Explore 6 Essential Reasons to Choose a Discretionary/Family Trust for Your Business.

By Defy Gunadi February 18, 2024 | Tags: Business Structure, Trust and Asset Protection, Trusts

6 Reasons for Discretionary or Family Trust in Your Business:

Are you thinking of starting a business and wondering which structure is best for your new venture? Small businesses in Australia are undeniably the backbone of our economy, playing a pivotal role in its strength and resilience. Astonishingly, 97% of all businesses in the country fall into this category, with 61% of these being driven by self-employed individuals who are not just sustaining their livelihoods but are also committed to growth and job creation.

If you find yourself among this dynamic group, striving to expand your business, it’s likely you’ve been diligently researching to discern the most suitable business structure to safeguard your venture’s future and facilitate its growth.

This article is particularly tailored for you, whether you’re just embarking on your entrepreneurial journey or are already navigating the complexities of business ownership. Our intention is to demystify the decision-making process by presenting a comprehensive two-part series that delves into the merits of operating your business through either a company or a trust structure. Our goal is to arm you with the knowledge to make informed decisions that align with your business’s objectives and growth trajectory.

For new business owners, it’s crucial to approach entrepreneurship with a clear understanding and realistic expectations. Here are some vital fact checks to consider:

Business is Hard:

The notion of financial freedom is frequently hyped in the marketplace, often linked with the idea that building a business can be a direct path to wealth. Many enter the small business world with the belief that simply setting up a business will lead to significant success and autonomy within a few years. However, the reality is far more complex. Achieving stability and growth in the initial years requires a business owner to wear multiple hats. You must be prepared to take on the roles of operator, financial controller, marketing manager, and administrator simultaneously. Success demands not just a great idea but also the ability to execute it effectively across all aspects of the business.

Recently, one of our clients made the bold decision to sell her thriving business, a venture she had passionately built from the ground up since 2021. In just three years, she turned her start-up into a success story, with annual revenues surpassing the million-dollar mark. For many entrepreneurs, this level of achievement represents the ultimate dream.

However, for her, this dream quickly transformed into a daunting reality. Despite her talent for scaling businesses, she found the accompanying workload and operational responsibilities overwhelming.

Her true passion lay in driving growth, not in managing the day-to-day tasks that business expansion entails. Ultimately, she chose to sell her business to a larger entity, transitioning from business owner to employee within the same organization. This move allowed her to focus on what she loves most: fuelling growth without the burden of operational management.

Discretionary or Family Trust — **small business** owners finding themselves investing significantly more hours to stay ahead

The Myth of Flexibility

A common misconception about entrepreneurship is the promise of greater flexibility. While it’s true that owning your own business may offer some flexibility in managing your schedule, especially if you’re looking to replace a traditional wage, the journey towards significant growth and success tells a different story. In pursuit of expanding your business, you might find yourself investing double the amount of time and effort compared to your employees. This increased workload is essential to navigate the countless challenges and opportunities that come with business growth.

For a small business aiming for growth, the concept of flexibility often translates to a commitment that far exceeds the typical 9-to-5, with small business owners finding themselves investing significantly more hours to stay ahead.

Business in a Discretionary Trust

Having addressed the challenging realities and acknowledging these facts, if we’re still keen on running our own business, let’s explore why operating our business through a Discretionary Trust could be a wise decision.

The Discretionary Trust is not the most common structure for running a small business in Australia. However, it is favoured by accountants and lawyers for the significant tax advantages it offers their clients. Many clients find the concept of a discretionary trust and its relationship with a corporate trustee challenging to understand.

In this article, we will briefly touch upon what a discretionary trust entails, as our primary focus will be on ‘why’ rather than ‘what.’ For those seeking more in-depth information, please visit our e-book library, where you can find comprehensive insights on the Discretionary Trust structure and an operational guide.

trustee has the authority to conduct business operations on behalf of the trust

What is A Discretionary (Family) Trust

A trust is essentially an arrangement where an individual or a company agrees to hold assets for the benefit of others. The individual or company managing the asset is referred to as the ‘trustee,’ while those who benefit from the trust are known as the ‘beneficiaries.’ Consider the example of John and Sue Smith, who decide to establish a trust. They form a corporate trustee named “ABC Pty Ltd,” with both John and Sue serving as the directors and shareholders of this trustee company. Additionally, John and Sue are the primary beneficiaries of the trust, and any relatives of John and Sue are designated as secondary and general beneficiaries.

