Choosing the right structure for your business is vital for its success and sustainability. One option that offers significant advantages is operating as a family trust. You may have heard that small business owners who run their business structure in this structure actually save tax – do they really?
In this blog post, we will explore the advantages and disadvantages of running your business as a trust and we’ll highlight the importance of preparing a distribution minute before 30 June each year.
Advantages of a Trust Structure
1. Tax Efficiency
Trusts can provide substantial tax benefits by allowing income to be distributed to beneficiaries in lower tax brackets, thereby reducing the overall tax liability. This is particularly advantageous for families or groups with members who have varying income levels. *(Refer example below).
2. Asset Protection
Assets held in a trust are generally protected from creditors, as they are owned by the trust and not by individual beneficiaries. This can safeguard family wealth and business assets from personal liabilities. You may have heard before that (similar to a trust), a company structure offers asset protection. Both structures offer limited liability, though a company structure may provide more straightforward asset protection due to direct ownership of assets.
3. Flexibility in Income Distribution
Trusts offer flexibility in distributing income and capital among beneficiaries. Trustees can allocate funds based on the needs and circumstances of each beneficiary, which can be particularly useful for managing family finances and ensuring funds are available for significant expenses like education or healthcare.
4. Succession Planning
Trusts facilitate smooth succession planning by allowing assets to be transferred to the next generation without the need for probate. This ensures that family wealth is preserved and passed on according to the wishes of the trust’s settlor.
5. Capital Gains Tax (CGT) Benefits
Trusts can benefit from the 50% CGT discount on the sale of assets held for more than 12 months, resulting in significant tax savings when disposing of long-term investments.
Differences between a Trust structure and a Partnership structure
A partnership is a more simple way of family members to share income. Under both structures, partners / beneficiaries are not legally required to pay themselves superannuation.
Here are the key differences:
- In a family trust, the trustee has the discretion to decide how income and capital are distributed among the beneficiaries each financial year. This allows for flexible and tax-efficient distributions based on the needs and tax positions of the beneficiaries. The amounts distributed to each beneficiary can vary from year to year, depending on the trustee’s decisions.
- In a partnership, profits and losses are distributed according to the partnership agreement, which typically specifies a fixed profit-sharing ratio for each partner. Each partner receives a share of the profits proportional to their ownership interest or as agreed upon in the partnership agreement.
- Trustees of a trust can distribute income to beneficiaries in lower tax brackets, thereby reducing the overall tax liability of the family. Trusts can benefit from the 50% Capital Gains Tax (CGT) discount on assets held for more than 12 months, which can be distributed to beneficiaries.
- Within a partnership structure, each partner is taxed individually on their share of the partnership’s income. The income is added to their personal tax return and taxed at their marginal tax rate. Unlike a family trust, a partnership does not offer the same flexibility for income splitting to minimise tax liability.
- A partnership is cheaper and easier to set up than a family trust.
- Beneficiaries of a trust can include immediate and extended family members, related entities, and sometimes other individuals or entities as specified in the trust deed. Beneficiaries do not need to be involved in the family business or work in it as their primary job.
- Partners are typically involved in the management and operation of the business. Their share of profits is often linked to their contribution to the business. Partners share joint and several liability for the debts and obligations of the partnership, which can expose their personal assets to risk.
- The trust deed governs the operation of the trust and outlines the rules for distributions. Trustees must prepare minutes and resolutions to document decisions about distributions, especially before the end of the financial year (30 June).
- The partnership agreement outlines the terms of the partnership, including profit-sharing ratios, roles, and responsibilities. Partnerships generally have fewer administrative requirements compared to trusts, but partners must still maintain accurate financial records and file partnership tax returns.
- In a partnership, tax losses are allocated to individual partners based on their ownership interest, allowing them to offset these losses against their other income, subject to non-commercial loss rules. In contrast, a trust retains its tax losses within the trust and cannot distribute them to beneficiaries. These losses are carried forward and can only be used to offset future income of the trust, provided the trust meets specific tests related to ownership or control.
