Tax traps flagged with restructuring of trusts

A family trust election enables entities to access certain tax concessions. However, family trust distribution tax will be imposed when distributions are made outside the family group.

“If the entity has made a family trust election, then we need to transfer at market value, or otherwise the transferee has to be part of the family group of the test individual,” Ms Tapiolas explained.

“We’ve had situations where a mum and dad trust owns shares in a company and we want to transfer 50 per cent of the shares over to their child’s trust. [In that situation], the first trust will need to make make a family trust election in order to pass on the franking credits. With the second trust, which is the son’s trust, we won’t want to make a family trust election in relation to, say, the dad, because they want that flexibility about where they can distribute to.

“You might think it’s not a problem to transfer it across at less than market value because the market substitution rule applies to the capital gain and we can use a small business CGT concession to get rid of the gain. [However], you’ve still got family trust distribution tax to think about.”

Ms Tapiolas said mum and dad might need to give that trust some money so that the trust can then pay market value for those shares.

“We can then transfer out of mum and dad, but we definitely need that transfer happening at market value; otherwise, we’ve got family trust distribution tax issues. So be really careful,” she warned.

“Something as innocent as that can cause a whole heap of tax issues.”

Where there are shares being transferred, Ms Tapiolas said it is also important to check to see whether the company has made an interposed entity election.

“If that is the case and the new shareholder is not in the family group of the relevant test individual, there will be family trust distribution tax on every dividend paid out of the company,” she cautioned.

She explained that most share sales agreements have a warranty about the fact that the company has not made an interposed entity election.

“As part of your due diligence, you need to make sure that the [company] hasn’t made an interposed entity election. The problem with the warranty is that if your client is the one that has bought these shares and has been paying all these dividends out, it’s the company who is now liable, which is now your client, and your client was the director that actually paid the dividends out. So, they’ll be the ones that are jointly and severally liable,” she warned.

“The problem with that is that warranty or indemnity is only as good as the ability of the person that we’re trying to make that claim against to pay us. So, you need to do that check.”