A trustee has the authority to conduct business operations on behalf of the trust, own shares in active companies, possess income-generating properties, engage in speculative ventures, or undertake any activity permissible for a company or individual. Importantly, the trust operates in such a way that it is not subject to the income tax rates applicable to proprietary companies. Instead, the trust files its own tax return and allocates profits to the beneficiaries.

Why Use a Discretionary Trust for your Business?

It Pays No Tax

Trusts don’t pay taxes in Australia. Surprisingly, this is a fact not many people know. Recently, one of the clients asked me if it is legal in Australia. Of course, it is legal in Australia. In Australia, trusts themselves are not typically subject to income tax. Instead, the tax responsibility is transferred to the beneficiaries of the trust based on their share of the trust’s income. This system is designed based on the principle that the income earned by the trust is ultimately for the benefit of the beneficiaries, and thus they should be taxed on it, not the trust entity itself.

Better Tax Planning

Yes, tax planning is legal. In fact, the ATO encourages people to engage in tax planning to steer clear of tax avoidance. Trusts, in particular, provide valuable tax planning opportunities by enabling the strategic distribution of income and tax liabilities among beneficiaries. This can enhance tax efficiency and potentially lessen the total tax load on both the business and its beneficiaries.

Take the example of John and Sue, who manage their small business via a Discretionary Trust. After drawing salaries, they report a business profit of $100K. They support two adult children, Julie and Joan, who are university students with annual fees of $20K each.

Additionally, Sue’s Aunt Sarah, who has been a supportive presence in their lives since her husband’s demise, depends on them financially. They also manage a Property Trust that incurs a $50K loss due to negative gearing. By allocating the profits as follows: $20K to Julie, $20K to Joan, $50K to the Property Trust, and $10K to Sarah, John and Sue can implement effective tax planning.

However, it’s crucial to navigate the intricacies of the reimbursement agreement rule, detailed in Section 100A, to ensure compliance and maximize tax benefits.

Capital Gain Discount

If you are operating a sellable business, which means you can sell your business to a third party when you decide to retire, your business becomes an asset. Unlike a company structure, the Discretionary Trust receives a 50% capital gains discount on the sale of assets.

For example, John and Sue decided to sell their business. They started the business with an initial investment of $100K, and after running it for 10 years, they decided to sell the business for $900K. Their capital gain is $800K, and the net capital gain is $400K after applying the 50% Capital Gains Discount. If they utilize other small business concessions like the 50% active asset discount and the small business retirement exemption, they can virtually reduce their tax to $0.

If you would like to learn more about how business capital gains tax works in a Trust, check out our case study on how Alex minimized his Capital Gains Tax to nil on a $2.85 million sale of a business.

No Div 7A Loan

Division 7A of the Australian Taxation Office (ATO) legislation is specifically designed to prevent private companies from making tax-free distributions of profits to shareholders or their associates in the form of loans or other payments that may not be treated as dividends. However, trusts are not covered by Division 7A because they are not considered companies under the Corporations Act.

In a trust structure, distributions are made to beneficiaries according to the trust deed, and these distributions are generally treated as trust income in the hands of the beneficiaries for tax purposes. Unlike companies, trusts distribute pre-tax income, and beneficiaries are taxed on these distributions at their personal income tax rates.

Since trusts are not subject to Division 7A, they do not have Division 7A loans. Instead, financial arrangements between trusts and their beneficiaries, or with other parties, must adhere to trust law and the tax laws applicable to trusts. If a private company beneficiary, entitled to income from a trust, does not receive the funds in its bank account within a specific period, and the trust retains the cash, it is considered that the company has ‘provided financial accommodation’ to its shareholder. In such cases, the arrangement with the private company beneficiary will be treated as if it falls under Division 7A.

