How family trusts are taxed, income splitting, CGT discounts and the traps

For a family business or an investment group, a discretionary family trust is one of the most popular structures in Australia for holding income-producing assets, and one of the most misunderstood. The headline appeal is tax flexibility: unlike a company, a trust does not pay tax on its income simply because the income was earned. Instead, the tax outcome is decided afresh each year, based on how the trustee distributes the trust's income among the family members who are entitled to it.

That flexibility is the source of both the main benefits and the main risks. Done well, a family trust lets a family flatten its overall tax bill by splitting income across lower brackets and by accessing the 50% capital gains tax (CGT) discount on assets held for more than 12 months. Done carelessly, distributions can be taxed at the top marginal rate in the trustee's hands, or attract penalty rates for children, or draw scrutiny from the Australian Taxation Office (ATO) under the anti-avoidance rules. This article walks through how the system actually operates: who the players are, what has to happen each year for the tax benefits to flow, where the traps sit, and when professional advice is worth engaging.

The cast: who does what in a family trust

A family trust is a discretionary trust. The trustee holds legal title to the assets, and has the discretion each year to decide which of the named beneficiaries receives what share of the income and capital. The key players are:

Settlor: The person who establishes the trust by giving it a nominal amount, often $10. Standard practice is for the settlor to step away afterwards and not be a beneficiary or trustee.
Trustee: The legal owner and manager of the trust's assets. A trustee can be an individual or a company, and owes fiduciary duties to the beneficiaries. The trustee decides how income is distributed each year.
Appointer: The person who holds the power to remove and appoint the trustee. This is effectively the control position in the structure, and is often held separately from the trustee role.
Beneficiaries: The people and entities named in the trust deed who may receive income or capital. A family trust deed usually covers a broad class: the person who set up the trust, their spouse, children, grandchildren, and often their companies and other trusts.
The ATO: The counterparty in the background. The rules for who pays tax on trust income sit in Division 6 of Part III of the Income Tax Assessment Act 1936 (Cth) (the ITAA 1936), and the ATO actively reviews how trusts distribute income.

The trust deed is the rulebook: it sets out who the beneficiaries are, what powers the trustee has, how distributions are decided, and when the trust must vest (commonly around 80 years, though this depends on the state and the deed). Because the trustee has a discretion, no beneficiary has a fixed right to income in any given year, which is what makes the structure tax-flexible, and also what makes it important that the paperwork is done properly.

How trust income is taxed: the annual flow

The trust itself is a taxpayer, but only in limited circumstances. The ordinary flow of a year looks like this:

The trust's net income for the year is worked out on tax principles, including any capital gains.
The trustee decides how that income will be distributed, usually by passing a resolution before the end of the income year on 30 June.
Beneficiaries who are presently entitled to a share of the income and are not under a legal disability are assessed on that share at their own marginal rates under s 97 of the ITAA 1936.
Where a beneficiary is a minor or otherwise under a legal disability, the trustee is assessed on that share under s 98 at the beneficiary's rates.
Income that no beneficiary is presently entitled to is taxed in the trustee's hands at a flat 45%, the rate fixed for s 99A of the ITAA 1936 by s 12(9) of the Income Tax Rates Act 1986 (Cth).

That last point is the one that surprises people. A trust does not escape tax by simply doing nothing. If the trustee does not distribute income by year end, or distributes it in a way the law does not recognise, the income is taxed in the trustee's hands at 45%, and the pass-through benefit is lost entirely.

"Present entitlement" also has to be real. A resolution on paper is not enough if the beneficiary never actually receives or controls the money in substance. Where the benefit of a distribution is redirected, the anti-avoidance rule in s 100A of the ITAA 1936 can deem the beneficiary never to have been presently entitled, with the income falling back into the trustee's hands at 45%.

