Case Study: How To Give Your Business The Benefits Of Both Companies And Trusts
Both companies and trusts have attractive features when it comes to asset protection, wealth creation and managing taxes. Which type of entity you choose to trade your business through will depend on your vision for your business, your appetite for risk and your long term wealth creation goals. For some people a simple company or discretionary trust will suffice, however where your business plans and wealth creation plans are more ambitious it would be great to be able to combine the benefits of both companies and trust. I am going to use Liam and Adele as a case study to demonstrate how we helped a client achieve just this. But first, let’s revisit what makes companies and trusts individually so appealing.
Companies
The key features of a company are:
It is a separate legal entity to that of its owners giving it limited liability.
Companies are taxed at a flat rate, currently 26% provided certain conditions are met (if it is trading and has a turnover of less than $50m it will be subject to the lower rate, all other companies are taxed at 30%) and reducing to 25% from 1 July 2021 onwards.
Generally there is the ability for profits to accumulate in the company (see our blogs FAQ: What is personal services income and do I earn any? and FAQ: What is a personal services business and is my business one? that explains the situations where profits must be paid out).
Opportunity to pay franked dividends to shareholders (check out our blog FAQ: Dividend, bonus or directors fee, which is better? for an explanation of how franking credits work).
Selling of shares makes transfer of ownership easy, if you want to bring in a business partner or exit your business altogether.
Discretionary trusts
Key features of discretionary trusts are:
Flexibility in the distribution of profit to trust beneficiaries who are then taxed at their marginal tax rate (at the time of writing the tax free threshold for individuals is $18,200 and a tax rate of 19% applies on income between $18,200 and $45,000 which is obviously lower than the company rate of tax), and if a company receives the distribution then taxed at the applicable company rate (this is explained further below). Caution should be used in distributing income to minors. Only the first $416 is tax free. Income between $416 and $1,307 is taxed at 66% and income over $1,307 is taxed at 45%.
Profits generally do not accumulate in a trust. Income must be distributed at the end of the financial year otherwise it attracts tax at 45%. Funds for working capital and expansion must then be lent back to the trust from after tax dollars. For example if the trust earns $100 which is taxed at 47% (as it is distributed to an individual on the highest marginal tax rate) there is $53 available to reinvest back in the trust. However for a company that has the ability to retain profits, if it earns $100 and is taxed at 26% in 2021 then it has $74 available to reinvest back in the company. This will be $75 in 2022 and ongoing.
With a company acting as trustee, a trust also has the benefit of limited liability.
Losses cannot be distributed to beneficiaries and can only be offset against future income provided that a number of requirements are met.
Case study facts
Now let’s take a look at how we helped Liam and Adele:
Liam studied marketing at university and has worked in marketing since he graduated.
Adele has had extensive experience in operations management for large corporations.
They are both aged 45 and have children aged 15 and 17 both children have the intention of attending university full time.
Their business plan was to quickly grow and be earning $600,000 per year in profit and then growing to $1 million. They had the contacts and experience to be able to fulfil this plan.
They had ideas of investing in other businesses and possibly a share portfolio.
The issues
The issues that Liam and Adele were faced with were:
Potentially wanting to start other new businesses after their law firm but not wanting to risk it not working out and losing both businesses.
Needing cash to reinvest in and grow their business.
The desire to build wealth.
What we did
To address these issues we:
Registered a new company, Liam & Adele Holdings Pty Ltd that is to be the trustee of Liam & Adele Family Trust.
Established Liam & Adele Family Trust, where the beneficiaries are Liam, Adele, their children and others as defined by the trust deed, including the potential to add a company as a beneficiary.
Established Liam & Adele Trading Pty Ltd where the shareholder is Liam & Adele Family Trust and Liam is the director.
Liam & Adele Family Trust is also to be the shareholder of any other trading companies established by Adele and Liam as well as the owner of any assets/investments with the exception of their family home.
The result
By doing this we were now in a position to:
Be able to accumulate profits in Liam & Adele Trading Pty Ltd as a tax effective means of growing the business ($74 of every hundred earned can be reinvested in 2021 and then $75 from 2022 onwards verus $53 of every hundred for a trust).
Pay surplus cash in the business to Liam & Adele Family Trust as fully franked dividends, protecting it from potentially hostile creditors (see our blog FAQ: Dividend, bonus or directors fee, which is better? for more information).
Ability to pay distributions from the Liam & Adele Family Trust to their children (once they turn 18) to pay for their university education. If they are only distributed franked dividends from the trust and their taxable income did not exceed $18,200 they would receive a 100% refund of the franking credit amount (see our blog FAQ: Dividend, bonus or directors fee, which is better? for an explanation of how franking credits work).
Ability to purchase other income earning assets in the Liam & Adele Trust and have flexibility over who in the family receives the income.
Have asset protection for the other income earning assets as their trading business is in a separate legal entity to the one holding their assets.
