Do you operate a business, or perhaps you are considering starting or buying a business in Penrith, Parramatta, Hawkesbury or Sydney?
There are many different ways you could structure your business. This article looks at three of the most common business structures which you should consider if you are a current or prospective business owner.
Before we explain a discretionary trust, you might be thinking to yourself ‘what’s a trust’? Trusts can best be described as a type of ‘relationship’. It is important to understand that a trust is not separate legal entities like a company. The common parties to a trust are:
- The Settlor: Generally sets up the trust, appoints beneficiaries, and gives the initial asset. The settlor is usually not a beneficiary.
- The Trustee/s: Owns/holds/controls the asset for the benefit of the beneficiaries. The Trustee is usually either an individual or a company and must act in the best interests of the beneficiaries.
- The Beneficiary or Beneficiaries: The individual, company, or in some cases another trust, which benefits from the trust.
A trust is normally governed by a Trust Deed. Now that we know at a basic level what a trust is, what is a discretionary trust? A discretionary trust, also known as a Family Trust, is commonly used for family businesses. The family business operates within the discretionary trust, and is controlled by the Trustee. The income or capital generated from the business can be distributed to the beneficiaries at the discretion of the Trustee. The Trustee in this scenario is normally another company, setup for the sole purpose of acting as Trustee for the trust. This is an important tool for limiting the liability of the Trustee. The beneficiaries are normally various classes of family members. One of the main benefits of a discretionary trust is the ability to reduce income tax.
Let us imagine that a mum and dad own and operate a successful small business. Due to the healthy profits generated, even when splitting the profits between themselves 50/50, they both pay income tax at the highest individual marginal rate (45%). It is important to note that the trust itself does not generally pay tax, but instead the beneficiaries pay income tax at the individual level following distribution. If that same family business was operated through a discretionary/family trust, the profits could be distributed to various family members who are on a lower marginal tax rate. The Trustee has the discretion to pick and choose which of the beneficiaries receive the income, and how much.
Another benefit is that the trust can access a discount on Capital Gains Tax if the disposed asset has been held in the trust for a minimum of 12 months. Finally, the assets within the Trust are not owned by the beneficiaries and therefore cannot be attacked by creditors if the beneficiaries suffer financial trouble (e.g bankruptcy).
In the context of business structures, a unit trust is often the preferred type of trust when separate entities, or unrelated individuals/families, come together to operate a business. For example, an ideal scenario would be where two families come together to purchase or start a business. The principles are similar to that of a discretionary trust, with some key differences which also make a unit trust somewhat similar to a company:
- Beneficiaries in a unit trust are known as ‘unit holders’.
- Income and capital must be distributed by the Trustee/s to unit holders. The Trustee has no discretion to determine who gets what (unlike with a discretionary trust).
- Distribution of income and capital is ‘fixed’, proportionate to the quantity of units held by the unitholder (a bit similar to the concept of shares in a company).
- Unlike beneficiaries in a discretionary trust, unit holders have a propriety interest in the assets of the business.
- Units within a unit trust can be bought, sold, or transferred, which is why a unit trust is preferable for when separate entities, individuals, or families come together to run a business.
Unit holders do not necessarily need to be individuals. They can be other trusts (for example, a family trust) or a company.
Most people are familiar with the concept of a company. The use of a company may be better suited to large businesses, or where long-term growth is the primary goal. Some advantages of a company are:
- Unlike a trust, a Company is a separate legal entity in its own right. It can sue or be sued, it can contract with other parties and it can buy, hold, transfer, or sell its own assets.
- Shareholders do not own company assets and are not liable for its debts. This also means that a shareholder’s assets are not exposed to company creditors.
- A major advantage for a company over a trust is that it can reinvest profits back into itself, instead of paying shareholders a dividend. This allows a company to grow and is especially useful for companies in a ‘start-up’ phase.
- Unlike trusts which can have a termination date, a company has perpetual succession.
- A company can take advantage of competitive company tax rates payable on profits.
The above article has provided a brief summary on three of the more common business structures. However, each business is different and has its own unique needs.
If you would like tailored advice for your business, please contact our office to arrange an appointment.
Written by Heath Adams