Asset Protection

Creating a discretionary trust means your personal assets are held in the trust, keeping them out of reach from business creditors. Imagine setting up such a trust with you and your family as beneficiaries, and you or a company you control as the trustee. In this setup, creditors, whether they’re after your personal or business assets, can’t touch the assets in the trust, even though you might be a beneficiary or the trustee.

This protection stems from the fact that in a discretionary trust, beneficiaries don’t actually own the trust’s assets, nor do they have guaranteed rights to them. They only have the possibility of receiving distributions, based on the trustee’s decisions. Also, creditors can’t go after the trust’s assets for any personal debts of the trustee, as long as those debts weren’t incurred in their role as a trustee.

Consider the example of John and Sue mentioned earlier. They have a property trust that holds their investment properties. Their business creditors cannot gain access to this property trust.

Exit Strategy and Estate Planning

Very few business owners plan their exit strategy when starting their business, often uncertain if the business will succeed, let alone plan for the transition to the next generation. A trust structure can turn this uncertainty into a well-planned transition, allowing the next generation to take over. By making the children co-trustees of the business trust through a trustee company, they can manage the business while you retain control over profit distribution, ensuring better asset protection from potential claims by ex-in-laws (the children’s estranged spouses).

Referring to the earlier example of John and Sue, should they choose to pass on the reins of business management to their children, they can simply appoint Julie and Joan as directors of the trustee company, giving them control over the business venture.

John and Sue’s ‘Will’ can then address the future of the Trust structure (i.e. replacement of primary beneficiaries, appointors etc.) after they pass away.

How does Section 100A effects Trust Distribution advantage?

Section 100A serves as a safeguard against tax avoidance manoeuvres involving trusts. It specifically addresses situations where trust income, ostensibly destined for a beneficiary, is instead directed to another party through a prearranged agreement, with tax reduction as a motivating factor. This provision ensures the integrity of trust distributions, ensuring they are not exploited for unintended tax advantages, thereby upholding the principles of equitable tax contribution.

Using the previous example of John, Sue, and Sue’s Aunt Sarah, let’s clarify the situation: Suppose Aunt Sarah was not financially reliant on John and Sue, and they never provided her with financial support. However, if John and Sue choose to distribute trust profits to Aunt Sarah purely to achieve a more favourable tax result—while keeping the actual cash for themselves—this arrangement could be seen as tax avoidance. The key point here is that the profit distribution to Aunt Sarah should reflect genuine financial support, not just a strategy to reduce tax liabilities.

In conclusion, navigating the complexities of business structures can be a daunting task for any entrepreneur. The decision to operate your business through a Discretionary/Family Trust holds significant potential for tax advantages, asset protection, and strategic estate planning, all of which are crucial for the long-term success and sustainability of your venture. However, the intricacies involved in setting up and managing a trust correctly are substantial and require a nuanced understanding of legal and tax implications.

At Investax, we understand the importance of making informed decisions that align with your unique business goals and personal financial situation. Our team of experienced tax specialists is dedicated to providing tailored advice and solutions that encompass the full spectrum of business structure needs. Whether you’re just starting out or looking to restructure your existing business, Investax is here to ensure that your business not only thrives but is also positioned for optimal growth and protection.

Pro Tips

Knowledge is the Key to Success- You should read our e-book on the Discretionary Trust, where we explain the roles of the trustee, beneficiaries, appointors, and settlor within the trust.
Bringing Investors – If you’re planning to bring investors into the business or considering offering partnerships to key employees, a Discretionary Trust might not be the ideal structure for your needs.
Multi Structure Strategy for Asset Protection – If you’re considering implementing a discretionary trust for your business, it’s essential to develop a long-term strategy for both your business and investment journey. Explore how multi-structure strategies including a bucket company can help protect your assets and safeguard your hard-earned investments.
Compliance – Operating a business through a trust involves complex legal and tax compliance requirements. Stay informed about your obligations under Section 100A and other relevant regulations to avoid unintended tax consequences.
Seek Professional Advice – Given the complexities of these structures, consulting with an expert is crucial. Your accountant and tax advisors should provide the guidance you need. If you’re uncertain about your current accountant’s expertise, please don’t hesitate to contact Investax for assistance.