Trusts and Taxes

Legal Nature of a Trust Fund

The ARROWS law firm deals with fund structuring on a daily basis. We see that clients often perceive a trust fund merely as a "safe deposit box." However, they forget that the safe must have the right "doors," otherwise they will pay a high duty upon withdrawal.

The Trust's Statute: Your Tax Constitution

Most tax problems do not stem from the law itself, but from a poorly written trust fund statute. The statute is not just a formal document for a notary. It is the "constitutional law" of your trust, defining what constitutes assets (contribution) and what constitutes an increase (profit).

If the statute does not clearly distinguish between the trust's principal (contributed assets) and the fruits of those assets, the trustee faces a burden of proof issue. In cases of doubt, the Tax Authority tends to view all payouts as a taxable share of profit.

This can be explained with a case study from our practice. A client contributed real estate worth CZK 50 million to a trust. After ten years, the trust sold the properties for CZK 70 million. The statute did not clearly specify how to handle the capital appreciation. The trustee paid the entire 70 million to the beneficiary (the son). The Tax Authority argued that CZK 20 million was the trust's profit, which should have been subject to withholding tax, not an exempt distribution of assets. A long dispute followed.

Had the statute been prepared by experts from ARROWS, it would have contained precise definitions for the allocation of capital appreciation, which would have eliminated the risk. Do not underestimate the preparation of the statute. For a review of yours, write to us at consultation@arws.cz. 

Basic Distinction: Profit Distribution vs. Asset Distribution

The fundamental criterion for taxation is the origin of the funds being paid out. We must strictly distinguish between two situations:

1. Distribution of a share of profit: The trust has earned money through its activities (rent, investments, dividends). It sends this money to the beneficiary.

2. Distribution of assets: The trust returns or distributes assets that were originally contributed to it (the principal).

While the distribution of a share of profit is subject to withholding tax, the distribution of assets can, under certain conditions, be completely tax-exempt.

If a trust fund generates a profit and decides to pay it out, this income is standardly taxed at a special tax rate (withholding tax) of 15%. In this case, the trust functions similarly to a business corporation paying a dividend. 

The ARROWS law firm will provide you with a legal analysis to confirm the correctness of the distribution procedure, so you can avoid accusations of tax evasion. Want to be sure your distributions are tax-optimal? Write to us at consultation@arws.cz. 

Tax Exemption: Family Ties are the Key to Savings

A specific and, for clients, most interesting situation arises if the beneficiary's income is classified as "other income" under Section 10 of the Income Tax Act, typically for a distribution that is not a share of profit (distribution of assets). Here, the family relationship between the trust's founder and the beneficiary plays a key role.

The law here mirrors the logic of the former gift tax:

• Exempt: If the beneficiary is a relative in the direct line (parents, children, grandparents) or collateral line (sibling, uncle, aunt, spouse) of the founder.

• Taxed: If the beneficiary is an unrelated person or a distant relative (second cousin, friend).

This rule is crucial for intergenerational capital transfer. If you were to gift assets directly to your son, he would not pay tax. A trust fund preserves this advantage but adds asset protection and control.

However, one must be careful with complex family constellations. In our practice, we deal with "patchwork" families, stepchildren, or unmarried partners. Here, the mere absence of a marriage certificate can mean the difference between 0% and 15% (or 23%) taxation. 

The ARROWS law firm can set up the structure in such a way that the tax burden is minimized even in these cases. Want to be sure your loved ones won't pay unnecessary taxes? Write to consultation@arws.cz. 

The Trust Fund as a Holding Company: Specifics of Business Trusts

Many of our clients, especially owners of medium and large companies, use trusts not just to manage family homes, but to contribute shares in their companies (s.r.o., a.s.). The trust thus becomes the "parent company" in a holding structure.

Here, the tax situation is specific:

1. Receipt of dividends into the trust: If the trust holds a share in a subsidiary (e.g., 100% of an s.r.o.) for the legally stipulated period (usually 12 months and at least a 10% share), the dividend payment from the subsidiary to the trust may be exempt from income tax (the so-called participation exemption).

2. Payout from the trust to the beneficiary: Here, the exemption does not apply automatically. When the trust sends this money to a natural person (the owner/beneficiary), it is a profit distribution, and a 15% withholding tax applies.

Many entrepreneurs mistakenly believe they can withdraw money from their company completely tax-free through a trust. This is not true. However, the trust allows for tax deferral. Money can flow into the trust untaxed (under the exemption) and the trust can further invest it (e.g., buy another company, real estate). The tax is paid only when you, as a private individual, want to enjoy the money.

In our portfolio, we manage the legal agenda for more than 150 joint-stock companies. We know how to set up a holding structure so that the trust serves as a strong investment center. Are you planning to place your company into a trust? Consult with us first at consultation@arws.cz. 

Holding Periods: Real Estate and Securities in a Trust

A trust fund is not just a conduit for money; it is also a long-term investor. A key question for tax optimization is the so-called holding period.

If a trust sells real estate or a security, this income is taxable income of the trust (at a rate of 21%). Are there any exceptions? Unfortunately, for legal entities (and thus trusts), the exemption after 5 or 10 years of holding, which we know for natural persons, does not apply. This is a disadvantage of trusts that is rarely discussed.

How do we at ARROWS solve this? If the goal is a future tax-free sale of real estate, the trust structure must be set up differently. For example, the trust could distribute the property to the beneficiary (if this is exempt – see above), and the beneficiary, as a natural person, sells the property. If the beneficiary meets their personal holding period, the sale can be exempt.

