A trust is an artificial legal construct that best describes a relationship between individuals. A trust relationship exists where there is a separation between legal ownership of an asset and the persons entitled to benefit from that asset (called beneficial ownership). Let me explain:
If I owned a block of land, and I said to you: “I am giving you this block of land, and I want you to hold it for the benefit of my children.” Do you own the land, or do my children?
In this hypothetical scenario, there is a division between legal ownership of the land and beneficial ownership. Having gifted the land to you, you will legally own that land (i.e. the title will be in your name). However, my gift to you was subject to certain conditions – namely that you hold the land for the benefit of my children – and therefore, your rights as owner of the land remains subject to my overriding wishes. This is the essence of a trust.
In the above example, you are known as the trustee of the trust and my children will be the beneficiaries. Legally, I would be referred to as a settlor, being the person who made the initial gift, and the terms and conditions that I have placed on you as a trustee will be written down in a trust deed. That’s it – the basics of trust law.
You are probably wondering how the above translates into a business structure? Fair call. Imagine the gift wasn’t land but rather a sum of money, and the trust deed authorised the trustee to do practically anything it wanted with that money to generate income and capital growth of the initial gift, provided always that the proceeds flow to the beneficiaries. The trustee could, theoretically, start a business with that money, and that business would be operated by the trustee for the benefit of the beneficiaries. You now have a business operating under a trust structure.
A few things to note before going any further:
- The trustee can be an individual or a company (referred to as a corporate trustee). In a business setting, a corporate trustee is always recommended, as it clearly delineates between the trust assets and your personal assets; and
- Beneficiaries can be individuals, classes of individuals (e.g. “all my children” without necessarily naming them), companies, or even other trusts.
There are many different types of trust that can be implemented. For the purpose of this post, I’ll focus on the two most common: discretionary trusts and unit trusts.
Under a discretionary trusts (often called a family trust), the trust deed specifies certain classes of beneficiaries that are entitled to receive the proceeds of the trust. The trustee is then granted the discretion to distribute those proceeds among the various beneficiaries in any way it deems fit and in its absolute discretion. This flexibility allows the trustee of a trust to distribute income to several family members, taking advantage of lower marginal tax rates (e.g. income derived from a business can be split with a stay at home spouse, thereby taking advantage of that spouse’s lower tax rate). A specific beneficiary under this type of trust does not have a right to the trust money unless and until the trustee decides to distribute funds to that beneficiary. So, in the above diagram Jane could distribute income to her spouse and children if she wanted to, but she is not required to distribute to any of them if she didn’t wish to do so.
A unit trust on the other hand divides the trust fund into units. The beneficiaries (called unit holders) hold the units in the trust and become entitled to the proceeds of the trust in proportion to the number of units they hold (e.g. if you hold 10% of the units, you will receive 10% of the proceeds). For this reason, holding units in a unit trust is similar to owing shares in a company.
When a business is operated by a trustee of a trust, the profits of the business flow through to the beneficiaries and are taxed at each beneficiary’s applicable rate. Some clients have understood this to mean that trusts don’t pay any tax – which is true in a way, but also not entirely accurate. Whilst the profits of the trust are not taxed at the trust level, that money is certainly taxed when it is distributed to each individual beneficiary.
Importantly, the trustee must distribute the profits of the trust each financial year, as a failure to do so will result in those funds being taxed at the top marginal rate (45%). This is one key difference between a trust and a company – as a company is able to retain cash reserves which are taxed at the company tax rate (which is 27.5% for small businesses, or 30% for all other companies).
Almost all modern business structures will involve a trust in some way. Even where your business is operated by a company, it is highly likely that the shares in that company will be held by your family/discretionary trust (see the diagram in this post for example). This allows for the dividend income to be split in a tax effective manner and opens up certain CGT discounts which are available if you sell any shares in that company.
Trusts open up the possibility of income splitting among a household. This can be incredibly beneficial from a tax perspective, particularly if your spouse is a stay at home parent and not otherwise earning an income. Distributions directed to that spouse will attract the $18,000 tax free threshold, and then likely a lower marginal rate. Therefore, trusts are a highly flexible and critical component of effective tax planning.
Given that running a business involves risk, assets that are held on trust are somewhat isolated from those risks. In the event that you become bankrupt, a family trust gives you scope to keep trust asset away from a trustee in bankruptcy.
Limited use if you are single (or your spouse is a high income earner)
Given that trusts open up the possibility of income splitting, it stands to reason that that will not be of much benefit if you do not have anyone to split that income with. Further, if you and your spouse are both high income earners, the benefits are significantly limited.
Costly and complicated
Of the basic business structures that I have covered on this blog, a trust is the most costly and complicated structure to establish and administer. These costs are ongoing, as each year you will need to document proper resolutions showing which beneficiaries received a distribution of trust income, as well as the usual returns for the trust and each individual beneficiary. When you add in the costs of establishing and administering a corporate trustee, it all adds up.