Example of the tax efficiency afforded by a Family Trust Structure
Let’s consider the Smith Family Trust, which has been set up by John and Jane Smith. The trust has three beneficiaries: John, Jane, and their adult daughter, Emily. The trust generates an annual income of $120,000.
Scenario Without a Family Trust
If John and Jane were to receive the entire $120,000 income directly, they would be taxed at their respective marginal tax rates. Assuming both John and Jane are in the highest tax bracket (47% including Medicare levy), the tax payable would be:
John’s Tax: $60,000 * 47% = $28,200
Jane’s Tax: $60,000 * 47% = $28,200
Total Tax Payable: $28,200 + $28,200 = $56,400
Scenario With a Family Trust
Using the family trust, the trustees can distribute the income to the beneficiaries in a tax-efficient manner. Let’s assume the following distribution:
John: $40,000
Jane: $40,000
Emily: $40,000
Assuming Emily has no other income and is in a lower tax bracket, the tax payable would be:
John’s Tax: $40,000 * 32.5% = $13,000
Jane’s Tax: $40,000 * 32.5% = $13,000
Emily’s Tax: $40,000 * 19% = $7,600
Total Tax Payable: $13,000 + $13,000 + $7,600 = $33,600
Tax Savings
By distributing the income through the family trust, the Smith family can significantly reduce their overall tax liability:
Without Trust: $56,400
With Trust: $33,600
Tax Savings: $56,400 – $33,600 = $22,800
This example illustrates how a family trust can be used to distribute income to beneficiaries in lower tax brackets, thereby achieving substantial tax savings.
Important note! The above scenario may not always be practical and apply to your specific situation (which we will outline further below by way of an example). For the above scenario to work and be a practical long-term solution, you’ll need to have beneficiaries whom it is going to be tax-effective to send distributions to – over a long period of time (i.e. not just a year or two).
Circumstances Where a Family Trust Distribution May NOT Be Viable
While family trusts offer numerous benefits, there are certain situations where a trust distribution strategy, like the one outlined in the example, may not be the most effective or viable option. Here are some scenarios where a family trust distribution may not work well:
1. High Compliance and Administrative Costs
Managing a family trust is complex and will require professional advice, which can be costly. The administrative burden of maintaining accurate records, preparing trust minutes, and ensuring compliance with tax laws can be significant. The costs associated with setting up and maintaining a trust, including legal and accounting fees, may outweigh the tax benefits, especially for smaller businesses.
2. Limited Beneficiaries
If your family is small and there are few beneficiaries, the ability to distribute income across multiple lower tax brackets is limited. This reduces the potential tax savings. Furthermore, if the business intends to distribute income to non-family members or unrelated entities, a family trust may not be the best structure due to the restrictions typically placed on beneficiaries. (In short, beneficiaries will typically include immediate and extended family members, related entities and and sometimes other individuals or entities as specified). The trust deed may exclude certain individuals or entities from being beneficiaries. For example, some deeds exclude individuals who are not related by blood or marriage.
3. High Income Beneficiaries & Distributions to minors
High Tax Brackets: If the beneficiaries are already in high tax brackets, distributing income to them may not result in significant tax savings. In such cases, the flat corporate tax rate of a company might be more advantageous. Distributions to minors are taxed at higher rates on unearned income, which can negate the tax benefits of using a trust.
4. Business Growth and Investment Needs
Reinvestment: If the business requires significant reinvestment of profits for growth, a company structure might be more suitable. Companies can retain earnings and reinvest them without immediate tax implications for shareholders.
Capital Raising: Companies can issue shares to raise capital, which is not possible with a trust structure. This can be crucial for businesses looking to expand or attract investors.
5. Asset Protection and Liability
Directors’ Liability: While a corporate trustee provides limited liability, the directors of the corporate trustee can still be personally liable for certain actions. In some cases, a company structure might offer clearer and more straightforward asset protection. Sole Trader Risks: For very small businesses or sole proprietors, the simplicity and direct control of a sole trader structure might be preferable, despite the lack of limited liability.
6. Regulatory and Reporting Requirements
Trust Reporting: Trusts have specific reporting requirements, including the preparation of trust tax returns and distribution statements. This can be burdensome compared to the relatively straightforward reporting requirements for sole traders.