This is exactly the type of "procedural detail" where a mistake costs millions. A layperson sells the property directly from the trust and unnecessarily pays a 21% tax. An ARROWS client knows how to proceed more effectively. Are you dealing with the sale of assets from a trust? Stop and write to us at consultation@arws.cz. 

Tax Deductibility of Costs: Optimizing the Tax Base

Even before a distribution occurs, the trust must tax its own income. This opens up space for claiming costs. However, not all expenses are tax-deductible.

• Deductible: Costs for repairs of a rented property, property tax, trustee's remuneration (if related to generating profit), legal services related to asset management.

• Non-deductible: Personal consumption of beneficiaries (vacations, cars for private use), costs for assets that do not generate income.

A major topic is the trustee's remuneration. If the trustee is a professional, their remuneration is a cost. If the trustee is a family member, tax authorities examine whether the remuneration is customary and not just a hidden distribution of profit.

Do you want to check if your trust is using all tax optimization possibilities? Write to us at consultation@arws.cz. 

AML and the Register of Beneficial Owners: The End of Anonymity?

Transparency is closely linked to taxes. Many clients established trusts with the vision of anonymity. Today, however, the Act on the Register of Beneficial Owners is in effect. A trust fund must register its founder, trustee, beneficiary, and persons with ultimate influence in this register.

This register is accessible not only to the police but also to tax authorities. The tax administrator can thus easily cross-check who the beneficiary in the register is, whether this beneficiary has declared their income (if they were supposed to), and whether their assets correspond to their lifestyle (indirect methods of proof).

A discrepancy between the entry in the Register of Beneficial Owners and the tax reality is a frequent trigger for an audit. At ARROWS, we handle registrations in the register for hundreds of entities and ensure that the legal status corresponds to the factual and tax reality. Is your entry in the Register of Beneficial Owners in order? Avoid fines and contact us at consultation@arws.cz. 

The Trustee's Role: Personal Liability

From the perspective of the Tax Code, the trustee of a trust fund acts as the tax remitter. It is the trustee who is responsible for the correct calculation, withholding, and payment of withholding tax.

If the trustee incorrectly assesses that a distribution is an exempt asset distribution when it is actually a taxable share of profit, and fails to withhold the tax, the Tax Authority will assess the tax on the trust. If the trust has no money, the problem is passed on. Moreover, the trustee is liable for damages caused by a breach of the duty of due managerial care. Beneficiaries can claim damages (the assessed penalty) from the trustee's personal assets.

We therefore strongly advise trustees not to rely on "common sense." Our firm regularly provides a "shield" for trustees in the form of binding legal opinions. If you act based on an expert opinion from a lawyer, your liability is significantly limited.

The tax impact depends on the setup of the statute and the division of roles in the trust; we describe the founder's control mechanisms in the article rights of the founder and supervision of the trustee. Are you a trustee and don't want to risk your personal assets? Secure legal protection at consultation@arws.cz. 

Beware of International Elements and Practical Complexities

Taxation becomes dramatically more complicated if the trust fund or beneficiary has ties abroad. Different rules apply to a Czech tax resident receiving payments from a Liechtenstein foundation, and different rules for a foreigner with income from a Czech trust.

This is where international directives, exchange of information, and CFC (Controlled Foreign Companies) rules come into play. The Czech Tax Authority now routinely receives information about the accounts of Czech citizens abroad. Thanks to our ARROWS International network and a decade of experience with cross-border cases, we can ensure that your structure works globally and is not the target of an international investigation.

It is important to realize that this issue is not static. Tax laws change, and what was valid when the trust was established may not be valid at the time of distribution. It's not just about filling out a form. It's about procedural details, proper accounting for the trust, and the ability to defend the chosen approach.

Our portfolio includes more than 150 joint-stock companies, 250 s.r.o.s, and 50 municipalities and regions, whom we help protect and manage their assets. We regularly cooperate with your corporate lawyers on specific tasks, such as setting up trust structures. Moreover, we connect our clients. If you are looking for investment opportunities for free capital in a trust or, conversely, are looking for an investor, we will be happy to introduce you within our network. Connect with us at consultation@arws.cz and get a tailor-made legal solution.

Conclusion: A Safe Harbour for Your Assets

The administration of a trust fund and its tax aspects are in many ways reminiscent of managing a complex business corporation, but with stricter demands for precision in family and property relationships. As is clear from the above, the line between exempt income and tax liability is thin and depends on details such as proper records, family relationships, the wording of the statute, or the nature of the funds being paid out.

In the real world, we encounter hidden exceptions, procedural deadlines, and traps in the form of holding periods that a layperson can easily overlook. Do not leave your lifelong-built assets to chance or the risks associated with a misinterpretation of the law. For the client, it is always safer and ultimately cheaper to have the entire agenda professionally handled by experts who deal with this issue daily.

The ARROWS law firm is ready to take responsibility for the legal setup of your processes. We are insured for damages up to CZK 500,000,000, which provides you with a guarantee you won't find with independent advisors. We can effectively combine legal protection with tax rationality and, thanks to our background in the ARROWS International network, also with international elements. If you do not want to risk mistakes, fines, or legal disputes, leave the concern for the legal and tax setup of the trust to us. Just contact the office at consultation@arws.cz and we will take care of the rest.