E+Co Alerts

29
Aug

Pros & Cons of using Trust structures in your business

Introduction

Clients setting up new businesses often ask us whether it would be advisable to operate their business through a trust structure. There is a common perception that utilising a trust can have tax advantages, though it is less well known exactly what these advantages are and whether they are suitable for every situation.

It is true that, provided correctly structured and tailored for the commercial circumstances, a trust structure can help optimise the tax position for business owners. On the other hand, the nature of trusts and the rules of trust law can make it harder to rapidly grow a business than a corporate structure.

In this paper we take a look at some of the main points to be aware of, including potential tax advantages, and some pros and cons versus corporate equity structures.

What is a Trust?

A trust is a creature the comes into existence through the terms of a deed (‘Trust Deed’), and is a mechanism to separate the legal ownership of the assets from their beneficial entitlement.

There are three main groups of players to be aware of in a typical trust structure, namely:

1. Trust: The trust is a legal creation under deed, though the trust itself is not a separate legal entity. It requires a trustee to own and operate the assets as the Trust cannot act in its own right.

2. Trustee: The legal entity who owns the assets and enters into contracts on the trust’s behalf. A Trustee may be thought of a third party hired to guard the business, but who is not entitled to the assets or the profits. Although the Trustee is personally liable, if it is a company its’ liability is limited, and it also usually has a contractual right of indemnity out of the Trust assets under the Trust Deed provided acting within its’ scope of authority.

3. Beneficiary: The person(s) entitled to the ‘benefit’ of the assets and profits of the business.

In discretionary trusts in Australia, there is a fourth player, being the ‘settlor’. This person makes a gift (or ‘settled sum’) of money under the Trust Deed. This ‘settled sum’ forms the initial trust assets. Under the Trust Deed, the settlor is expressly excluded from receiving back the settled sum or being a beneficiary of the trust

Common Trust Structures

Generally in Australia, there are two common species of trust structures that business owners employ for their businesses:

(i) discretionary trusts; and

(ii) unit trusts, with a number of sub-species.

These are further discussed below.

Discretionary Trust

As the name implies, a discretionary trust empowers the Trustee under the Trust Deed to use its ‘discretion’ over the amounts or proportions of income and capital distributed to the beneficiaries.

E.g. Let’s say that a discretionary trust with two beneficiaries makes a $100,000 annual profit in two successive years. In the first year, the Trustee elects to distribute $95,000 to Beneficiary A and $5,000 to Beneficiary B. In the second year, the Trustee elects to distribute $25,000 to Beneficiary A and $75,000 to Beneficiary B.

These kinds of discretionary elections are often made for tax reasons, where the two beneficiaries are closely related and they are seeking to maximise the collective benefit of the lower income tax threshholds.

Thus the discretionary trust is often a creature adopted by families, who may wish to split income between husbands, wives and children. Where unrelated individuals come together to operate a business, discretionary trusts are less common.

Discretionary trusts also have capital benefits, as a capital gains tax discount is available on the capital gain from disposal of assets held for more than 12 months. This discount is also available to individuals who hold shares, but not companies who hold shares.

Unit Trust

Unlike a discretionary trust, a unit trust does not give the trustee discretion to elect how to split income between beneficiaries. Instead, a Unit Trust Deed splits the trust property into fixed ‘units’ that in that sense are analagous to equity shares in a company. A unit trust does not have a settlor.

The Unit Trust creature comes in a number of breeds:

1. Standard Unit Trust: Divides the Trust into units all of the same class that gives the beneficiaries (or unit holders) equal rights to vote and share in the distribution of income and capital in proportion to the number of units held.
2. Multi-Class Unit Trust: Has different classes of units each with different rights to share in the distribution of capital and income. Some unit holders may have voting rights, while others may not.
3. Hybrid Unit Trust: This breed of unit trust has a division that is a Discretionary Trust, and thus is a slight exotic cross-breed tha blends the discretion of a Discretionary Trust with the rigidity of a fixed trust.
4. Fixed Unit Trust for NSW Land Tax purposes: This creature is only found in NSW and is used for ‘property rich’ businesses. If correctly structured, the trust will be able to avail itself of the land tax free threshold.

Pros and Cons of using Trusts

So.…why would you choose to use a Trust? It depends on individual circumstances though there are certain basic pros and cons. At high level:

Pros
• Income splitting advantages.
• Capital gains tax discounts.
• Land tax benefits for fixed unit trusts in NSW.
• Privacy – less transparent than a corporate vehicle.
• Protection against creditors as beneficiaries do not own the trust assets. (Though in a unit trust a bankrupt beneficiary’s units are treated as an asset and can be available to a creditor/trustee in bankruptcy.)

Cons
• Can be more expensive and complex than a company structure.
• Profits must be distributed to beneficiaries each financial year – retaining earnings to build the business is not permitted.
• Only profits – and not losses – can be distributed to beneficiaries.
• A trust must distribute profit/income to beneficiaries each financial year. Otherwise, the trustee must pay tax on any undistributed (i.e. accumulated) income at the highest marginal rate.
• If seeking investment, investors will generally prefer a company structure.
• Varying the Trust Deed could amount to resettlement and trigger capital gains tax and stamp duty.
• May be more difficult to borrow against than a corporate structure.
• Trustees can be personally liable for the trust’s debts.

Some final comments

Considerations of the right legal structure for your business depend on individual circumstances. Despite potential tax advantages, a trust structure will not always be the most suitable vehicle and indeed may not be appropriate for businesses wanting to rapidly grow scale by reinvesting profits and/or attracting third party capital.

This paper is to assist you to think about some of the issues under Australian law and practice, but is not a substitute for legal or tax advice, and should not be relied upon. We are happy to provide further legal guidance, and can be contacted as per below:

James Edwards
Principal
James@ecolegal.com.au
02 8399 1043

Kelly Tomasich
Senior Lawyer
Kelly@ecolegal.com.au
02 8399 1043

About James Edwards
James is the founder and principal of Edwards + Co, and advises businesses on legal and commercial issues in a world enabled, disrupted and re-assembled by the internet of everything.

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