The trustee's compliance duties are correspondingly serious: lodge an annual trust tax return, keep the records of each year's distribution decision, and provide each beneficiary with a distribution statement so they can report their share. None of this is optional, and the ATO can apply penalties and interest for failures, including the trustee beneficiary reporting rules that apply to closely held trusts.

Income splitting: the main benefit and its limits

The primary tax advantage of a family trust is the ability to split income among family members so that it is taxed at lower marginal rates overall. Where one high earner might pay tax on the top slice of a large trust distribution at 45%, the same income directed to several family members who are in lower brackets, or who have unused parts of their $18,200 tax-free threshold, produces a materially lower combined bill.

A simple example: a trust earns $200,000 in a year. Distributed entirely to one individual who is already in the top bracket, most of it is taxed at 45%. Distributed across a spouse and adult children with lower incomes, the same $200,000 can be taxed at much lower average rates. That spread, repeated year after year, is the core of the structure's value.

But income splitting has hard limits:

Minor beneficiaries: Distributions to children under 18 are generally taxed at penalty rates under Division 6AA of Part III of the ITAA 1936, with rates set in the Income Tax Rates Act 1986 (Cth). Broadly, the first $416 of a minor's unearned income is tax-free, the next slice is taxed at 66%, and anything above that at the top marginal rate of 45%. The main exception is income from a testamentary trust or a deceased estate, which under s 102AG of the ITAA 1936 is treated as excepted trust income and does not attract the penalty rates.
Reimbursement agreements: If income is distributed to a beneficiary in a low bracket but the benefit of that distribution flows back to the trust, the family company, or anyone else, s 100A can unwind the arrangement entirely. The ATO has made s 100A a compliance focus, and recent guidance emphasises that the beneficiary must actually receive and control the distribution.
General anti-avoidance: Part IVA of the ITAA 1936 gives the ATO a further power to cancel tax benefits from contrived arrangements, including artificial income-splitting schemes that have no commercial substance.

Splitting income genuinely among family members who are real beneficiaries, and who actually receive and deal with their distributions, is legitimate and common. The line is crossed when the split is a fiction. The ATO has published extensive guidance on the difference, and it is one of the most common areas where trusts get into trouble.

Capital gains: the 50% discount through the trust

When the trust sells a CGT asset that it has held for more than 12 months, such as an investment property, shares, or business assets, the gain can qualify for the 50% CGT discount that applies to individuals and trusts under Division 115 of the Income Tax Assessment Act 1997 (Cth) (the ITAA 1997). The 12-month holding requirement is in s 115-25, and the discount percentage for individuals and trusts is 50% for CGT events before 1 July 2027, after which legislated changes reduce it, so the rate applying to any planned disposal should be confirmed at the time.

The trust does not keep the benefit of the discount for itself. Under Subdivision 115-C of the ITAA 1997, the trust's net capital gain is treated as a capital gain made by each beneficiary who receives a share of it. That has two practical consequences. First, the beneficiary can apply their own capital losses against their share of the trust's gain before the discount is applied, which can eliminate tax on the gain entirely. Second, the trustee can direct the gain to the beneficiary best placed to absorb it, such as one with capital losses or a low income year.

Capital gains can also be streamed to specific beneficiaries rather than falling into the general income pool, but only if the trustee's determination is properly made in time. A gain that is only discovered after year end can be difficult to direct efficiently, which is a common trap when a sale completes late in June. Detailed records of acquisition dates and costs matter, because the 12-month rule, the discount percentage, and any small business CGT concessions a trading trust might access all turn on them.

The family trust election and the 47% penalty

A trust is not a "family trust" for tax purposes just because its name says so. Under Schedule 2F of the ITAA 1936, the trustee must actively make a family trust election (FTE), specifying an individual whose family group the trust will serve, and the trust must pass the family control test. The ATO explains that an FTE is voluntary, but once made it is difficult to vary or revoke.