While companies have their own set of regulatory requirements, they may offer more streamlined processes for certain types of businesses, particularly those with significant administrative resources.
7. If you set up a family trust to divert income that is essentially employment income to family members and beneficiaries, you are in breach of the personal services income (PSI) laws. This scenario highlights that a family trust is not the correct structure for handling such income.
Example 1: Scenario Where a Family Trust May NOT Be Ideal
Scenario: Family-Owned Retail Business with high operational costs
Type of Business: A family-owned retail store selling clothing and accessories.
Operational Costs: High fixed costs, including rent, utilities, and inventory.
Revenue: Moderate and stable, but with thin profit margins.
Family Members: The business is run by a couple, with occasional help from their adult children.
Challenges with a Family Trust Structure:
High Operational Costs:
Income Distribution: The primary benefit of a family trust is the ability to distribute income to beneficiaries in lower tax brackets. However, if the business has high operational costs and thin profit margins, there may not be sufficient income to distribute, reducing the tax efficiency benefits.
Cash Flow Management: The need to distribute income to beneficiaries can strain the business’s cash flow, especially when operational costs are high and profits are low.
Administrative Complexity:
Record-Keeping: Managing a family trust requires meticulous record-keeping, including preparing trust minutes and ensuring compliance with the trust deed. This can be burdensome for a small retail business where the owners are already stretched thin managing day-to-day operations.
Professional Fees: The costs associated with legal and accounting services to maintain the trust can be significant, potentially outweighing the tax benefits for a business with modest profits.
Limited Beneficiaries:
Small Family Size: If the family is small and there are few beneficiaries, the ability to distribute income across multiple lower tax brackets is limited. This reduces the potential tax savings.
Non-Family Employees: If the business relies primarily on non-family employees, a family trust may not be the best structure, as it primarily benefits family members.
Asset Protection:
Personal Guarantees: Retail businesses often require personal guarantees for leases and supplier agreements. While a family trust provides some asset protection, personal guarantees can still expose the owners’ personal assets to risk.
Corporate Trustee Costs: Using a corporate trustee can provide additional asset protection, but it also adds to the complexity and cost of managing the trust.
Alternative Structure: Sole Trader or Partnership
Simplicity: A sole trader or partnership structure is simpler to manage, with fewer administrative and compliance requirements.
Direct Control: The owners have direct control over the business and its finances, allowing for more straightforward decision-making.
Cost-Effective: Lower setup and ongoing costs compared to a family trust, making it more suitable for a business with thin profit margins.
Flexibility: Easier to manage cash flow and reinvest profits into the business without the need to distribute income to beneficiaries.
Conclusion
In this scenario, setting up as a family trust may not be ideal due to high operational costs, limited income for distribution, administrative complexity, and the need for direct control and flexibility. A sole trader or partnership structure would be more suitable for managing the business efficiently, minimizing costs, and allowing for straightforward decision-making. Consulting with a qualified legal or tax adviser is recommended to determine the best structure for the specific needs and goals of the family-owned retail business.
Example 2: Scenario where a Family Trust may NOT be ideal
Scenario: Tech Startup Seeking Venture Capital
Type of Business: A tech startup developing innovative software solutions.
Growth Stage: Early-stage, looking to scale rapidly.
Funding Needs: Requires significant capital investment to develop products, hire talent, and expand market reach.
Ownership: Founders are considering bringing in external investors.
Challenges with a Family Trust Structure:
Capital Raising:
Investor Reluctance: Venture capitalists and other external investors typically prefer investing in companies (corporations) rather than trusts. This is because companies offer shares that represent ownership, which can be easily bought, sold, or transferred.
Equity Issuance: A family trust cannot issue shares, making it difficult to attract investors who seek equity stakes in exchange for their investment.
Complexity and Compliance:
Administrative Burden: Managing a family trust involves significant administrative tasks, including preparing trust minutes, ensuring compliance with the trust deed, and managing distributions. This can be burdensome for a fast-growing startup that needs to focus on scaling its operations.
