By Steve Burnham
While unearned income distributed by a trust to minor beneficiaries is generally taxed at punitive rates, this is not always the case, in particular where assets have devolved to the trustee as a result of death or disability. Taxpayers and advisers should therefore be vigilant to ensure that the opportunity to distribute income to minor beneficiaries and attract ordinary tax rates is not overlooked
Minor income generally
The income of children less than 18 years old on the last day of the income year is taxed differently from other Australian residents. The rules governing minors are contained in Division 6AA (ITAA36). The basis upon which minors are taxed is demonstrated in the diagram below.
For a person under the age of 18 on the last day of the income year, three questions are relevant in determining how their income will be taxed. The first is whether the person is an “excepted person” for the purposes of ITAA36 (see below). If the answer to this question is “yes” the income of the minor, including trust distributions, is taxed at normal rates and the low income tax offset is available.
Secondly, is the income “excepted income”? If so, it is taxed at normal rates, however other income will be taxed at the special rates for minors. Table 1 below sets out the persons who are classified as “excepted”. If a taxpayer is not an excepted person it will be necessary to consider whether particular income is excepted income (see Table 2). The third enquiry is whether income received is “excepted trust income”.
Trust income derived by minor
Where a beneficiary of a trust estate is a “prescribed person” (that is, not an excepted person), trust distributions may be “excepted trust income” in accordance with s102AG ITAA36 and taxed at normal marginal rates. Table 3 below indicates the circumstances in which income may be classified as excepted trust income.
Common scenarios that may result in the receipt of excepted trust income by a minor beneficiary include:
- income distributed from an estate that is not fully administered — may be important in situations where estate finalisation is delayed due to complexity or legal issues
- income distributed from a testamentary trust — should be considered in the estate planning phase
- income derived from assets gifted by an estate beneficiary within three years of the death of the deceased person — can achieve the same tax benefits as a testamentary trust.
WARNING Where parties are not dealing with each other at arm’s length in relation to the derivation, or in relation to the act or transaction, the excepted trust income is only so much of that income as would have been derived if they had been dealing with each other at arm’s length in relation to the derivation, or in relation to the act or transaction.
Example The Dimer family is made up of five members. Basil and Cleo Dimer are the parents of three children:
- Paul (aged six)
- Nick, (aged nine) and
- Rebecca (aged seven).
The assets owned by the couple are the marital home, three investment properties, and listed shares.
Cleo and Basil want to ensure their children are all provided for adequately. However they express concern that should they pass away in an untimely fashion they are unsure which of their children should inherit which asset, and that their dominant purpose in bequeathing a certain mix of their assets to their children should be based on their children’s needs. This assessment of needs should occur when Paul (the youngest child) reaches the age of 25.
Their professional advisers suggest that Cleo and Basil set up a testamentary trust. In the event of their untimely passing their assets would be transferred from the deceased estates into the testamentary trust in accordance with their wills.
A summary of the position which should ensue follows:
Under Division 128 Income Tax Assessment Act 1997
- Generally, the CGT assets of a resident deceased person are passed from the deceased person to their deceased estate tax-free.
- The CGT assets would then pass to a resident beneficiary (the testamentary trust) tax-free.
- The cost bases of the CGT assets will be those of the deceased if the assets were acquired post-CGT, or market value in the case of pre-CGT assets.
Under Division 6AA Income Tax Assessment Act 1936
- The property devolved to the testamentary trust for the benefit of the three children.
- Item 4 in Table 3 below should apply so that income distributed to, or applied for the benefit of, the minor children will be taxed at ordinary rates.
In the event that income from the investment was to pass to the three children while they were minors, a comparison of the tax liability under alternate scenarios is as follows. Assume annual net investment income of $120,000 derived equally by the children. The position of each would be:
(a) Via testamentary trust
Taxable income ………………….$40,000
Tax payable ……………………….$ 5,147
Net funds …………………………..$34,853
(b) Via, say, a family trust
Taxable income ………………….$40,000
Tax payable ……………………….$18,600
Net funds …………………………..$14,733
Note: The differences with the above totals are due to testamentary trusts retaining the tax-free threshold, whereas a family trust distributing to minors must account for income according to the rates for minors. Section 102AG provides that so much of trust income as is “in the opinion of the Commissioner” excepted trust income will be taxed at ordinary marginal rates. In the event of doubt as to whether income is properly categorised as excepted trust income, it would be prudent to obtain a tax ruling before implementing the arrangement.
Use of a testamentary trust also facilitates asset protection and enables Basil and Cleo to defer the passing of assets to their children to a time considered most appropriate given their individual circumstances.
Source: Tax & Super Australia