There’s a lot of misunderstanding surrounding family trusts and why they get so much attention from the tax office. It’s not all about the tax. So to help dispel the myths, here’s an in-depth breakdown of the pros and cons of family trusts and what to consider when establishing structures for trading entities.
It is probably safe to assume that you are aware of what a family trust is, however just in case: a family trust is essentially a trust that has been established to hold assets or run a business on behalf of a family. Usually, a family member will manage the trust as trustee [or director of a corporate trustee] and the profits are distributed at the discretion of the trustee in accordance with the trust deed. There are no fixed entitlements to distributions in a discretionary family trust.
Although a family trust can be used to run a business, and it can have tax advantages from doing so [via tax effective distributions to entities and individuals], that does not always make it the best vehicle for a business. Much like purchasing assets to get depreciation deductions – you should never do something just for the tax benefit.
profits must be distributed
While not technically true that profits must be distributed [the trustee can always choose not to distribute the profits and pay tax at the highest marginal rate], it is unlikely anyone actually wants to proactively do that.
So, with that aside the profits of the family trust will usually then be distributed to eligible beneficiaries. It’s this profit distribution that many trustees use to take advantage of family members with lower tax rates if available or sending it off to a bucket company [watch out for Unpaid Present Entitlement issues]. As a family trust is a discretionary trust, the trustee can change who and where they distribute profits to each year [don’t forget your trustee resolution!]
However, this process of benefiting from lower tax rates or using a bucket company creates three problems:
- no retained working capital in the business
- no fixed entitlement to income to assist with personal lending, and
- income must be distributed for tax purposes every year.
retaining working capital requires a work around
One of the impacts of distributing profits to beneficiaries is that if the business requires retained profits for working capital, it effectively needs part or all the distributions to be lent back into the trust.
If these loans come from a bucket company, they will be caught by the private company loan rules contained in Division 7A of the Tax Act, just to ensure the trust can use its own business profits to meet its future capital needs.
The rules contained in Division 7A apply to payments, loans and assets of a private company provided to shareholders and their associates. These loans and assets can be treated as deemed dividends with no franking credits unless they are put on complying loan terms with minimum interest and repayment amounts. These rules now also extend to Unpaid Present Entitlements owed to private companies that are reinvested in working capital of the Trust.
problems with finance
Whilst I have heard it said that there can be problems accessing funding for family trusts from financial institutions because the structure is complicated, I don’t find this to be a problem specifically for the trust. If the business can pass all other bank requirements, and the bank is educated on the structure, just being in a trust should not necessarily stop it from getting a loan.
However, a family trust can impact the ability for family members to get finance. No fixed interest in the business means there is no certainty to an individual’s entitlements to profit – especially if that individual is not a trustee or director of the corporate trustee.
Consider the adult children of the business’ founder that work in the business. They are potentially not trustees and cannot determine distributions. They derive all income from the trust, and possibly have their wages ‘topped up’ via a trust distribution, often paid in cash. This may happen every year. However as this ‘top up’ is not fixed, most lenders will not include it when determining an individual’s borrowing capacity. This can at times greatly reduce that person’s available credit limits, even though they can afford the loan based on the profit distributions that they are receiving.
Whereas if the adult children had a fixed interest [via a company or unit trust for example] the lender is far more likely to include their fixed entitlement to profits as part of their income when determining serviceability.
Repayment of debt via a trust structure also creates complexity. Due to profits needing to be distributed to either individual beneficiaries or a bucket company, the debt will need to be repaid with ‘after tax’ dollars. This means that beneficiaries require the ability to cash flow fund tax liabilities from distributions and repayment of debt.
The difficulty in obtaining personal finance for the next generation of the family is not the only issue created by a lack of fixed interest.
If there are multiple generations of a family working in a business, it is important for their own asset position and estate planning to have an actual stake in the business. A family trust structure means that for most adult beneficiaries working in the business they will have no defined interest in that business, and effectively nothing to then pass on to their own children.