Why would a trustee make one? An FTE gives the trust concessional treatment in several areas: it can use carried-forward trust losses more easily, it can access franking credits on share investments, it is excluded from the trustee beneficiary reporting rules, and it can use the small business restructure roll-over.

The price is a severe restriction. While an FTE is in force, any distribution or present entitlement conferred on someone outside the specified individual's family group attracts family trust distribution tax (FTDT) at the top marginal rate plus the Medicare levy, currently 47%, under s 271-15 of Schedule 2F of the ITAA 1936. The ATO has flagged FTDT as an active compliance area, particularly where trustees overlook the election's scope after a change in the family's circumstances, such as a marriage breakdown, an adult child's new partner, or a business co-owner's company being added as a beneficiary. Because an FTE can only be varied in limited circumstances and cannot simply be revoked, the decision to make one should be treated as long-term.

Losses, asset protection and other edges

Three other features of the structure are worth understanding before setting one up:

Losses stay in the trust: Unlike a company's losses, a trust's losses cannot be distributed to beneficiaries. They are carried forward inside the trust, and can only be offset against future trust income if the trust satisfies the trust loss tests, or if the trustee has made an FTE. A trust that makes losses for several years may find those losses trapped unless the tests are met.
Asset protection is real but not absolute: Because the trustee holds the assets separately from the personal assets of the beneficiaries, a beneficiary's bankruptcy or personal legal problems generally do not give creditors access to trust assets. That separation is one of the main reasons business owners use trusts. But protection has limits: transfers of assets into a trust can be set aside under bankruptcy and fraudulent-conveyance rules if they were made to defeat creditors, and if the trustee is also a beneficiary and becomes bankrupt, control of the trust can be disrupted. Asset protection should never be the sole reason for a structure, and it works best when the trust is established well before any financial difficulty appears.
Estate planning flows through: A broad beneficiary class means wealth can pass to the next generation according to the trustee's decisions, without the assets forming part of a deceased's personal estate. The trust deed and the appointment of an appointer do most of the work here, which is why both need to be reviewed as the family's circumstances change.

Where professional help pays for itself

None of this requires a lawyer to be involved every year, but there are four points in the life of a trust where the cost of getting it wrong far exceeds the cost of advice:

The annual distribution decision: The resolution that determines who is presently entitled to what must be made in time, must be within the trustee's powers under the deed, and must not create a s 100A problem. An accountant can compute the numbers; a lawyer checks the deed and the anti-avoidance exposure before the resolution is signed.
Before the trust is established: The choice of trustee (individual versus corporate), the drafting of the beneficiary class, who should be appointer, and whether an FTE is ever likely to be needed are decisions that are expensive to change later. Amending a deed can itself have tax consequences, including in some cases a deemed resettlement of the trust.
Before a major asset sale: Whether the 12-month rule is met, whether the gain can be streamed, whether small business CGT concessions apply, and which beneficiary should receive the gain are all decisions best made before the contract settles, not after.
When the family changes: Marriage breakdowns, new partners, children becoming adults, and disputes between siblings all raise questions about whether the current deed, the current trustee, and any FTE still fit the family. The ATO's current focus on FTDT means an election that no longer matches the family's reality is a liability rather than a benefit.

The two decisions that set your trust's tax bill

Everything in this article ultimately reduces to two decisions. The first is the annual resolution: made in time, documented, and reflecting a genuine distribution to real beneficiaries, it delivers the pass-through benefit that makes a family trust attractive. Missed or artificial, it produces a 45% tax bill in the trustee's hands and, in the worst cases, an ATO review. The second is the election: an FTE unlocks useful concessions but locks in a 47% penalty on any distribution outside the family group, and it is very hard to undo.

Both decisions are made before the end of the income year, and both are routine for advisers who work with family trusts. A conversation with a lawyer or tax adviser before 30 June, before a sale, or before an FTE is made, is a modest cost compared with the tax, penalties, and unwinding that follow a mistake. It is the kind of advice that pays for itself in the first distribution it protects.