What are trusts, how do they reduce tax, and what is Labor rumoured to change?

Rumour has it that the Labor Government might close a huge tax loophole that rich people have been using for years to avoid paying tax.

Apparently, they will create a minimum tax rate of 30% for trusts.

Don’t know what a trust is? Don’t worry, you’re not alone.

They’re a way of holding assets that allow the owners to pay less tax.

Assets are just things that can make money. So, the trust could hold a business, shares, or an investment property. Anything of value that is expected to make the owner money. These income earning assets are put into the trust, and then the trust owns them.

They have become increasingly popular in recent years. My colleague, David Richardson, estimates that a fifth of all income runs through a trust. That’s not a sign that lots of people use trusts, but rather, how much money is in them.

The most popular type of trust is called a discretionary or family trust.

There are two types of people involved with a trust. A trustee, who oversees the trust and its beneficiaries (the people who can be paid money from the trust).

In a discretionary trust, the trustee decides how much income is paid out of the trust and which beneficiaries get paid and how much they get paid.

So, how are trusts used to avoid tax?

Through what’s called ‘income splitting’.

Imagine someone sets up a trust and becomes the trustee. They also make their partner and two adult children, trust beneficiaries.

This person has set up the trust because they work as a consultant; they do work for various clients and get paid for that work. They set up a business for this consultancy and then put that business into the trust. This means the trust is earning the income from the consulting, and the trustee can decide who gets paid and how much each person gets from that consulting income.

The trustee can split the income up to four ways (themselves, their partner, and two adult children).

By doing it this way, any income from the business can be split up to four ways in any manner the trustee decides. This means less tax will be paid than if just the trustee, for example, were paid all the income.

How will the rumoured changes impact income splitting?

The rumour is that the government will make some changes to try and reduce this tax minimisation. We don’t know exactly what they are planning to do but it has been hinted that they will create a minimum tax rate of 30% on all payouts from trusts.

This would dramatically reduce the benefit from income splitting and is likely to raise billions of dollars from the richest Australians.

Why is the government acting now?

The government is acting because the number of trusts has been rapidly growing.

Over 27 years, the number of trusts has more than doubled and the number of discretionary trusts has increased one and half times. Over that same period, the population has only increased by 50%.

This means that discretionary trusts are increasing three times faster than the population.

There is one group where trusts have been very popular. Those on very high incomes. People who earn more than $1 million per year.

Most people earn most of their income from wages. There are some exceptions to this. Retired people, for example, earn most of their income from superannuation and the age pension.

But for most of us, wages are the biggest source of income. In fact, for people who earn between $90,000 and $100,000 per year, which is about the average full-time wage, they get 88% of their total income from wages.

But people earning more than $1 million per year earn their income in a very different way.

As the graph below shows, in 2011-12, people earning more than $1 million a year earned just 20% of their income from wages. Dividends accounted for 17%, capital gains 14%, and partnerships and trusts (P&T) were just 12%.

But fast forward to 2022-23 (the latest year we have tax data for), and things have changed.

Wages dropped to 18%, and dividends had fallen to 13%. Capital gains and almost doubled to 26%, and partnerships and trusts had doubled to 24%.

The reason is straightforward. Capital gains and trusts are great ways of reducing the amount of tax that rich people pay. The capital gains tax discount means you only pay tax on half the capital gain and trusts allow for all sorts of tax-reducing options.

In this budget, we might see the government crack down on both of these tax-avoiding methods used by super high-income earners.

Everyone should pay their fair share, and it is good news if the government has decided to start closing these tax loopholes.