When launching a new business, choosing the appropriate business structure will be necessary to its success. In this series of articles on business structures, we have been unpacking each structure’s advantages and disadvantages. Already we have looked at running your business as a sole trader, partnership and as a company. This week, we turn to consider the disadvantages of running your business through a trust.
What is a Trust?
As already discussed, a trust is not a separate legal entity, unlike a company. A trust is a structure in which a person or company (the trustee) owns property and carries out the business on behalf of the beneficiaries of the trust. Family businesses commonly structure their business as a discretionary trust. Each family member can then be made a beneficiary without having any involvement in how the business operates.
There are two main types of trust: discretionary and unit trust. With a discretionary trust, the trustee has complete discretion as to how to distribute the trust funds amongst the beneficiaries. A unit trust is advantageous when there is more than one family involved. Each unitholder receives a fixed amount of trust funds, consistent with the number of units held.
Trustees are legally liable for the trust’s debts. They can use the trust funds to satisfy the debts, but are personally responsible for covering the difference from their resources. This can be a disadvantage if the trustee is an individual rather than a limited liability company.
The trustee must apply for a tax file number and lodge an annual tax return. The trust is, however, not liable to pay tax.
What are the Disadvantages?
Although there are certain advantages to running a business through a trust, there are also disadvantages that we set out below.
- Expensive and complexity: Trusts can be expensive and complex to set up and administer.
- Liability: Trustees are legally liable for the debts of the trust. Although they can use the trust assets to meet those debts, they are responsible for any shortfall. You can limit liability where a trustee is a company rather than an individual. This is why it is generally recommended to have a corporate trustee.
- Investment: It may be difficult to borrow funds. Investors prefer to invest in a company structure rather than a trust structure.
- Dissolution and amendment: It is hard to dissolve or amend an established trust, particularly where children are involved. Varying the terms or objects of the trust could amount to resettlement and liability for capital gains tax and stamp duty arising.
- Retention of profits: Any profits retained and reinvested in the business will incur a penalty tax rate. Currently, the penalty tax rate is 49%. If the business requires working capital, then a company structure is more appropriate. Undistributed company profits are only taxed at the company rate, which is currently 30%.
- Losses: You cannot distribute losses, only profits of the business. Any profits earned will incur increased tax rates.
- Perpetuity Period: In New South Wales, the life of a trust is limited to 80 years.
As discussed last week in our business structure series, we set out the advantages of running your business through a trust. We hope that you can now better weigh up the disadvantages and decide whether it is the most appropriate structure for you and your business.
If you are looking into how to set up your business or are considering changing your business structure to one that is more beneficial to you, LegalVision’s business structuring experts can provide you with comprehensive and tailored advice.
Questions? Get in touch on 1300 544 755.