Fixed vs Discretionary Trusts

As I've noted in earlier posts (see here and here and here), there's some key differences between fixed and discretionary trusts.

These differences matter because so-called family trusts are usually organised as discretionary trusts (hence recent political moves to impose greater regulation on them). There is however, no reason why a person who wishes to utilise a trust in the family context couldn't setup a fixed trust instead, while deriving many of the benefits commonly provided by a discretionary trust structure.

Fixed Trusts

A trust is a legal obligation one person (a trustee) owes to another in respect of the management of property/wealth.

Imagine a trust fund, which consists of money and shares. You and one other person are the beneficiaries of that trust fund, so the trustee's job is to manage that wealth for your benefit and to pay you money out of the trust fund (according to the terms of the trust).

If the terms of the trust are written in such a way that you and the other beneficiary are each entitled to 50% of the trust fund, then you each have a fixed interest in the trust fund. This is a fixed trust.

This is still a fixed trust even if the terms of the trust only give you a 25% share, while the other beneficiary receives a 75% share. Both of your interests are still fixed according to the terms of the trust; they're just fixed at unequal amounts.

If you have a fixed interest in a trust, then you are also said to own that part of the trust, even though you don't control it: the trustee does but for you benefit.

Discretionary Trusts

A discretionary trust works similarly to a fixed trust, but with one key difference: neither you nor the other beneficiary has a fixed interest in the trust fund. This is due to the way the terms of the trust are drafted.

For example, in the fixed trust discussed above, your interest in the trust fund is fixed according to a percentage. In a discretionary trust however, the terms of the trust may state that the trustee has a discretion as to how much money you receive from the trust. As a result you may receive something, or you may receive nothing at all: the trustee can give 100% to the other beneficiary.

This means while you have an interest in the trust, you don't really own it in the same way you would a fixed interest in a fixed trust. That's because in the fixed trust, you have an absolute right to a specific part of the trust fund: you will receive it no matter what. In a discretionary trust though, you may never receive anything if the trustee doesn't exercise the discretion in your favour.

If you're seeking to minimise your tax burden, this is why discretionary trusts are preferred: they allow you to allocate income as needed between the various beneficiaries. That being said, you can achieve a similar result with a fixed trust.

Income splitting

The key to tax minimisation in the trust context is income splitting, which works by allowing a person (we'll call them the originator) to funnel income that would otherwise be taxed to him or her into the trust fund, and then allocate that income to the beneficiaries of the trust.

Effectively, the income of one person is split among a number of people (the beneficiaries of the trust). If those beneficiaries are in a lower income tax bracket than the originator (the person doing the funnelling), then obviously they won't pay as much tax on that income as the originator would have.

Income splitting works in the family context by allowing the income of those who earn the most to split it among the family unit, and allocate some of it to those who earn the least; thus taking advantage of those family members' lower income tax thresholds. The result is that the family, as a whole, is paying less tax on the same amount of money than it would have if that money was solely attributed to the originator.

Income splitting in fixed trusts

Income splitting is commonly thought to be a phenomenon of discretionary trusts, hence recent political moves to tax distributions made from them at a higher rate; but there's no reason why income splitting cannot be achieved in a fixed trust. After all, the only difference between a fixed trust and a discretionary trust is that in the fixed trust the amount of money you receive is fixed by the terms of the trust in advance; whereas in a discretionary trust it can be determined (and therefore, altered) by the trustee at any time. Income that is put into the trust fund however, is still split among a number of beneficiaries. The only difference in terms of income splitting then, is a discretionary trust is somewhat more flexible.

What is seemingly ignored by politicians and tax experts on this subject though, is that income splitting is still easily achievable in a fixed trust, and that it can be made to be almost as flexible as a discretionary trust.

The way this is achieved is by stating, in the terms of the trust, that the beneficiaries' interests may be altered at any time through amending the trust's terms. This is perfectly valid under trust law, and represents a means of altering the beneficiaries' interests (and therefore, income) in the trust to achieve a similar functional result as a discretionary trust.

So, don't like the present allocation of income? Simply change the trust's terms and, just like that, you have the benefits of the discretionary trust structure, but without the associated stigma and political attention.