How a discretionary trust works, a worked example for Australian business owners

A discretionary trust is one of the most common ways Australian small businesses are structured, and for good reason: it gives the people running the business flexibility to decide, year by year, who receives the profits. But that flexibility only exists if the machinery behind it works. The trust deed has to be right, the trustee has to act properly, and the annual decisions about who gets what have to be made and recorded in time. When those pieces line up, a discretionary trust can be a useful vehicle for a family business. When they do not, the outcomes can be expensive and hard to unwind.

This guide walks through how a discretionary trust actually operates: the people involved and what each one does, how a business runs through a trust, what happens to each year's profit, the traps that catch owners out, and where professional help is genuinely needed. It is general information only, not tax advice. Trust tax outcomes depend on your deed, your circumstances and the way decisions are made, so treat the example below as an illustration, not a plan.

The moving parts of a discretionary trust

A trust is an obligation to hold property for the benefit of others. The ATO describes it as a relationship, not a separate legal entity, although a trust is treated as a taxpayer in its own right for tax administration purposes (ATO, Trusts, trustees and beneficiaries). Because the trust itself cannot sign anything or hold anything in its own name, the roles matter:

Trustee: the legal owner of the trust's assets and the party that deals with the outside world. Under trust law, a trustee is personally liable for the debts of the trust, but is entitled to be indemnified out of trust property for liabilities incurred in the proper exercise of its powers.
Appointor: the person or persons given power under the deed to remove and replace the trustee. In a discretionary trust the appointor is effectively the ultimate control lever, even if they play no other part in the business.
Beneficiaries: the people or entities who may receive income or capital from the trust. In a discretionary trust no beneficiary has a fixed entitlement; each is simply eligible to be considered when the trustee exercises its discretion.
Settlor: the person who establishes the trust and settles the initial sum of money, often a nominal amount. The settlor usually has no ongoing role or rights.
Trust deed: the document that sets the rules, including who can benefit, who holds power, what the trustee may do, and when the trust ends.

The trustee may be an individual or a company. Many business owners choose a company as trustee so that the same people can manage the business as directors, and so the trustee's identity does not change every time an individual's circumstances change.

Setting the trust up: the deed decides almost everything

A discretionary trust is created by a trust deed, under which the settlor settles a sum of money or an asset on the trustee to hold on the terms of the deed. From that point the deed is the rulebook for the life of the trust. It fixes the class of beneficiaries, the powers of the trustee (including powers to distribute income and capital, invest, borrow and carry on a business), the identity of the appointor, and the vesting date on which the trust must wind up and distribute its assets.

Small drafting differences in the deed produce big practical differences later. A deed that gives the trustee a broad power to distribute to "such of the beneficiaries as the trustee determines" behaves differently from one that requires the trustee to follow a set order or that restricts distributions to a narrow class. The vesting date matters too: many older deeds vest on a date tied to the life of a person, and a trust that has technically vested can no longer be administered as a discretionary trust in the same way. The provisions dealing with the appointor are equally important, because they determine who can remove the trustee and what happens if the appointor dies or loses capacity. These are the clauses a lawyer should review before you sign, not after a dispute starts.

Running a business through a trust: who signs what

Because a trust is not a separate legal person, everything the business does happens through the trustee. The trustee signs the lease, enters the supplier agreements, employs the staff, opens the bank accounts and is the party named in the business's customer terms. For that reason the trustee's name should appear in full on contracts, usually in a form like "Moretti Services Pty Ltd as trustee for the Moretti Family Trust", so there is no doubt about who is responsible if a dispute arises.

The flip side of the trustee being "on the hook" is that the trustee is personally liable for the trust's debts, subject to its right of indemnity out of trust assets. That is why the corporate trustee is so common: a company can act as trustee in perpetuity, and the individuals behind it generally are not personally liable for the company's debts. That protection is not absolute. Directors of a corporate trustee remain subject to their statutory duties, including the duty to prevent the company trading while insolvent, and a trustee that acts outside the deed, or in breach of trust, can lose the benefit of its indemnity.

