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Instead of simply setting up a company, many business owners choose to operate and distribute business profits through a trust business structure.
The reason is that you can take advantage of the tax benefits of income-splitting, a common strategy in family-run companies.
In saying that, there is still a high level of liability with limited asset protection if the trust isn’t set up in the right way.
Why set up a trust business structure?
The first thing to keep in mind with a trust is that it isn’t a separate legal entity but rather a business structure.
The trustee, which is usually the company itself, operates as a business for the benefit of beneficiaries (you as the director and your family).
Although a trust is a great way to income split and leverage the marginal tax rate of your beneficiaries, the initial and ongoing administration costs can be high.
How is a trust set up?
It’s best to think of a trust as a pyramid, with funds being distributed down to the beneficiaries.
It’s made up of the following individuals:
- Settlor: The person who settles money on the trust.
- Trustee: This is the legal owner of the trust property/assets/money. They carry out the transactions of the trust in the trust name, must adhere to the trust deed and act in the best interests of the beneficiaries.
- Appointer: They have the power to remove a trustee and appoint a new one in the event of the former trustee’s death, bankruptcy or incapacitation. If the trustee is a company, then a new trustee is appointed if the company is wound up.
- Beneficiaries: These are the people actually named in the trust deed entitled or at least expected to receive distributed income or capital. This would either be at the discretion of the trustee or a predetermined amount as is the case in a unit trust structure.
What’s the difference between unit and discretionary?
A discretionary trust is commonly used in family-run businesses because the trustee or company will distribute funds to beneficiaries based on their discretion in compliance with the trust deed.
In that way, you can decide how to divide money between the beneficiaries, yourself included, based on your individual tax rates.
Where more than one family is involved in the business, you’re usually better off setting up a unit trust.
Each beneficiary receives a predetermined “share” of the income/capital in the trust as set out in the trust deed.
This removes the “discretionary” nature of the trust which is more attractive where unrelated parties are involved.
What are the pros of a trust?
Most people set up a trust in a way where the company is appointed as the trustee.
If a beneficiary is sued or incur debts in some way, creditors and litigators don’t have recourse to repossess their property or income.
This is because the trustee owns the trust property and not you as the beneficiary.
Apart from asset protection, a trust business structure also allows for:
- Tax planning: The trustee can distribute income to the beneficiaries with the lowest marginal tax rates to minimise the amount of tax payable on distributed income or capital. It’s very different to a company structure because even though profits are taxed at the lower company tax rate (30%), the wage or dividend then paid out to you as the director is taxed at your personal tax rate, which can be significant depending on the amount.
- Trusts aren’t taxed: The trust doesn’t incur income tax if all of the trust income is distributed to adult resident beneficiaries.
- Privacy: You actually don’t need to register the trust with the Australian Securities and Investments Commission (ASIC) although the company itself (acting as the trustee) will need to be.
- Capital Gains Tax (CGT) discount: A 50% discount applies to the disposal of assets held for over 12 months by the trust. Applicable to discretionary trusts only and only if beneficiaries are individuals (not companies).
- Great for passive investments as well: Many people with passive investments like freehold commercial property choose to hold the asset within a trust. You and your family, acting as beneficiaries, can receive rental income from a positively-geared property and take advantage of marginal tax rates by having the funds favourably distributed (as per the trust deed).
- Estate planning: Avoid the costs and delays of probate court by setting up a discretionary trust for your child.
- Freedom to use income: Once the beneficiaries receive their proportion of income or capital from the trust, they’re free to do with the income as they wish.
Trust versus company
Ultimately, if you set up a company, you own that company. It’s your asset meaning it is worth something and you have an asset that a creditor can get access to.
A trust, on the other hand, is a fluid structure that isn’t really owned by anyone. It’s controlled by someone but it’s not owned.
In that sense, a trust is really for business owners that are really worried about asset protection.
Someone who owns their own medical practice, for example, may own that in a company business structure.
However, they may also have an income-producing asset like an investment property.
So the medical practitioner may want the income earned from the property to be distributed through the trust while the business itself will be owned through a company structure.
What are the cons of a trust?
- There is still some personal liability: In the event that a trustee (your company) falls into financial trouble and there isn’t enough assets in the trust to pay your debts, the creditor may be able to make a claim against the beneficiaries. A trust is only as good as the corporate trustee so this kind of ownership structure really only suits businesses in a strong financial position and generating repeat profit.
- The trust doesn’t last forever: As per the rule against perpetuities, the trust structure will cease to exist after 80 years (different rules apply in South Australia).
- Complex: A trust adds another layer of complexity to your business and requires the services of an accountant and a solicitor.
- Set-up costs can be high: Typically $1000-$2000
- Ongoing costs can be high: Typically, $1,500-$2,500 in accountancy fees, not including costs of filing and preparing annual tax returns.
- Difficulty getting finance: If you need to get a home loan, it can be difficult to get approved with your bank but we’re specialists at trust loans and know how to get tough applications approved.
- There is no lower tax rate: Unlike a company, a trust doesn’t get favourable tax rates. If you can’t effectively income-split to beneficiaries (your family or otherwise) to leverage the tax benefits, a trust wouldn’t be that beneficial to you. However, there are CGT tax concessions available (must meet certain requirements).
- The trustee can still be taxed: If your plans are to use funds in the trust for your future business growth plans, the trustee will actually incur personal tax on that undistributed income. In addition, where income is distributed to non-residents or minors, the trustee is assessed on that share on the beneficiary’s behalf. That’s why it often makes sense to have a corporate trustee rather than an individual.
- You have to trust the trustee: Not necessarily a drawback but if you can’t rely on the trustee (your company), there is obviously advantage in simply running the business in a company structure.
You can set up multiple trusts
There’s no reason why you wouldn’t set up two trusts or more.
You could have one for your business (a risky asset) and a few others for your passive investments.
It’s all about separating risk: the more assets you have to lose, the more reason to set up a trust.
How does it work?
- The trust must have its own Tax File Number (TFN) for lodging its annual tax returns, showing all income and deductions of the business, plus any distributions to beneficiaries.
- You’ll need to register the trust with an Australian Business Number (ABN).
- If the annual turnover of the trust is $75,000 or over, Goods and Services Tax (GST) is payable.
- Beneficiaries may be liable to make Pay As You Go (PAYG) instalments on distributions they receive.
- The trust is actually liable to make superannuation contributions for any of its employees which can include trustees if they’re employed by the trust.
What should be in the trust deed?
The trust deed is the mandate that basically tells the parties in the trust:
- What the trust is for,
- Whom the trustee/s is,
- Who the beneficiaries are,
- The rights and obligations of the parties; and
- How to distribute income from the trust property.
In a way, it’s similar to a company constitution but the key difference is that the reliability of the trust comes down to the relationships between the different parties.
Can I exit the trust?
If you have a trust, you can’t simply sell the trust to someone else: you have to sell the business and someone has to buy the business from the trust.
The reason is that you might have licences owned only by the trust or the trustee which might be difficult to transfer.
If you want to transfer the trust with all of the assets intact, it’s a lot easier in a company because you’re just selling the shares while the company and its assets still exists.
A solicitor is essential whenever dismantling a trust.
We’re commercial property loan specialists!
If you need help in getting approved for a commercial loan for your trust, call us on 1300 889 743 or complete our free assessment form to speak with one our specialist mortgage brokers.
Although we can’t provide advice or assistance in setting up a trust, we can help you get approved for a commercial property loan for your business.
Discover we can help you borrow up to the maximum Loan to Value Ratio (LVR) and qualify for competitive commercial interest rates.