Unit Trusts vs Discretionary Trusts: Which Structure Is Right for Your Investment in Australia?

What is a Unit Trust?

A unit trust is a trust structure where trust assets are divided into defined shares called units. Each unit holder has a fixed interest or defined interest in the trust’s net asset value, income, and capital gains, based on the number of units they own. The unit trust deed outlines the rights and obligations of unit holders and the trustee, making the arrangement clear for all parties.

Key Features of Unit Trusts

Unit trusts have several distinctive characteristics:

• Fixed entitlements: Each unit holder has a clearly defined share of the trust assets, net income, and income distribution, proportional to their units.

• Transferability: Units can often be sold, making it easier for unit holders or new equity partners to enter or exit the investment.

• Clear ownership: The structure is transparent, with each unit holder’s interest in the underlying property, net asset, or net loss clearly set out in the unit trust deed.

• Asset protection: While not a separate legal entity, a unit trust can provide some asset protection advantages, depending on how the trust is structured.

Unit trusts are commonly used for pooled investments, such as mutual funds or property investment, where multiple investors or equity partners contribute capital and receive units in return.

How Unit Trusts Work in Australia

In Australia, a unit trust operates as an investment structure where the trustee manages all the property and trust income for the benefit of unit holders. Income and capital gains are distributed based on the number of units held. For example, if you own 100 out of 1,000 initial units, you’re entitled to 10% of the trust’s income and capital gains.

Unit trusts can be either fixed unit trusts or non fixed trusts. A fixed trust means unit holders have fixed entitlements to income and capital, which is important for land tax purposes and income tax assessment. For NSW land tax purposes, the Land Tax Management Act sets out specific rules for fixed trusts, and whether the trust is considered fixed can affect the tax free threshold and other land tax benefits.

Distributions from a unit trust are generally made according to Australian accounting principles, and the trust is required to report net income, capital or revenue losses, and capital gains tax obligations. Unit trusts may also provide access to foreign tax credits, small business concessions, and other tax advantages, depending on the circumstances.

What is a Discretionary Trust?

A discretionary trust, often called a family discretionary trust, is a trust where the trustee has discretion over distributing all the income and capital among beneficiaries. The beneficiaries do not have a fixed entitlement or defined shares in the trust assets; instead, the trustee decides how to allocate trust income and capital income each year.

This flexibility makes discretionary trusts popular for family trusts and asset protection in Australia.

Key Features of Discretionary Trusts

Discretionary trusts offer several advantages:

• Flexibility: The trustee can choose how to distribute income and capital gains among beneficiaries, which can help with tax planning and adapting to changing needs.

• Asset protection: Since beneficiaries have no fixed interest, trust assets are generally protected from creditors of individual beneficiaries.

• Tax benefits: The trustee can distribute income to beneficiaries in lower tax brackets, potentially reducing the overall income tax paid by the family group.

Discretionary trusts are often used for family businesses, property investment, and managing wealth across generations. The trust deed sets out the rules for the trustee’s discretion and the range of potential beneficiaries.

How Discretionary Trusts Work in Australia

In a discretionary trust, the trustee manages all the property and trust income, deciding each year how to distribute income and capital gains among beneficiaries. Beneficiaries have a potential interest, but no fixed entitlement, so the trustee’s decisions determine who receives distributions and how much.

For tax purposes, discretionary trusts are treated differently from fixed trusts. The trustee’s discretion can provide tax advantages, but it also means the trust is not considered a fixed trust for certain land tax and income tax assessment act requirements. This can affect eligibility for the tax free threshold and other concessions.

Comparing Unit Trusts and Discretionary Trusts

When deciding between these trust structures, it’s important to understand their differences in ownership, control, tax benefits, and asset protection.

Ownership and Control

Unit trusts give unit holders a fixed legal or equitable interest in the trust assets. The trustee, which may be a trustee company, acts according to the unit trust deed and the interests of the unit holders. This structure is suitable when multiple investors or equity partners want a clear, defined interest in the investment.

Discretionary trusts, on the other hand, give the trustee full discretion over income distribution and capital gains. Beneficiaries do not have a fixed entitlement, and the trust deed outlines the trustee’s powers and responsibilities.

Distribution of Income and Capital

In a unit trust, income and capital gains are distributed to unit holders based on their fixed entitlements. This makes predicting trust income and capital income straightforward, which is useful for investment structures involving unrelated parties or new units issued to new equity partners.

Discretionary trusts allow the trustee to decide how to distribute all the income and capital each year. This flexibility can provide tax benefits by distributing income to beneficiaries with lower income tax rates, but it also means beneficiaries have no fixed entitlement.