Liam & Adele can loan back funds to the Liam & Adele Family Trust for the purpose of purchasing further assets or they may choose to gift the money to the trust. A deed of gift legal document and is another strategy in providing asset protection. Any loan from Liam to the trust is an asset of Liam’s. If Liam is sued in his capacity as a director of Liam & Adele Trading Pty Ltd then the value of the loan is available to pay any liability that arises. A deed of gift prevents this.
I have illustrated this result in the Liam & Adele Family Group Structure chart in part 1. The solid pink lines in the chart represent the relationships between the entities and the dotted pink lines the flow of cash.
What next?
As Liam and Adele’s children get older and start earning their own income there is no benefit in distributing income to them. Their home is paid for and their cash requirements are no longer as great and with the profits in the business continuing to grow the question becomes what to do with the surplus cash? This is where Part 2 of the Liam & Adele Family Group Structure comes into play. What we will do next to cater for Liam and Adele’s change in circumstances is:
Register Liam & Adele Investments Pty Ltd
This will be the trustee of Liam & Adele Investment Trust.
Setup Liam & Adele Investment Trust
This will own the shares in Liam and Adele Wealth Pty Ltd.
Register Liam and Adele Wealth Pty Ltd
This gives the Liam & Adele Family Trust the ability to distribute income to a corporate beneficiary. Assuming that this company is set up after 1 July 2021 it will be taxed at 25% so long as no more than 80% of the distribution it receives from the Liam & Adele Family Trust is from passive sources (eg rents, dividends, interest). Note that any dividend income flowing through from Liam & Adele Trading Pty Ltd is not considered passive and retains its character for the purpose of determining if the 25% tax rate applies.
If Liam & Adele Wealth Pty Ltd only receives fully franked dividend income belonging to Liam & Adele Trading Pty Ltd then it will have no further tax to pay. If it were to receive other types of income distributions and no more than 80% of it passive then the remainder of the income would also be taxed at 25%. If more than 80% of the distribution is passive income then the income would be taxed at 30% and a tax credit for the Liam & Adele Trading income received.
The distribution from Liam & Adele Family Trust needs to be paid in physical cash otherwise there is an unpaid present entitlement to trust income which would require loan agreements to be put in place or face unpleasant tax consequences.
Liam and Adele Wealth Pty Ltd will be able to accumulate profits and with the help of a financial planner invest in appropriate assets to further grow their wealth.
Should Liam and Adele ever need to access funds from Liam and Adele Wealth they can do so tax effectively by paying a fully franked dividend to Liam and Adele Investment Trust where there is the flexibility to distribute to Liam, Adele, their children and other individuals (which could include parents and grandchildren) as defined and allowed for in the trust deed.
Furthermore, if Liam and Adele Trading Pty Ltd has an unexpected opportunity to expand and needs extra funding to do so, Liam & Adele Wealth Pty Ltd can loan money back to Liam & Adele Trading Pty Ltd with a loan agreement in place and taking security over the assets of Liam & Adele Trading Pty Ltd. If Liam & Adele Trading Pty Ltd were successfully sued for any reason and the company needed to be liquidated in order to pay, Liam & Adele Wealth Pty Ltd’s loan would be repaid first. Our blog post The problem with leaving profits in your company talks about this further.
This strategy is illustrated in Part 2 of the Liam & Adele Family Group Structure chart.
Other considerations
This is a complex structure and is not for everyone. We recommend getting separate legal advice in relation to who the trust appointor/s (the person or people who have ultimate control of a trust) should be. Careful consideration needs to be given to who should be the director/s of the various companies and who should be the shareholders of the trustee companies. Consideration also needs to be given to the appropriateness of using gifts when getting money into trusts from beneficiaries. Finally a review of a trust deed should be conducted prior to adding a corporate beneficiary. This can only be done if the trust deed allows. Accounting Heart works hand in hand with a number of lawyers who provide such advice and can provide a referral if requested.
Final words
The establishment of any group structure is never simply a matter of set and forget. It is something that should be regularly reviewed and amended as needed (added to and subtracted from). Furthermore once you have started a business in a particular structure you aren’t necessarily locked into it. There are restructuring options available and relief from paying capital gains tax (CGT) if the entity qualifies for the small business restructure rollover.
This blog post was written in March 2021 and is in accordance with all tax rates and legislation applicable at that time.
If you would like specific advice tailored to your business and circumstances, Accounting Heart offers affordable service packages where you can work with Sonia one-on-one to help you get your business where you want it to be. Book your FREE Discovery Call to find out more.
Disclaimer: This is general information only and is not advice of any sort. No warranty or representation is provided by Accounting Heart Pty Ltd as to the accuracy, currency or completeness of the information contained in this blog. Readers of this blog should not act or refrain from acting in reliance upon any information contained herein and must always obtain appropriate taxation and / or other advice as may be appropriate having regard to their particular circumstances.