It is relatively naïve to assume that all families will get along well and will all work just as hard as each other in the same business. And although family trusts are often seen as a great vehicle for a family business [as the business in theory can easily pass from one generation to the next until it vests], it makes actual estate planning incredibly difficult.
The reality is not all families get along all the time and it is common to have a family business that not all family members work in. This then becomes complicated when non-working members are part of the beneficiary pool, and a very simple question is asked – who really owns this thing?
no ability to have others buy in
If a business is run in a family trust, there is no ability to take on new investors. This means that if the company grows, or changes direction there is no way that you could have a third party buy in to the business. That includes no ability to bring employees on as owners and no option to bring on new business partners that are not beneficiaries per the deed.
Not every family business will be small and stay small, and not every family business will be passed down to the next generation. Many small businesses in Australia will grow and will employ great people. More and more business owners are looking to their employees as part of the growth of their business and eventual succession plans. This often involves having employees participate in employee share plans, employee share option plans, or just straight buying in. None of these options are available to a family trust.
Employees aren’t the only people that may want to invest in a business, many SME’s have a great business that may attract third party interest. Someone that is not a family member may want to buy in and contribute capital to help the business continue to grow. Again, this cannot occur in a family trust.
To allow any investment from outside the family, the business would need to be moved to another entity with all the potential tax issues and headache that those sorts of things bring.
the ATO is not a fan
It is no secret the ATO is not a fan of family trusts. It may be for this reason that trusts aren’t always included in new measures and aren’t always eligible for the same offsets and grants. This should be considered when looking at operating a business in a family trust. Two current items you cannot take advantage of in a family trust include:
- Loss carry back tax offset: For any businesses that have been operating in family trusts and will suffer from losses in the 2021 and/or 2022 financial years, there is no ability to apply the loss back measures as they are not eligible entities.
- Research and development tax incentives: Again, family trusts will not be eligible for these incentives that provide a tax offset for certain research and development activities.
expiration of Trusts
Whilst not high on my list of reasons not to [as it is probably not very common], there is a concern about running a business in an entity that has a defined expiration date. Due to the ‘rule against perpetuities’ most trusts have a finite date that they will vest with many being 80 years.
I know that 80 years sounds like a long time and many SMEs don’t quite make it that far, however I am seeing more and more businesses [and have a quite a few as clients] that are hitting that 40-50 year mark. Now in the case of a family business, it will only take one more generation for these businesses to hit their vesting date, at which point the trust’s assets will need to be addressed per the deed.
What this means for the trust and the beneficiaries will vary depending on the business, its assets etc, but it can have considerable tax implications.
does this mean I should never use family trusts?
Family trusts have their place, and they absolutely exist in my client base [mostly as investment vehicles]. I do believe however that they are often not best suited to run a business for the myriad of reasons listed above and when inheriting these kinds of clients from other accountants we are often faced with the challenge of having to move the business out of the trust as the structure is no longer [or never was] fit for purpose.
When looking at the kind of entity to set up to run a business, family trusts really only have a place when you are absolutely sure that the business will:
- Have a short shelf life
- Be unlikely to grow or need working capital to be reinvested
- Have no need or desire for additional investors or owners
- Have enough adult beneficiaries with low tax thresholds to make the effort worth it
- Have no need for beneficiaries to show a defined interest in ownership, and
- Not hold significant debt
Otherwise, you may find corporate structure is a better option.
I personally have been pleasantly surprised multiple times over the years at what my clients have been able to achieve in their businesses.
The entrepreneurial spirit runs strong in Australia, as does the opportunity for dedicated business owners and although none of us have crystal balls, we shouldn’t discount our client’s capacity for growth.
Just because something might start small it may not stay that way.
We should always consider more than just tax savings when establishing structures for trading entities.
If you have any queries or concerns, please do not hesitate to give us a buzz on 1300 BDEPOT or email email@example.com.