Are you thinking about your current business structure and wondering if it’s still the right fit for your growing business?
In our 3 part Business Structuring series, we analyse the risks and benefits of a selection of common business structures.
In part 1 we examined operating as a sole trader, in part 2 we explored the business structure company and for part 3 we reviewed the risks and benefits of a Discretionary Trust – continue reading to find out if this business structure is right for you.
Discretionary Trust
A trust is essentially a relationship of obligation between a trustee and beneficiaries. The trustee holds legal ownership of the trust’s assets and manages them for the beneficial owners (the beneficiaries). Trust structures are commonly used to either hold investment assets or to run a business. The key roles include the trustee, primary beneficiaries, settlor & appointors.
The creator of the trust, known as the settlor, gifts the trust an amount of money or property, and sets out the rules of the trust in a document know as a trust deed. The settled sum is often minimal (say $10), and the settlor is independent person (often an accountant or lawyer as the settlor cannot be a beneficiary of the trust).
Trustees must familiarise themselves with the specific terms of their trust deed and ensure that they act in accordance with the terms laid out in the deed. Practically, trust deeds are complex documents to read and understand, and often trustees seek the advice of accountants and lawyers to ensure they comply with their legal obligations. The trustee is ultimately responsible for the conduct and affairs of the trust.
The trust’s appointor has the power to remove or appoint the trustee as they please. The appointor holds ultimate power, and the position must be given careful consideration when the trust deed is initially drafted. It is also wise to consider appointor succession provisions and to write them into the deed at the outset.
There are many types of trusts
One of the most common is knowns as a discretionary trust. With discretionary trusts, the beneficiaries are named and defined in the terms of the trust deed. The primary beneficiaries are often a married couple or a set of closely related family members, and additional potential beneficiaries are often defined very broadly so that most people within the primary beneficiaries’ extended family group are classed as beneficiaries. Companies, trusts and charities can also be trust beneficiaries in certain circumstances.
Discretionary trusts wield great flexibility from an income tax perspective, as the trustee isn’t bound to distribute the trust’s profits to beneficiaries in a fixed or predetermined way. Often trust deeds simply prescribe that the trustee distributes the trust’s annual profits to the beneficiaries, giving the trustee complete discretion as to which beneficiaries will receive those profits and what proportion each will receive. The trust’s profits are ultimately taxed in the hands of the beneficiaries that receive them. If the trustee doesn’t effectively distribute the trust’s profit in writing by 30 June in any given year, the trustee will be assessed on the undistributed profit at the highest marginal tax rate.
Trust example – purchase of investment assets
Following from the sole trader and company example, Rachel’s business ticks along for a few years and more staff are hired. The rented office space no longer accommodates the growing number of staff, and Rachel starts looking for a commercial office space to purchase for her business operations. Rachel is married to Maxwell, who works in part time paid employment and spends the remainder of his time caring for their children.
How well does the discretionary trust structure suit this asset purchase?
As a commercial property is an expensive purchase, asset protection is a key consideration. Appointing a newly established company to act as trustee adds in an additional layer of protection, so that the assets owned by the trust are clearly segregated from Rachel’s personal assets and from her advertising agency business dealings. Should Rachel’s advertising agency business run into financial trouble and become unable to pay its debts, provided that Rachel (as the advertising agency’s director) has acted in a proper way, the assets owned by the discretionary trust (the commercial property) will likely be shielded from the advertising agencies creditors.
Rachel’s advertising agency (the trading entity) can enter into a lease agreement with her discretionary trust to rent the property at arm’s length market rate. Rachel has obtained estimates the property’s expected outgoings and costs (rates, land tax, loan interest) and has found the trust will likely earn a small profit on the lease arrangement each year (subject to rental market fluctuations).
From an income tax point of view
The discretionary trust will provide a high level of flexibility around which of Rachel’s family members or associated entities receive the trust’s income distributions each year. In early years, trust profits may be distributed to Maxwell as his taxable income is expected to be low due to working part time. This may shift in future years if Rachel’s taxable income decreases, and Maxwell’s increases. Keep in mind that it is allowable to distribute trust income to children that are younger than 18 years old, however the tax rate on these distributions is prohibitive. Once children turn 18, trust distributions they receive are taxed at adult marginal rates.
Access to the capital gains tax discount is also an important deciding factor. If the trust sells the commercial property and makes a profit, the capital gain will be distributed to the trustee’s chosen beneficiaries. If the selected beneficiaries are individuals and the property has been held for longer than 12 months, they will be entitled to claim the 50% capital gains tax discount. There may also be the ability to apply the small business capital gains tax concessions to reduce the taxable gain even further, should eligibility requirements be met.
Rachel and Maxwell discuss their options and conclude that while the trust structure will involve additional set up and administration costs, the benefits obtained by way of asset protection and income distribution flexibility are very attractive.
How your business accountant can help you
At Crest Accountants, we have a range of business structuring services all benefiting from our extensive experience in working with and advising about the processes, systems, and plans, essential to the overall structure and success of a business. We take the time to get to know our clients so that you feel confident we have your best interest at heart.
Contact us and book an appointment to discuss your business accounting needs today.
Disclaimer: The information contained in this news post is general in nature and is intended to provide a general summary only and should not be relied on as a substitute for professional advice.
