What a trust is not
To many taxpayers a Trust is some airy fairy tax dodge used by the wealthy to ensure that they pay very little tax or none at all. Many people are vague about trusts and some even have the mistaken idea that trusts are illegal or have been banned by the Tax Department.
Trusts are very much alive and well and still regularly used to protect both taxpayers and their families from creditors and the IRD. The creation of a trust, therefore, is not solely a tax saving device.
It used to be what some people call the “I’ll earn it and the kids get it” type of structure. Trusts have changed however and this is no longer always the case.
What is a trust?
A trust is a type of legal entity that can own and hold title to property held for the benefit of one or more persons. It is a legal relationship, which is created when a person (known as a settlor) places assets in the control of another person (trustee) and these assets are intended to benefit other people (beneficiaries) or they are for a specified purpose.
- The person who creates a trust is known as the trust creator, grantor or settlor.
- The person who administers the trust and holds its properties is called a trustee.
- The people who are intended to benefit from the trust are known as beneficiaries.
Even though the assets, which are transferred to the trust through the trustees, become the property of the trustees, the fact is they only hold those assets on trust for the benefit of others (the beneficiaries). The trustees are the temporary owners of the property and they have to deal with it as set out in the trust.
Definition of a trust
The most commonly used definition of a trust is;
“A trust is an equitable obligation that binds a person called a trustee to deal with property over which he/she has control (called a trust property) for the benefit of other people (beneficiaries) and of whom he himself may be one and may also benefit anyone else who may enforce the obligation”.
It is not an accepted as a legal entity like a company so action can be brought against it for liabilities which have no limitation under law.
Requirements of a trust
The requirements of a Valid Trust are that there must be property capable of being the subject for of the Trust; and a Trustee who has control of the Trust property and who is under a clearly defined obligation to deal with it for the benefit of beneficiaries.
A trust must have the following essential elements:
- A settlor. (The person who creates the trust).
- The assets. (Consists of property, money or similar, which is put into the trust)
- A trust deed. (The trust agreement or documentation formalising the trust and setting out various information)
- Trustees. (The person or people in charge of running the trust).
- Beneficiaries. (The people or organisation who receive the benefit from the trust)
The law states that the settlor must have the intention of creating a trust in order for it to be valid. This means that a valid trust can’t come into being simply by accident.
Main reasons for forming a trust
Some of the reasons for forming a trust include the following:
- Estate Planning.
Although there is no longer estate duty or wealth tax, it is still sensible to arrange proper estate planning using a trust.
- Protection from Creditors.
By having assets (that you or your business owns) safely secured in a trust, any potential loss of those assets to creditors (if the business runs into trouble) is averted. A trust is used to protect assets against claims resulting from business debts or other liabilities. This protection or exposure to potential liabilities is a big advantage with trusts.
- Tax Savings.
If the trust is properly administered, then the correct allocation of income belonging to the trust, beneficiaries and others will result in taxation savings. This tax advantage is another reason why trusts are used.
- Claims by Family Members etc.
If you transfer your assets into a family trust while you are alive then those assets will not be subject to any claims after your death from family members or others that you don’t wish to benefit with your assets.
- Matrimonial or Relationship Property.
You can use a trust to prevent your assets being classified as relationship property (used to be called matrimonial). This means your spouse would be prevented from claiming a share of your assets if it became necessary to divide this relationship property up. It can also be used to secure assets from other relationships such as defacto or similar. It can help you prevent your assets going to parties that you do not want to benefit.
- Asset Testing in Retirement.
Another important advantage of a trust is when your assets are asset tested for various benefits and subsidies. If the assets are held in your name they will not be exempt from inclusion in the assessment for rest home subsidies etc. If they are held by the trust they are excluded – because they do not belong to you personally. The trust has to be set up correctly, of course, because it can be challenged if its sole purpose is to deprive you of income and assets, simply to allow you to qualify for a subsidy or other benefit.
Advantages and disadvantages of trusts
Advantages of trusts
A family trust can:
- Save Income Tax by its unique income splitting ability
- Provide a good defence for your family against creditors
- Provide a protection for your family against outsiders getting their hands on family assets
- Protect you against legislation which endeavours to rewrite your will after you die and that distributes your estate if you die without a will or a complete will
- Avoid the problems of probate
- Allow you to manage your family assets as you think fit
- Provides secrecy because they are not a matter of public record
- Saves Administration costs
- It can, if properly drafted, be unwound more easily than other business devices.
