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Understanding the complex rules is critical for trustees as the ATO cracks down on tax minimisation.
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Insight: The ATO's recent activity with family trust elections
26 December 2024
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For anyone with a family trust, it is extremely important to understand the family trust election (FTE) rules, which broadly operate to ensure income, losses, and tax benefits are confined within the trust's designated family group. The rules are designed to limit misuse of family trusts to minimise or avoid tax and are currently a key focus area for the ATO.
Key features of the FTE rules
Family trust
A family trust is a discretionary trust that makes a valid FTE under the tax legislation. To qualify, the trust must identify a specified individual (the "test individual"), and all distributions must remain within the "family group" of the test individual as defined in the legislation.
Making the election
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An FTE is made by lodging the appropriate election form with the ATO.
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The election is irrevocable, meaning once made, it cannot be withdrawn or altered except in certain limited circumstances, typically only within four years of the year for which the election has been made.
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The election locks the trust into a specific family group determined with reference to the test individual, even after that person’s death.
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Elections can be made retrospectively to apply with effect from a prior year.
Family group definition
The family group includes the test individual, their spouse, children, various other family members (such as parents, grandparents, siblings, nephews, nieces, lineal descendants of the test individual), the spouse of any of these individuals and certain other related entities, such as companies and trusts controlled by family members.
An interposed entity election (IEE) can also be made to allow distributions to an entity outside the defined family group. The requirements for making an IEE are complex, and unintended consequences can arise so great care should be taken when considering an IEE – this is not a step to be taken lightly.
Advantages of making a FTE
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Losses or bad debt deductions can be carried forward without being subject to certain complex trust loss tests.
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Simplified compliance with franking credit rules when distributing income from investments, allowing franking credits to be passed through to trust beneficiaries in situations where that may not otherwise be possible.
Family trust distribution tax (FTDT)
If the trust distributes income to individuals or entities outside the family group, a penalty tax of 47 per cent applies to prevent leakage of concessional tax benefits.
Recent ATO activity
Increased compliance focus
The ATO is currently taking a greater interest in family trusts to ensure compliance with FTE rules. Non-compliance with the rules has been a recurring theme identified by the ATO in many of its recent reviews of high-net-wealth family groups. This is a key element of the ATO's broader concern regarding the use of trust structures for tax minimisation purposes. It is therefore important to take stock of existing structures and ensure that any potential issues with the FTE rules are identified and addressed where possible as a matter of priority.
Reviewing FTEs
The ATO, as part of its compliance activity, will review whether family trust elections are valid and properly documented. This includes ensuring that elections are made on time and that all requirements have been satisfied.
Distributions outside defined family groups
A key area of focus for the ATO will be identifying the nominated test individual and ensuring that there have been no distributions to non-family members, with a resulting liability for FTDT and potentially significant penalties.
Data matching
With the ever-increasing improvements in data analytics and information-sharing, the ATO is better placed to identify discrepancies between trust declarations and reported distributions and raise FTDT assessments.
Updated website guidance and webinars
While there are no recent ATO rulings in this area, in November 2024 the ATO updated its detailed website guidance and on 21 November 2024 held the first in a series of webinars aimed at educating taxpayers on the key requirements of the FTE rules and risk areas.
Common challenges and risks
Irrevocable elections
The permanence of family trust elections, with certain exceptions, can cause unintended long-term consequences. It is critical to carefully assess the circumstances of a trust and its beneficiaries before making an FTE.
Unintended distributions
Distributing to entities or individuals outside the family group, even inadvertently, can cause heavy tax liabilities. This can arise, for example, where distributions are made between multiple trusts in a group and the trusts do not all have the same nominated test individual.
Record-keeping requirements
Detailed records will be important to show the ATO that the trustees have complied with the FTE rules, which helps minimise penalties in an ATO review.
Distributions to related entities
Defining and managing distributions is more difficult, and carries more risk, when distributions are made to related entities as it is necessary to analyse the control of these entities to determine whether they fall within the family group.
Conclusion
The FTE rules help maximise the flexibility and tax benefits available when using family trusts although the rules are complex and the consequences of breaching the requirements can be significant.
Trustees should ensure accurate and timely elections, and proper documentation and carefully consider income and capital distributions each year to ensure the FTE rules are not breached. The ATO’s increased focus in this area and improved data-matching capabilities make awareness of and compliance with the rules more important than ever.
Peter Bembrick, tax partner, HLB Mann Judd Sydney
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