A further point owners often miss is that choosing a trust structure does not change the compliance obligations that apply to the business itself. If the trust operates a business that sells to consumers, the Australian Consumer Law (the ACL), which sits in Schedule 2 of the Competition and Consumer Act 2010 (Cth), applies to that business in the same way it applies to any other trader. Section 18 of the ACL provides that a person must not, in trade or commerce, engage in conduct that is misleading or deceptive, and the consumer guarantees in the ACL apply to goods and services supplied to consumers regardless of the entity behind the sale. Similarly, if the business collects personal information, the Privacy Act 1988 (Cth) may apply to how that information is handled, and if the trustee employs staff, the Fair Work system applies to that employment relationship no matter what structure sits above it. A trust changes ownership and profit distribution; it does not change the rules that protect customers, data subjects or employees.

The annual distribution cycle: where the flexibility shows up

The defining feature of a discretionary trust is what happens to each year's profit. The cycle runs in stages, and each stage has a consequence:

Net income: at the end of the financial year the trustee works out the trust's net income. The ATO explains that the net income of a trust, effectively its taxable income, is its assessable income for the year less allowable deductions, calculated on the assumption that the trustee is a resident. This is a tax law concept, and it can differ from the "income" of the trust as defined in the deed (ATO, Trust income). That gap between deed income and net income is one of the reasons trust distributions are not as simple as splitting the bank balance.
The distribution decision: who gets what is decided by a resolution made under the deed, and it should be documented in the minutes or in a signed trustee resolution. The ATO's guidance for trustees is that a beneficiary generally needs to be "presently entitled" to income by the end of the income year, meaning they have a present right to demand payment, and in practice the resolution should be made by 30 June.
The tax outcome follows the entitlement: beneficiaries are assessed on their share of the trust's net income based on the share of trust income to which they are presently entitled, regardless of whether the money has actually been paid to them. An adult beneficiary pays tax on that share at their own marginal rates. This is the proportionate approach, and it is what makes a discretionary trust useful for income splitting across a family.

A worked example: the Moretti Family Trust

The Moretti family runs a commercial cleaning business through the Moretti Family Trust, with Moretti Services Pty Ltd as trustee. In a good year the trust has net income of $240,000. At the end of the year the trustee resolves to distribute $110,000 to Rosa, who works in the business full time, $95,000 to her husband Marco, who manages operations part time, and $35,000 to their adult daughter Elena, who is studying and helps with the books. Each of them is presently entitled to their share and is assessed on it at their own marginal rates. The trust itself pays no tax on that income, and it does not matter that the money stays in the business bank account until the family decides to draw it down.

Contrast that with what happens if the resolution is missed. If the trustee makes no effective resolution by 30 June, no beneficiary is presently entitled to the income, and under s 99A of the Income Tax Assessment Act 1936 (Cth) the trustee is assessed on the undistributed net income at the top marginal rate that applies to individuals (s 99A, ITAA 1936). On $240,000 that produces a tax bill the family almost certainly did not plan for, and it is a reminder that the "flexibility" of a discretionary trust is really a deadline: the trustee's discretion must be exercised, and exercised in time.

The example also shows where the limits sit. Distributions to children under 18 are generally taxed at higher rates, so the trustee would not usually distribute the cleaning business's income to a minor child. And if the trust's profit had included a capital gain or franked dividends, the outcome would have been more complex still.

Streaming, losses and other complications

Two features of the distribution rules matter for owners planning ahead:

Streaming capital gains and franked dividends: if the deed allows, these amounts can be streamed to particular beneficiaries by making them "specifically entitled" to those amounts (ATO, Streaming trust capital gains and franked distributions). That allows a beneficiary to apply their own capital losses against a streamed gain, to use the capital gains tax discount, and to get the benefit of franking credits attached to a streamed dividend. Amounts that are not streamed are allocated proportionately to beneficiaries based on their present entitlements.
Trust losses: a loss made by a trust in an income year cannot be distributed to beneficiaries to offset their other income. It stays in the trust and can be carried forward to reduce the trust's net income in a later year (ATO, Trust income). A business owner who expects a loss year to shelter their personal income through the trust will be disappointed; that is simply not how the rules work.

