If you have a discretionary family trust, then chances are your accountant has mentioned ‘unpaid present entitlements’ or ‘UPEs’. No doubt you have just nodded wisely, but deep down, do you really know what this means?
Every financial year the trustee of your trust has a choice to either:
- Distribute the income of the trust to beneficiaries; or
- ‘Accumulate’ the income into the trust, (i.e. keep the income in the trust).
As a general rule, the trustee will want to distribute all of the income to beneficiaries (rather than accumulate the income in the trust). This is because of the tax outcomes.
If the trustee distributes the income to a beneficiary, then the beneficiary will pay tax on the distribution at their marginal rate of tax – which could be anywhere between 0% and 47%. If the beneficiary is a company, then the company will pay tax on the distribution at the flat company rate of tax (namely, 27.5% or 30%).
However, if the trustee does not distribute some of the income to a beneficiary, then the trustee will be the person liable to pay tax on that undistributed income. Furthermore, the trustee will pay tax on every dollar of this undistributed income at the top marginal rate of tax of 47%.
So, the outcome of all of this is that the trustee will want to distribute all of the income of the trust each year to avoid having to pay tax on the income at the top rate.
However, the trustee may need some of the income to fund its ongoing activities. This causes a tension between the trustee having to distribute all of the income to keep the tax burden down, but also needing to keep some of the cash that represents that income for working capital purposes.
What is the outcome of this tension – an ‘unpaid present entitlement’.
An unpaid present entitlement arises when the trustee makes a distribution of income to a beneficiary, but keeps the cash referable to that distribution. The distribution is left ‘unpaid’. However, to make the distribution effective for tax purposes, the beneficiary must be ‘presently entitled’ to the distribution. This means that the beneficiary must have the legal right to require the trustee to pay them the cash when the beneficiary asks for it. To achieve this outcome the trustee resolves before the end of the financial year to irrevocably distribute the income to the beneficiary.
So why are unpaid present entitlements so important?
There are a couple of contexts in which you need to be careful with these UPEs.
The first is Division 7A. If the trustee distributes income to a company (to cap the rate of tax at 30% – read our article about ‘bucket companies’), but keeps the cash in the trust (or makes the cash available to a different beneficiary), then Division 7A can raise its ugly head. This is because the company has paid tax on the income, but someone other than the company has use of the cash (i.e. the trustee or other beneficiary). This can result in a ‘deemed distribution’ by the company to the trustee (or other beneficiary). Division 7A is a whole topic in itself. But take our word for it, if you inadvertently trigger this division, then tax of around 64% can arise.
The other circumstance in which UPEs can cause issues is in your estate planning. A UPE owed to an individual is an ‘asset’ of that individual. This is because the individual can demand payment of the UPE from the trust. Often people use trusts to pass assets to the next generation without the assets passing through their personal estate. However, if there is a UPE outstanding from the trust to the individual, then the UPE will go through their personal estate. This can open up estate challenges and other unintended consequences – you can get a better understanding of this issue by reading this article.
So, next time your accountant mentions ‘UPEs’, you can smile wisely and ask if they have Division 7A and your estate planning under control.