A discretionary trust is a popular choice among Aussies, especially those with family wealth and businesses. That’s why most people in Australia know them as “family trusts.”
In Australia, it’s common to create a family (discretionary) trust for:
- Passing income to family members
- Protecting assets
- Saving tax
But why is it called “Discretionary”?
Simple, because the trustee has the discretion to decide who among the beneficiaries gets a distribution, how much they get, and when they will get it.
What’s more important is that no beneficiary has a fixed or guaranteed right; the trustee decides on this each year.
Key people involved in a discretionary trust
- Trustee: The person or company who controls the trust and makes decisions about distributions.
- Settlor: The person who sets up the trust
- Beneficiaries: The people or entities who can receive benefits from the trust (often family members).
Are discretionary trusts taxed?
Not usually directly, but yes, in some cases. In Australia, a discretionary trust usually does not pay tax itself. The beneficiaries are taxed on their shares of the trust’s income. It goes like this:
- If the trustee distributes capital (the fund itself) to a beneficiary, it might not be taxable (depends on how it’s structured and whether it triggers capital gains).
- If the trustee distributes earnings (income like rent or dividends), the beneficiary pays income tax on those.
Funds (the trust’s assets) and earnings (the income generated by those assets) are not the same. Australian tax applies to the earnings, not to the capital, unless there’s a capital gains event.
So, what happens when a US citizen uses an Australian discretionary trust?
When a US citizen in Australia uses a discretionary trust, it gets more complicated because of US tax laws and how they look at a discretionary trust.
When a US citizen is involved with an Australian discretionary trust, several things can happen:
- There will be heavy US tax reporting on the trust
- There will be possible US taxation on the trusts’ earnings (double taxation)
- There can be gift tax and estate reporting obligations.
How does the US look at a discretionary trust?
Because of the difference in tax laws between the two countries, the US doesn’t recognize Australian trust categories directly. Discretionary trusts confuse the IRS, so they often categorize them as a Foreign Grantor Trust (FGT).
A foreign grantor trust is a trust created in a foreign country. The US person who funds or controls the trust is personally taxed on all the trust’s income, whether or not they actually receive distributions, and must file heavy IRS disclosures.
Heavy US tax reporting
The individual must disclose the existence of the trust on complicated IRS forms like Form 3520 and Form 3520-A. Even if the trust makes no distributions, reporting is mandatory if the US citizen is involved with a discretionary trust.
Unfortunately, missing these forms brings automatic penalties starting around US$10,000 per form.
Double taxation on discretionary trusts
A discretionary trust can cause double taxation between Australia and the US because Australia taxes trust distributions while the US taxes trust earnings (same income).
So, the US doesn’t care if the income is distributed among beneficiaries; the US taxes the grantor (US citizen) personally, even if the trust distributes income to others under Australian law.
Avoiding double taxation on discretionary trusts
Foreign Tax Credit (FTC)
The main way to reduce double taxation is to use foreign tax credits. For example, if a US citizen pays tax in Australia on the trust’s income, they can usually claim a credit against their US taxes.
Treaty provisions
The treaty does not have specific rules about discretionary trusts, but it does have rules regarding how dividends, interests, and capital gains should be taxed, which can improve the taxation of the trust’s earnings.
Please note that they do not completely prevent double taxation for discretionary trusts because of timing and ownership mismatches. Careful planning is needed each year to minimize problems.
Gift and estate tax worries on discretionary trusts
The US has gift tax and estate tax rules that apply to worldwide assets of US citizens including discretionary trusts, that can accidentally trigger gift or estate tax problems because the IRS looks at who really owns or controls the assets.
Simply said, if a US citizen creates a discretionary trust and gives away assets into it, that transfer may be seen by the IRS as a gift. For example, A US citizen moves US$2 million of property into a discretionary trust that benefits their kids. That transfer is a US$2 million gift to the trust for US tax purposes and may require filing Form 709 (US gift tax return).
Estate tax
If a US citizen still controls or benefits from the discretionary trust at death, the IRS may still include it as part of their taxable estate.
So, if a US citizen’s estate (worldwide assets) exceeds a threshold limit, estate tax applies at 40% on the excess. Even if Australia doesn’t have an estate tax, the US does for its citizens.
Trust structuring, legal advice, and correct US tax filings are essential to avoid huge penalties and unexpected taxes.