Flexibility and Asset Protection

Discretionary trusts generally offer more flexibility and asset protection advantages. The trustee’s discretion can help protect trust assets from creditors, as beneficiaries do not have a defined interest in the trust.

Unit trusts provide less flexibility, as unit holders have fixed interests and entitlements. However, the transparency and certainty of a fixed unit trust can be beneficial for unrelated investors or pooled investments.

Tax Implications

Tax treatment is a key consideration:

• Unit trusts: Income and capital gains are attributed to unit holders based on their fixed entitlements for income tax purposes. This provides certainty but less opportunity for tax planning.

• Discretionary trusts: The trustee can distribute income and capital gains to beneficiaries in a tax-efficient way, potentially reducing the overall tax burden. However, such a trust may not qualify as a fixed trust for land tax or income tax assessment act purposes, which can affect eligibility for certain concessions.

Both trust structures must comply with income tax obligations, including reporting net income, capital or revenue losses, and capital gains tax. Stamp duty may apply when selling units or transferring interests in the trust.

Which Trust Structure Is Right for Your Investment?

The best choice depends on your investment goals, tax purposes, and need for asset protection.

When to Choose a Unit Trust

A unit trust structure is often suitable when you’re investing with unrelated parties or multiple investors who want fixed entitlements and clear ownership. This approach is also ideal if you need a transparent structure for property investment, mutual funds, or pooled investments, where each party’s interest is well defined. Another advantage of a unit trust is the flexibility to transfer units, bring in new equity partners, or sell units at market value, making it easier to adapt to changing circumstances. In addition, a fixed unit trust can provide certain land tax benefits for NSW land tax purposes, provided it meets the requirements set out in the Land Tax Management Act.

When to Choose a Discretionary Trust

A discretionary trust may be the better option if you are managing a family business or family trusts and want the flexibility to distribute income and capital gains as circumstances change. This structure is particularly helpful when asset protection is a priority, as discretionary trusts can help shield trust assets from creditors. Additionally, discretionary trusts offer the opportunity to take advantage of tax benefits by distributing income to beneficiaries in lower tax brackets. These trusts are commonly used for family discretionary trusts, especially where the underlying property is expected to generate significant income or capital gains.

Setting Up a Trust in Australia

Establishing a trust involves several important steps, whether you choose a unit trust or discretionary trust.

Key Steps to Establish a Trust

To set up a trust, you’ll typically start by deciding on the trust structure that fits your needs. It’s important to consider whether a fixed trust or non fixed trust is appropriate for your investment goals and circumstances. Once you’ve made this decision, you’ll need to have a trust deed or unit trust deed prepared by a professional to ensure all legal requirements are met and your intentions are clearly documented.

Next, you’ll appoint a trustee, which can be either an individual or a trustee company, depending on your preferences and the level of control or asset protection you require. After appointing the trustee, you’ll obtain an ABN and TFN for the trust, which are necessary for tax purposes and compliance with the Australian Taxation Office.

With these details in place, you’ll open a dedicated bank account for the trust to keep all financial transactions separate and transparent. If your trust’s activities require it, you may also need to register for GST. It’s also essential to consider land tax and stamp duty implications, especially if your trust will be used for property investment. Seeking professional advice at this stage can help ensure the trust is set up correctly and all tax obligations are addressed from the outset.

Compliance Considerations

Ongoing compliance is a key part of managing a trust. You’ll need to keep proper records in line with Australian accounting principles, which helps ensure transparency and makes annual reporting straightforward. Each year, you’ll prepare financial statements and tax returns for the trust, reporting net income, capital gains, and any capital or revenue losses.

If you have a discretionary trust, it’s worth considering whether to make a family trust election for tax purposes, as this can affect eligibility for certain tax concessions and benefits. Regularly reviewing your trust’s compliance obligations with a professional can help you stay on top of requirements and avoid any surprises.

Conclusion

Both unit trusts and discretionary trusts offer potential benefits for Australian investors, but the right choice depends on your specific circumstances, investment structure, and goals for asset protection, tax advantages, and income distribution. Unit trusts provide fixed entitlements and transparency, making them ideal for unrelated investors or pooled investments. Discretionary trusts offer flexibility and tax benefits, especially for family trusts and asset protection.

Before making a decision, we recommend seeking professional advice from our team. We’re here to help you understand the tax benefits, asset protection advantages, and compliance requirements for each trust structure, so you can choose the option that best supports your financial future.