Death, deceased estates, and family trust elections: Schedule 2F and succession
The family trust election (FTE) rules in Schedule 2F of the Income Tax Assessment Act 1936 (ITAA 36) have formed part of Australian tax law for almost 30 years. Schedule 2F's application to succession events - in particular the death of the individual whose family group defines the boundaries of a family trust - creates difficulties for trustees and advisers.
Death does not suspend the obligations imposed by an FTE. Family trust distribution tax (FTDT) continues to arise automatically upon any distribution made outside the test individual's family group, irrespective of whether the test individual is alive or dead.
This article considers the FTE rules as they apply on the death of a test individual: the continuity of the FTE, the composition of the family and family group following death, the constraints on making new elections after the test individual has died, and the options available to trustees and advisers.
The FTE regime
For taxation purposes, a trust is a family trust only when an FTE in respect of that trust is in force. The trustee makes the FTE, which must nominate an individual (whom Schedule 2F refers to throughout as either the 'test individual' or 'primary individual') whose family group determines the persons and entities to whom the trust may distribute income or capital without attracting FTDT.
The choice of test individual is critical: it fixes the boundaries within which the trust may distribute without incurring FTDT.
The test individual's 'family', as defined in section 272-95 of Schedule 2F, includes parents and grandparents, children and grandchildren, siblings and their lineal descendants, and the spouses of all such persons.
The 'family group', defined in section 272-90 of Schedule 2F, extends beyond the family and includes, inter alia, companies, partnerships, and trusts that have made interposed entity elections (IEEs) in respect of the relevant family trust, entities in which members of the family hold all fixed entitlements to income and capital, and individuals who are no longer members of the family.
The two concepts are not interchangeable: a person may remain a member of the family group without being a member of the family, and Schedule 2F applies the two concepts independently.
The law imposes FTDT at the rate of 47% on the amount or value of any distribution or conferral of present entitlement made by a family trust or interposed entity to a person outside the test individual's family group. It arises automatically, without the need for the Commissioner to issue an assessment, 21 days after the relevant distribution.
FTDT is a punitive impost, and therefore trustees must identify who is, and who is not, within the family group at the time of each distribution.
Unlike income tax, which is subject to the Commissioner's power of amendment and the time limits that section 170 of the ITAA 36 imposes on that power, FTDT arises automatically by operation of statute without the need for an assessment. The amendment periods in section 170 do not apply to FTDT and liabilities may therefore accrue back to the commencement of Schedule 2F in 1996.
The effect of death on the FTE
In Interpretative Decision ATO ID 2014/3, the Australian Taxation Office (ATO) takes the view that the test individual must be alive at the time of the election, but that the later death of that individual does not bring the FTE to an end. The FTE continues in force for so long as the trust exists, irrespective of whether the test individual is still alive.
Death does not permit variation of the test individual. The general power to vary the test individual in Schedule 2F is subject to strict time limits: the trustee must generally make a variation within a four-year window from the income year specified in the original election.
That window was intended to allow rectification of mistakes, rather than to permit variation under an otherwise irrevocable regime, and death does not create a separate or extended period within which the trustee may make a variation. Where the test individual has died and the surviving family wishes to establish new trusts, admit new entities, or rationalise the group's structure, Schedule 2F's constraints present a substantial obstacle.
The death of the test individual does not, however, prevent any other trust, company, or partnership from making an IEE to be included in the test individual's family group. Entities may therefore join the family group by making IEEs in respect of the existing family trust, notwithstanding that the trustee cannot make a new FTE nominating that individual. The IEE mechanism is therefore the primary, if limited, succession measure available after the test individual's death.
The family and family group following death
Membership of the test individual's 'family' is not lost merely because another family member has died. Section 272-95 of Schedule 2F defines the family by reference to relationships, whether by blood, marriage, adoption, or step, rather than by survival. A child of the test individual remains a family member whether or not the test individual is alive. A sibling of the test individual's spouse remains a family member whether or not the test individual or the spouse has died.
Section 272-90 of Schedule 2F contains two provisions that address the effect of death on family group membership.
A person who was the spouse of the test individual, or of a member of the test individual's family, immediately before the death of that individual or family member, and who has subsequently become the spouse of a person who is not a member of the test individual's family, remains a member of the family group (but not the family). A surviving spouse who remarries outside the family therefore remains in the family group, notwithstanding that the remarriage removes them from the 'family'.
If the test individual and all members of the test individual's family are deceased, the deceased estates of the test individual and each of those family members are members of the test individual's family group. A family trust with a long-deceased test individual, where the entire family has since died, may accordingly continue making distributions to the deceased estates without triggering FTDT.
Section 272-40 of Schedule 2F addresses fixed entitlements held at the time of death. If, immediately before an individual dies, that person holds a fixed entitlement to a share of the income or capital of a trust, partnership, or company directly or indirectly and for their own benefit, the individual is taken to continue to hold that entitlement for so long as it is held by someone as trustee of the individual's estate, or is held by a person who received it as a beneficiary of the estate. This deeming rule preserves the group's ability to satisfy tests that depend on the identity of fixed entitlement holders, despite the individual's death.
Practical difficulties: distributions to deceased estates and testamentary trusts
Two difficulties arise in practice. The first concerns a deceased estate that receives a distribution from a family trust whose FTE nominates a deceased individual as the test individual. The second concerns a testamentary trust established under a will that wishes to pass on the benefit of franking credits to its beneficiaries. The options available to trustees are limited by the irrevocability of the FTE and the ATO view on the prohibition on nominating a deceased person as a new test individual.
Where a deceased estate receives a distribution from a family trust whose test individual has died, the executors of the estate must consider whether the estate is a member of the family group. That question turns on whether the deceased estate falls within the section 272-90 family group definition, which does not include the deceased estate of the test individual unless all living family members have also died.
