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Trusts – Legal disability and trust distributions

There are three recognised forms of legal disability for the purposes of trust taxation: being a minor, being a bankrupt and being insane. Beneficiaries of all three forms of legal disability have special rules applicable to them if they become entitled to a trust distribution.

Present entitlement?

It is often in the interests of beneficiaries to ensure that they are the party being taxed on trust income, due to the penalty rate of tax that applies where the trustee is taxed instead. Normally beneficiary taxation will be ensured by making beneficiaries presently entitled to all the income of the trust.
Present entitlement” means that the beneficiary must have an indefeasible absolutely vested beneficial interest in the trust income, which is not contingent but whose payment may be demanded immediately by the beneficiary.
However, the trust provisions of the tax law recognise the possible situation where a person under a legal disability is presently entitled to the income of the trust.

Legal disability

If any beneficiary who is presently entitled to a portion of the income of a trust is a minor, a bankrupt or insane, then the trustee is the party liable to pay tax on that portion of the trust income.
This may seem indistinguishable from the situation where no beneficiary is presently entitled to that income. However, the situation is different, because:
  • the disabled beneficiary’s portion of the income is not aggregated with any other amounts, but is assessed separately in respect of each disabled beneficiary; and
  • the applicable rate of tax is the beneficiary’s rate, not the punitive rate.

Example: Disabled beneficiary

M is 17 years old. She is a beneficiary of her family trust, X Trust. In 2011/12, X Trust earns $200,000 in rental income. It wants to distribute the amount to its ten beneficiaries, aiming to income split between the family members.
X Trust splits $150,000 between the other 9 family members, who are not under legal disability. However, X Trust is not sure how to treat the remaining $50,000.
In this case, it would be wise for X Trust to make M presently entitled to the $50,000. Although X Trust’s trustee will be liable to income tax, it will be at M’s marginal rate, not at the punitive rate that would apply if nobody became presently entitled to the amount.

Conclusion

If you have concerns about trusts and legal disabilities, call LAC Lawyers and we can provide advice and assistance.

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