Trusts tax crackdown: hard times ahead for family dog

A new ATO ruling and guidelines have just made family trusts a lot more complex for a whole lot of professionals.

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The Australian Taxation Office released a draft ruling and set of “practical compliance guidelines” on family trusts late last month that has accountants for professionals running for cover all over the country. 

The guidelines release was part of a broader release by the ATO which includes division 7A of the Income Tax Assessment Act. They are targeting distributions from family trusts to lower-taxed family members, where the beneficiary returns the distribution back to the trust or another family member.  

In other words, if your family trust is distributing to your kids, and the paperwork on that distribution and reasons aren’t clear, the ATO might come looking for any potential tax saving that the distribution generated. 

Trusts are typically associated with high-net-worth people, even though it is a common vehicle used by ordinary mums and dads who may have a small business or money they wish to protect. They are not of the ilk of a Bill Gates or Jeff Bezos. It is primarily used for asset protection and a safe way to create wealth and help family members in need.  

The ATO’s new s.100A and Div 7a rules (see detailed references below) after industry consultation are set to come into effect by 1 July. You do not have a lot of time and will need to discuss this with your accountant soon. 

The main points from the biggest ruling in decades that affects your family trust are summarised here:  

Take a typical doctor, Dr Good, with two adult children, a service trust that owns and runs a group practice. They have a family trust that has as beneficiaries Mum and Dad, two kids at uni, a “bucket company” corporate beneficiary, Ben the family dog, and a self-managed super fund. 

1. Remember, from 17 December 2022, to apply the new income splitting service trust or entity rules first, make sure you do not have high service fees. Factor paying an arms-length salary to the practice owner who bills fee for service for managing the practice. 

2. No more allocating $180,000 to adult children at uni but not paying it to them. In fact, maybe pay out all their uni fees with the allocation – an early inheritance. 

3. No more allocating money to your bucket company or any other entity, including Ben the dog, so you can pay a lower rate of tax. 

4. Service trusts that allocate but do not pay family trust profit distributions may require written Div 7a loan agreements to the bucket company, so expect compliance costs and documentation to increase. 

5. The rules remain murky in some parts. The ATO admits they are “not law but guidelines” and even they are not certain of what will unfold. Sounds a bit like the payroll tax rules. 

Where to from here? 

1. Document everything: Make sure you have a well-documented defence with your tax lawyer and accountant if you are planning to diverge from a ruling or seek a private ruling (be sure not to trigger a tax audit).  

2. Don’t distribute income to questionable entities that will face scrutiny and likely an audit, for example, to another trust or entity (a superfund, a foreign company, distant relatives or Ben). 

3. Run joint family bank accounts with your named beneficiaries. This is the only way a trust can distribute to spouses, or dependent adult children, or if a complying Division 7A loan agreement is in place (e.g. with a bucket company). 

4. The flow of payments matter: Just pay out before the end of any financial year any trust distribution with cash and avoid journal entries.  

1. Pay your kids out and give them an early inheritance. Remember, this will be hard to get back. 

2. It is not a good idea to get your kids to pay you back as soon as you have paid them their trust distribution. It may be called a “reimbursement” which they do not like. 

3. Stop taking money out or lending money from one bank account and transferring it to another that is not consistent with your business model, and legal and tax structure. Avoid a “circular flow of funds” (see para 15).  

5. Large loan repayments: These need to be handled carefully and are likely to cause a compliance problem, and you may not have enough money to pay your trust distributions. Make sure you have some good savings or standby loan facilities available. 

6. Expect your accountant to go into panic mode if they have been entering a lot of journal entries in relation to trust allocations on your books and not doing as set out above. There is retrospective application. The ATO are targeting arrangements usually implemented by using journal entries (which themselves are of no legal effect). 

At a minimum, look at doing the following: 

1. Ask your accountant in writing to review distribution patterns and journals in detail for the past two years for all of your entities. This is the first step to determine if any remedial action is required now. 
   
   This will be a big task, so expect a healthy bill. The new rules are long and complex.  

2. Revisit tax planning for the future. There maybe systemic issues. Serious sanctions can apply to your tax agent if you do not do the right thing. Do not expect any favours. No client is worth losing their livelihood over. The same principles apply in medicine.  

3. It should be a buy-once cry-once experience. However, budget for constant compliance changes as the rules keep being modified by regulators and Court decisions. It is the cost of doing business, like paying for your car to be serviced regularly.  

The bottom line: at least pay your kids their $180,000 trust distribution. Make sure it is not a book entry where you have no intention to pay. For example, pay their schools fees from a joint family account.  

One major conflict is how a major Federal Court ruling late last year on a number of the issues raised above did not stop the ATO from publishing what appears to be a conflicting guide.  

The case confirmed bucket companies are legitimate, and it is not tax avoidance. The main argument could be they are there for wealth creation and asset protection. The ATO is seeking to challenge this notion. 

For those who like the gory details of the case, I have made a brief reference below. 

Justice Logan of the Federal Court handed down his decision on the 21st December 2021 in Guardian AIT Pty Ltd ATF Australian Investment Trust v Commissioner of Taxation [2021] FCA 1619, in relation to section 100A and the Part IVA anti-avoidance provisions. This case concerned what has come to be described as a typical “washing machine” arrangement: that is, an arrangement where a trust makes a distribution of income to a corporate beneficiary, and the corporate beneficiary in sequence distributes a dividend back to the trust. The ATO is appealing this decision. 

It’s confusing. 

Normally, court decisions have precedence over tax rulings. I would not be surprised if some elements of this ruling are watered down. However, key parts will remain, such as proving you are making actual bank payments, with no funny side deals. The burden of proof is on you, however. 

Remember, the tax office is not the law. It simply administers it. Be prepared to clearly defend your position. It might prevent an expensive and time-consuming full-scale audit.  

Don’t panic 

You may feel you are flying off the seat of your pants, but do not panic.  

The bottom line: do not change your tax structures or arrangements without consulting your tax advisor first.  

This is not the end of family trusts. They are important for asset protection. You just need to administer them properly.  

As a footnote: For those of you who like doing your own tax returns or research, here are all the new rules you can read up on with heaps of examples. 

23rd Feb 2022, the Australian Taxation Office released their long-awaited draft guidance on section 100A and Division 7A of Part III of the ITAA 1936. 

The draft guidance materials consist of: 

TR 2022/D1 — Income tax: s 100A reimbursement agreements 

PCG 2022/D1 — Section 100A reimbursement agreements — ATO compliance approach 

TA 2022/1 — Parents benefitting from the trust entitlement of their children over 18 years of age 

TD 2022/D1 — Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of ‘financial accommodation’ 2021  

ATO Decision Impact Statement MJ and IT Holdings Pty Ltd and Commissioner of Taxation Commissioner of Taxation v Cassaniti [2018] FCAFC 212 

This is an edited version of an article David Dahm published on his own company’s blog HERE. 

David Dahm is CEO and founder of the national medical and healthcare chartered accounting firm Health and Life and global Founder and CEO of the not for profit project the International Healthcare Standards and Ethics Board (www.ihseb.org)