The executors should consider making an IEE with respect to the family trust. An IEE made by the executors as trustees of the estate would bring the estate within the family group of the family trust's test individual, enabling the trust to make future distributions without triggering FTDT. The death of the test individual does not prevent the executors from making such an IEE. The executor must, however, satisfy the family control test in relation to the trust that has made the FTE, and must verify that any distributions the estate made during the retrospective period (if the IEE is to apply retrospectively) were made to members of the test individual's family group.
A further difficulty arises where a testamentary trust is established under the will of the test individual, or of another family member, and that testamentary trust wishes to access franking credits attached to dividends. The trustee of the testamentary trust must satisfy the 'qualified person' requirements under former Division 1A of Part IIIAA of the ITAA 36.
A family trust can satisfy those requirements because the FTE causes the trust to be a qualified person. However, the testamentary trust, if it has not made an FTE nominating a living individual as the test individual, may not be a family trust for these purposes, and its beneficiaries may be unable to access the associated franking credits. The trustee of the testamentary trust should therefore consider whether to make a fresh FTE nominating a living individual.
That FTE would create two separate family groups – that of the deceased test individual and that of the test individual of the testamentary trust. If either trust wishes to distribute to the other, the trustees should consider making IEEs so that both trusts fall within both family groups.
Succession planning and the 'dormant trust' strategy
Because the death of the test individual prevents the making of new FTEs nominating that individual, the family group cannot expand through new FTEs from that point. Pre-death planning is accordingly essential to retain the flexibility that Schedule 2F otherwise provides.
One strategy, most relevant where the test individual is advanced in age or in ill health, is to establish 'dormant' trusts (trusts that hold no assets and have no income at the time of establishment) and to make FTEs in respect of each while the test individual is alive. Each dormant trust will be within the family group of the test individual by reason of the FTE.
After the test individual's death, those dormant trusts (each having made an FTE nominating the same test individual) are members of the existing family trust's family group and may therefore acquire assets, conduct business, or receive distributions without the need for an IEE..
A similar, though structurally distinct, strategy may be employed for companies. If the test individual establishes and holds all shares in shelf companies during their lifetime, those companies will be members of the family group because the test individual holds all fixed entitlements to their income and capital. Following the test individual's death, the test individual is deemed to continue to hold those entitlements for so long as they are held by the trustee of the individual’s estate or by a beneficiary of the estate. This can preserve the companies' membership of the family group without the need for an interposed entity election.
Where the test individual has already died and the family group wishes to establish or fund new structures, fewer options are available. One approach is to distribute funds from an existing family trust to a living family member, whose receipt will not attract FTDT, and to have that individual contribute the funds to a new entity as capital. Any new FTE made in respect of a new trust will necessarily nominate a different (living) test individual. Advisers should confirm that the family group defined by that new test individual covers the persons and entities to whom the new trust will distribute, and that distributions between existing family trusts (whose test individual is deceased) and the new trust do not trigger FTDT.
The death of the test individual does not prevent other entities from making IEEs to be included in the test individual's family group. Where a new trust is established after the test individual's death and the trustee of that trust wishes to bring the new trust within the family group of an existing family trust whose test individual is deceased, the trustee may make an IEE in respect of that existing family trust. The new trust must, however, satisfy the family control test in relation to the existing family trust, and the applicable retrospective conditions if the IEE is to apply from an earlier income year.
The case for reform
The operation of the FTE rules in the context of death and succession exposes a gap in the legislative scheme: Parliament enacted the rules in 1998 for a narrower purpose than the purposes to which they are now applied, and nearly 30 years of practice have shown that the original drafting left important questions unaddressed.
The inability to nominate a deceased person as the test individual in a new FTE, the absence of any death-triggered right to vary the test individual, and the effective irrevocability of elections mean that a decision made at the establishment of the trust imposes constraints on the group decades later, regardless of subsequent changes to the family's composition or the structure of the group.
The Senate Economics Legislation Committee heard during its 1997 consideration of Schedule 2F that the provisions were so complex that they would impose significant compliance costs and that many taxpayers would be unable to comply. Those concerns have proved well-founded. Trustees and advisers regularly encounter these difficulties in applying Schedule 2F in the context of death and succession.
A targeted legislative reform - for example, making death a trigger for variation of the test individual, or permitting the appointment of a successor test individual within a defined period following death - would reduce the compliance burden without compromising the anti-avoidance purpose of the rules.
Conclusion
The FTE regime continues in force beyond the death of the test individual, but the rules governing the composition of the family group, and the constraints on making new elections or varying existing ones after death, create considerable compliance difficulties. The main rules, or ATO interpretations of the rules, may be summarised as follows:
the test individual's death does not terminate the FTE;
death does not trigger a right to vary the test individual;
the death of any family member does not extinguish that person's membership of the family;
the family group extends to include surviving spouses who have remarried outside the family;
where the entire family has died, the deceased estates of the test individual and family members form part of the family group; and
a deceased individual is deemed to continue holding fixed entitlements for so long as those entitlements are held by the trustee of their estate or by a beneficiary of the estate.
New IEEs can still be made after the test individual's death, but the ATO view is no trustee can nominate a deceased individual in a new FTE. Pre-death planning - the establishment of dormant trusts and companies and the making of elections whilst the test individual is alive - is a means of managing Schedule 2F’s constraints in a succession context.
For more information contact:
Neil Brydges
Principal | Accredited Specialist in Tax Law
M +61 407 821 157 | T +61 3 9611 0176
E: nbrydges@sladen.com.au
Daniel Smedley
Principal | Accredited Specialist in Tax Law
M +61 411 319 327 | T +61 3 9611 0105
E: dsmedley@sladen.com.au