Disadvantages of trusts
- You may still pay some tax
- Provisions relating to minor beneficiaries require careful management as special rules apply now as to age etc.
- The need for expert drafting. Without this, advantages “a” to “j” will not arise. This is not an area for the home handy person or the over enthusiastic legal novice.
- Expense in setting up: It may cost a considerable amount ($1000 and up) to set up a trust. This is once only cost.
Trustee income is all the income derived by a trustee other than the income that has been distributed to beneficiaries. The income distributed is beneficiary’s income. Complying trusts are taxed at 33%. Foreign sourced income derived by a trustee is liable to New Zealand tax.
How family trusts are treated for NZ tax
Trusts are not separate entities for income tax purposes in this country. There are no rules in the Income Tax Act governing the residence of trusts. Tax obligations of family trusts depend on how the trust is classified under New Zealand law. Tax treatment of the trust depends on where the settlor (or the originator) of the trust is resident.
Types of NZ trusts
New Zealand has 3 types of trusts:
- Complying trust – a standard New Zealand resident trust with New Zealand resident trustees and a New Zealand resident settlor.
- Non-complying trust – a trust that was a foreign trust but the settlor has become a New Zealand tax resident.
- Foreign trust – a trust where the settlor is a non-resident at the time a distribution is made. As a trust does not have a legal personality, there is no concept of residency for trusts. However, a trust is recognised as a New Zealand taxpayer and therefore New Zealand generally verifies the residency of the trustee.
Tax obligations for your trust
Your Trust’s tax obligations are:
- If a complying trust, file tax returns and pay tax on the Trust’s worldwide income (i.e. all income whether it is derived in New Zealand or overseas) less any distributions of income made to its beneficiaries
- If a non-complying or foreign trust with trustees who are NZ residents, the trust is taxable on income earned in NZ. A foreign trust has extra disclosures to make
- If it is a non-complying trust with non-New Zealand resident trustees, the settlor of the trust is liable to pay income tax on the trust’s worldwide income being the an agent for the trust.
If you have an offshore trust, it is treated as a “foreign trust” until you become a New Zealand tax resident. Once you’re a New Zealand resident, the trust will be treated as a “non-complying trust” that within 12 months can elect to be a complying trust.
Beneficiary income you receive from a trust
Your tax obligation depends on the type of trust that pays you the distribution.
- A complying trust – You’ll file your tax return and pay tax on beneficiary income received from a complying trust in the normal way. No tax is payable if distribution is accumulated income of the trust.
- A non-complying trust – You are liable for tax at a 45% rate for distributions from a non-complying trust.
- A foreign trust – No tax is due by you if (a) It is a distribution of capital gains, or (b) The payment is made out of the corpus/capital of the trust.
The exemption for capital gains does not apply to the gains the foreign trust derives from transactions between associated persons. All other distributions are taxable.
How a trust or estate starts
To create a trust, a person (the settlor) gives money or property to another person (the trustee), to be held in trust for the benefit of either the trust’s beneficiaries, or a purpose recognised by law. There should be a signed trust deed (agreement) that acknowledges the settlement, but it is possible to establish a trust verbally.
The trustee holds the trust’s property in trust for the beneficiary, and administers or manages the trust. A trustee includes an executor or administrator of an estate, which may be the Public Trustee or the Maori Trustee. Companies may also act as trustees.
A settlor of the trust is any person who directly or indirectly does any of these things, or who has done so in the past:
- disposes of any property to the trust for less than its market value
- makes property or funds available to the trust (or for its benefit) for less than market value
- provides services to the trust for less than market value
- acquires any property or service from the trust for greater than market value
Trusts may also be settled by companies.
Determining who is a settlor of a trust and whether they are a resident is important for establishing whether the trust’s overseas income is taxable in New Zealand. These factors also affect the category of a trust, and therefore which distributions to beneficiaries are non-taxable.
A settlement is any action that makes a person a settlor of a trust. This includes any failure to act, and entering into any transactions that are part of one of the actions listed above.