Selecting the right business structure involves considering various factors such as asset protection and tax implications. Among the options are operating through a trading trust or a company. This article will explore the key considerations when making this decision.
Understanding Trading Trusts
A trading trust involves a trustee managing business assets and contracts on behalf of the trust, which can be an individual or a company. While a trust isn't a separate legal entity, the trustee assumes responsibility for the trust's operations and debts. Typically, using a corporate trustee can lessen owners' liability.
Exploring Companies
Companies are distinct legal entities from their directors and shareholders, granting them legal rights like individuals. Companies can acquire assets and enter contracts independently, with debts primarily belonging to the company rather than its directors or shareholders.
Factors for Business Owners to Consider:
1. ASSET PROTECTION
Opting to operate your business through a company offers significant asset protection benefits. Directors of a private company limited by shares are protected from the company's debts, given the company's status as a separate legal entity.
As a director, safeguarding against insolvent trading is a priority. Failure to prevent the company from trading while insolvent constitutes a breach of directors' duties, potentially rendering you legally liable for the company's debts during such periods.
Shareholders, however, generally bear no legal responsibility for company debts beyond any unpaid share amounts.
This asset protection advantage can extend to businesses structured as trusts, particularly when using a corporate trustee. Yet, the specifics depend on the terms outlined in the trust deed. Seeking legal counsel during the trust establishment phase is crucial.
If an individual serves as the trustee in a trading trust, personal liability risks emerge. In such cases, the trustee may face personal liability for the trust's debts, possibly leading to the use of personal assets to settle the trust's obligations.
2. CAPITAL GAINS TAX
Operating through a trading trust opens up the possibility of accessing small business capital gains tax (CGT) concessions, subject to specific criteria:
- A $2 million turnover; or
- A $6 million net asset value.
These concessions offer options to reduce, disregard, or defer capital gains from active assets used in small businesses. For instance:
If your business generates a profit from selling an asset, typically, you'd owe CGT on that gain. However, if your business meets the requirements—owning the asset for at least 12 months and being an Australian tax resident—you could qualify for a 50% CGT discount.
Notably, if your business operates as a company, it's ineligible for this discount. In contrast, a trading trust can leverage the 50% CGT discount, potentially providing significant tax advantages.
3. TAX EFFICIENCY
Using a trading discretionary trust often proves to be a highly tax-efficient approach to business management. Profits can be readily distributed among family members and other beneficiaries, allowing for distribution in a manner that minimizes tax obligations, typically at the lowest individual marginal tax rate, subject to specific regulations.
However, the prevalence of trading discretionary trusts is relatively low due to the trustee's discretion in determining distribution proportions, particularly when unrelated beneficiaries are involved.
In contrast, trading unit trusts are more common. In this structure, each investor or owner holds a defined number of units, similar to shares in a company. Consequently, distributions are fixed in proportion to each unitholder's units.
Regarding companies classified as 'base rate entities,' tax obligations are set at a rate of 25%. A company qualifies as a 'base rate entity' if its aggregated turnover for the income year is less than the aggregated turnover threshold for that income year, and 80% or less of its assessable income for that year constitutes base rate entity passive income.
4. WORKING CAPITAL
Companies have the flexibility to retain profits annually and reinvest them into business growth or opt to distribute dividends to shareholders, albeit without any obligation to do so.
In contrast, trusts operate differently regarding tax obligations. Unlike companies, trusts are not subject to corporate tax rates on their net income each fiscal year. Typically, if a trust distributes assets to beneficiaries, any resulting income—such as cash—is taxed at the beneficiary or unitholder level.
However, if your trading trust accrues net income for the year but doesn't distribute it entirely to beneficiaries or unitholders, the trustee becomes liable for tax payments on behalf of the trust. This liability entails taxation at the highest individual marginal rate.
5. INVESTMENT AND FINANCING
Choosing a company structure might be preferable if you anticipate raising capital through equity or debt financing. Investors and institutional lenders tend to favor companies over trusts, perceiving them as more secure investment options.
In addition, as a startup, you may consider your business to:
Qualify as an Early Stage Innovation Company (ESIC)
access Research and Development tax incentives, or
establish an employee share option scheme.
Operating as a company is often the more favorable choice.
6. COMPLIANCE WITH REGULATIONS
If your business operates via a trading unit trust and exceeds 20 unitholders, with these unitholders lacking involvement in daily operations, registering the unit trust as a managed investment scheme becomes mandatory. Failure to register when required incurs fines for the trustee.