Where it goes wrong: the traps that cost owners money

The most common problems with discretionary trusts are not exotic. They are failures of decision-making, documentation and control:

Missed or defective resolutions: The 30 June resolution is the single most consequential decision a trustee makes each year. If it is missing, late, inconsistent with the deed, or poorly recorded, the income can end up taxed in the trustee's hands at the top marginal rate under s 99A, or become the subject of a dispute between family members about what was actually decided.
Reimbursement agreements: Section 100A of the Income Tax Assessment Act 1936 (Cth) is an anti-avoidance rule that can apply where a beneficiary's entitlement to trust income arises under a reimbursement agreement, for example an arrangement where income is distributed to a low-rate beneficiary but the economic benefit is routed back to the trustee or another person (ATO, Reimbursement agreements and section 100A). Where it applies, the trustee can be assessed on the income at the top marginal rate, and the ATO's guidance in this area has made it a live compliance concern for trusts that use circular arrangements.
Loans and Division 7A: Money moving between a trust and the people behind it is a frequent source of unintended tax. If the structure involves a private company, for example a corporate trustee, loans or payments from the company to its shareholders or their associates can be treated as dividends under Division 7A of the Income Tax Assessment Act 1936 (Cth) unless they are repaid or documented as complying loan agreements (ss 109C-109D, ITAA 1936). Unpaid present entitlements between a trust and a company carry their own rules. The lesson is to document and repay inter-entity loans on commercial terms, with advice, rather than treating the trust's bank account as a personal account.
Appointor gaps: If the deed does not say what happens when the appointor dies or loses capacity, the family can find itself unable to change trustee at the very moment it needs to, and disputes over control can paralyse the business. Succession for the appointor role should be planned when the trust is set up, not after a death.
Compliance that follows the business, not the structure: As noted above, operating through a trust does not remove consumer law, privacy or employment obligations. On privacy specifically, the Privacy Act 1988 (Cth) generally does not apply to small business operators, which the Act defines by reference to an annual turnover of $3,000,000 or less in the previous financial year, and it expressly recognises that a trust can be a small business operator (s 6D, Privacy Act 1988). But the exemption has exceptions, for example where the business trades in personal information, so a trust-based business that collects customer data should check its position rather than assume it is exempt.

When professional help is genuinely needed

A discretionary trust is not a set-and-forget document. There are three points in the life of a trust where professional input is close to essential.

At establishment, a lawyer should draft or review the trust deed, including the appointor provisions, the vesting date and the powers the trustee needs for the actual business, and an accountant should advise on the tax settings, including whether a family trust election makes sense for the beneficiary class. At the end of each financial year, the distribution plan should be worked through with a tax adviser before the resolution is made: the interplay of net income, streaming, minor beneficiaries and s 100A risk is precisely where owners save or lose real money. And when the structure changes, whether that is bringing in a partner, selling an asset, lending between entities or planning succession, both disciplines should be involved before documents are signed, not after the ATO or a lender raises a problem.

A lawyer's role in this area is often misunderstood. The value is not in producing boilerplate; it is in checking that the deed, the corporate trustee's constitution, the commercial contracts and the compliance documents all match how the business actually operates, and in making sure the control arrangements survive the people who set them up.

The 30 June resolution: where flexibility becomes a tax outcome

Across all of this, the point where a discretionary trust's flexibility becomes real, or evaporates, is the trustee's annual resolution. Make it properly, on time, within the deed and with advice, and the trust delivers the income-splitting outcome the family planned for. Miss it, document it badly, or structure the year's arrangements around a reimbursement agreement, and the same profit is taxed at the top marginal rate in the trustee's hands, with the family's planning undone by a missing signature or a missed date.

If you are setting up a trust, changing how an existing one operates, or simply unsure whether your resolutions and inter-entity loans have been handled correctly, a conversation with a lawyer before 30 June is far cheaper than unwinding a s 99A assessment or a Division 7A dividend later. A consultation to review the deed and the decision-making process is a modest cost compared with the tax outcomes it protects against, and it will tell you quickly whether your structure, and your paperwork, are actually doing what you think they are.