What’s in a name?
Many small businesses begin life as sole trader operations. The individual is the business, with full ownership and full liability. Business income (or loss) is declared in the personal tax return, and the operator has complete liability should things go pear-shaped.
A development of that concept is a partnership, which may involve a couple, two friends, or a small number of people. In respect of ownership, responsibility, liability, and taxation, partnerships are substantially similar to sole traders – simply divided up into more segments of ownership.
When an operating business grows significantly, it may wish to diversify or redirect risk, attract new investment, or seek to reduce taxation liabilities.
The two general choices are:
- Trust
- Company
Further, trusts can also operate as:
- Discretionary trusts
- Unit trusts
Trust – discretionary or unit?
A trust is an entity that is set up so that the trustee has responsibility for administering the business in compliance with a trust deed. The trustee has discretion as to how the profits of the business are directed to the beneficiaries and may apportion those profits to attain the most beneficial taxation result, with each beneficiary paying tax at their individual rate. Discretionary trusts are quite often referred to as family trusts, and often suit a family business operation, with significant versatility in the efficient distribution of profits.
However, where beneficiaries are not as personally connected, it may well be that they need a far more defined degree of ownership. In such cases, a trust may be divided into several equal parts, or units, and remuneration of profits will be equally distributed amongst the beneficiaries, who are now unit holders. Taxation remains at personal rates, and as with individuals, the trust can take advantage of the 50% discount on certain capital gains.
Assets of a trust are owned by the trustee, and therefore have a degree of protection from adverse beneficiary circumstances. While a trust can distribute profits, it cannot distribute losses, which must remain within the trust. Since trustees hold ownership, they also hold liability, and it is for this reason that trusts will often be configured with a company specifically established with the sole purpose of being trustees.
Trusts involve certain setup costs involving the trust deed, however, the most obvious disadvantage becomes apparent when a business is growing rapidly with increasing profits. Personal tax rates may become onerous, and new investors may well desire the security and credibility of an incorporated company.
In good company
While a trust is not a separate legal entity, a company is and provides complete separation of liability. While a company may have no access to capital gains concessions, it pays tax at current company tax rates, which may well be somewhat less than the top marginal personal rates.
The shareholders of the company are completely removed from liability, which is held by the directors of the company, and they have defined obligations under the Corporations Act. Nevertheless, in a limited liability company, the directors are not personally liable, except for fraud or deliberate abuse of power.
The company structure has specific establishment costs, as well as the ongoing costs of ASIC reporting and taxation declaration.
Growing businesses will eventually arrive at a point where a more formal structure is desired. Whether that is in the form of a trust or a company will depend upon many factors, making sound professional advice imperative.