Regulatory Requirements: Trusts have specific reporting and compliance requirements that may add complexity and cost, which can be a distraction for a startup.
Tax Considerations:
Reinvestment Needs: Startups often need to reinvest profits back into the business to fuel growth. In a family trust, distributing income to beneficiaries may not align with the need to retain and reinvest earnings.
Tax Efficiency: While family trusts offer tax efficiency through income distribution, the startup may not generate significant profits initially. The tax benefits of a trust may be less relevant compared to the need for reinvestment and growth.
Control and Decision-Making:
Decision-Making Flexibility: Startups require agile decision-making processes. The need to consult trustees and adhere to the trust deed can slow down decision-making, which is critical for a startup’s success.
Founder Control: Founders may prefer to retain direct control over the business, which is more straightforward in a company structure where they can hold majority shares and make decisions as directors.
Alternative Structure: Company
Equity Financing: A company structure allows the startup to issue shares and attract venture capital and other forms of equity financing.
Limited Liability: Shareholders have limited liability, protecting their personal assets.
Reinvestment: Companies can retain earnings and reinvest them into the business without immediate tax implications for shareholders.
Regulatory Framework: While companies have their own compliance requirements, they are often more familiar and acceptable to investors and financial institutions.
Conclusion
In this scenario, setting up as a family trust would not be ideal due to the need for significant capital investment, the complexity of managing a trust, and the importance of agile decision-making. A company structure would be more suitable for attracting investors, retaining earnings for growth, and providing the founders with the flexibility and control needed to scale the business rapidly.
Importance of the Distribution Minute Before 30 June
The end of the financial year, 30 June, is a critical date for trusts. Trustees must make resolutions regarding the distribution of trust income by this date to ensure that beneficiaries are made presently entitled to the income for that financial year. Failure to do so can result in unintended tax consequences, such as the trustee being assessed on the trust’s net income at the top marginal tax rate.
Trustees must ensure that their resolutions comply with the terms of the trust deed. This includes verifying that the intended beneficiaries are within the class of persons who can be appointed trust income and are not excluded from being beneficiaries.
Resolutions must be clear and unambiguous to avoid any disputes or misunderstandings. Ambiguity in resolutions can lead to unintended tax outcomes and potential legal challenges.
If trustees wish to make beneficiaries specifically entitled to franked dividends or capital gains, they must make specific resolutions dealing with these entitlements by 30 June. This ensures that the correct tax treatment is applied to these distributions.
Trustees should notify beneficiaries of their entitlements within a reasonable time of them becoming entitled. This helps beneficiaries understand their tax obligations and ensures transparency in the administration of the trust.
Conclusion
Choosing the right business structure is crucial for the success and sustainability of your enterprise. Operating as a family trust offers significant advantages, particularly in terms of tax efficiency, asset protection, flexibility in income distribution, succession planning, and capital gains tax benefits. By distributing income to beneficiaries in lower tax brackets, a family trust can help reduce overall tax liability, as demonstrated by our Smith Family Trust example.
However, a family trust is not without its drawbacks. High compliance and administrative costs, limited beneficiaries, high-income beneficiaries, and specific business needs such as reinvestment and capital raising can make this structure less suitable for certain businesses. For instance, family-owned retail businesses with high operational costs and tech startups seeking venture capital might find the administrative burden and complexity of a family trust prohibitive.
In contrast, simpler structures like sole proprietorships or partnerships might be more appropriate for smaller businesses with thin profit margins, while companies offer better avenues for raising capital and retaining earnings for growth.
The importance of preparing a distribution minute before 30 June cannot be overstated. Trustees must resolve trust income distributions by this date to ensure tax efficiency and compliance with trust deed terms. Clear and unambiguous resolutions, specific entitlements for franked dividends or capital gains, and timely notification to beneficiaries are essential practices for avoiding unintended tax consequences and ensuring smooth trust administration.
In summary, while a family trust can provide substantial benefits, it is essential to carefully consider your specific circumstances and seek professional advice to determine the most appropriate structure for your business. For more information and to discuss if a family trust structure is right for you, don’t hesitate to get in touch with our team.
