or a family trust. The label does not change the control architecture; the deed does.

Liability: what a trust does and does not protect

Trusts are often sold as asset protection, and they do separate business risk from personal wealth to a degree, but the protection is not automatic and it has limits.

The trustee contracts in its own name and is the entity that can be sued. The trustee has a statutory right to be indemnified out of trust assets for expenses incurred in the execution of the trust, which is how a trust structure is meant to shield the people behind it. But that indemnity is only as good as the assets in the trust. If the trust has no assets, or the liabilities exceed them, an individual trustee remains personally exposed, because the indemnity cannot reach beyond what the trust owns.

That is the main reason so many Australian family businesses use a corporate trustee. A company as trustee gives creditors a separate entity to pursue, and it avoids an individual signing contracts in their own name as trustee. But a corporate trustee does not eliminate personal exposure: directors can still be personally liable in some situations, such as for certain statutory liabilities, and a director who gives a personal guarantee to a bank or landlord is on the hook regardless of the structure. The protection a trust provides also does nothing for the quality of your contracts, insurance and compliance, which remain the first line of defence.

Administration: the ongoing obligations

A trust only works if it is administered properly, and this is where most small business trust problems actually start. In practical terms, the standing obligations are:

• Trustee resolutions: The trustee must decide and document distributions before the end of the income year, typically by a resolution that records which beneficiaries are presently entitled to what. The ATO publishes a resolution checklist covering the deed, the beneficiary class, vesting and any FTE in force.
• Correct entity name: Invoices, contracts and bank accounts must be in the name of the trustee as trustee for the trust, not the owner’s personal name.
• Registrations: The trust needs its own ABN and TFN, and possibly GST registration, and these need to be used consistently across banking, suppliers and payment platforms.
• Record keeping: Financial records and distribution documents need to be kept and reported in the trust’s tax return each year.

The structure decision is made once, but the administration is annual. If you are not prepared for that ongoing discipline, a trust can create more problems than it solves, and a simpler structure such as a company may serve you better.

When a trust is not the right vehicle

A discretionary trust suits a business where control and benefit will stay within a defined group and profits can be distributed flexibly. It is a poor fit where you want to raise outside equity, because investors generally want shares in a company rather than a discretionary interest in a trust, and an FTE would make outside participation actively expensive. It is also a poor fit where you want minimal administration, or where the people involved are not able to keep clean records of trustee decisions. Working through these thresholds with your accountant before you commit is cheaper than unwinding a structure later.

How Artificer Legal helps you make and act on this call

A decision between a discretionary trust with or without an FTE turns on assumptions about the future: who will be in the family group, whether outside money will ever be needed, how control should pass between generations. An Artificer Legal practitioner’s role is to stress-test those assumptions against the way the deed and the tax rules actually operate, and then to build the documents the chosen path needs.

That starts with the trust deed, which must define the beneficiary class, the trustee’s powers, the distribution mechanics, the appointor arrangements and the succession position coherently, because the deed governs every distribution you will make for the life of the trust. Where a corporate trustee is used, we also document the company’s governance, often through a constitution and, where several family members are involved, a shareholders agreement that covers decision-making, transfers and exits. We can also review an existing deed before you make an FTE, because the election interacts with the deed’s terms, and an election made on top of a poorly drafted deed can lock in problems for decades. The tax modelling itself is your accountant’s job, and the two advisers need to work to the same set of facts.

The decision turns on the deed, not the label

The question most business owners actually face is not “discretionary trust or family trust”, because in most cases those are the same structure. It is whether the trust deed should be drawn to confine benefits to a family group, and whether an FTE should be made on top of it, with all the concessions and constraints that flow from that choice.

The label you use with your accountant is close to irrelevant. The deed is the document that determines who can benefit, who controls the trust and how distributions work, and the FTE is the election that determines who can receive money without triggering top-rate tax. Spend your effort there, and treat the FTE as the one-way door it is: model the concessions you want, confirm the family control test is satisfied, and be certain about who must never receive a distribution while the election is in force. A discretionary trust structured and administered properly is a flexible and durable vehicle for a family business. The same trust with a sloppy deed and no thought given to the election is where the cost shows up, usually years later and usually in a dispute.