Like all major business decisions, deciding on a suitable business structure requires a full understanding of the advantages and disadvantages of your options. Two types of options for setting up your business are through a discretionary trust or a separate limited liability company.
Company – Advantages
Upon incorporation of your business, your legal identity is separated from the business. This ensures that the personal assets of the owner are protected should the business be unable to pay off its debts. There are also tax benefits with the corporate rate set at 30%, although small businesses are subject to a reduced tax rate of 27.5% in 2019/20 financial year if they are turning over less than $50 million.
Companies are a separate legal entity so it will be paying its own income tax. This means that the profits of the business can remain in the company without it needing to be paid out to the owners. Thus, it allows family groups to minimise its tax without paying the highest marginal tax rates of 45% as an individual.
Pty Ltd Companies are regulated by the Corporation Act of Australia meaning that the company will follow specific rules and shareholders and creditors will have specific rights. Investors and banks prefer to deal with Pty Ltd companies when it comes to funding and raising capital as they know that their rights and powers are protected.
Company – Disadvantages
Capital gains concessions, unfortunately, do not apply towards companies. This concession allows for a 50% discount for assets held for more than 12 months or more at the time of being sold or when relevant capital gains may occur. This is due to conditions that require you to operate your business as a sole trader, partnership or as a family discretionary trust.
Additionally, take into consideration the implications of directorship responsibilities when setting up your company. These duties are regulated by the Australian Securities and Investment Commission (ASIC) and should be considered when making the decision to set up your business as a company.
Discretionary Trust – Advantages
From a tax standpoint, setting up a discretionary trust is one of the most effective structures. A discretionary trust means that the profits of the business can be distributed to family member(s) so that the lowest possible individual marginal tax rates apply. This may not be evenly distributed and can be changed each time there is a distribution.
Discretionary trusts also afford asset protection should your business no longer continue to operate due it not being able to pay off its debts. Creditors of the business do not have any claims against assets that the trust owns. However, creditors directly towards the trust do have claims against these assets.
Additionally, whilst companies are unable to enjoy the capital gains discount concession, discretionary trusts can take advantage of this and pass it on to the individual beneficiaries.
Discretionary Trust – Disadvantages
Trust structures are a much more complex and expensive process to establish than a company structure. There are generally also complications surrounding any alterations or dissolving of an established trust, which may result in resettlement and being subject to capital gains tax/stamp duty.
Secondly, a discretionary trust must distribute its profits to beneficiaries each financial year. Failure to do so results in the trustee paying any undistributed profits at the highest marginal tax rate. This tends to be an issue when the business requires ongoing working capital. Usually, a business that is going through a major growth stage, a company structure can be more appropriate due to lower tax rates on undistributed profits.
Thirdly, discretionary trusts usually involve family members as the parties are comfortable for a trustee to have discretion over distribution amounts each beneficiary receives. If your business is not a family business and operates with independent individuals, this may be a less appropriate options as each party will want to know exactly what will be received rather than the trustee exercising their discretion for distribution.
Lastly, If you are looking for outside investment and/or finance, it is far more difficult to receive funding due to the complex structure of a discretionary trust. Investors tend to prefer to deal with Pty Ltd Companies as they have rights and powers as a shareholder. A beneficiary of a trust, on the other hand, do not have such perks and thus investors prefer dealing with Pty Ltd Company.
A unit trust, unlike a discretionary trust, may be used to divide the trust property into quantified units. Beneficiaries are then allocated units in a similar fashion to shareholders’ holdings in a company. This ensures a clear understanding of each unitholders’ exact holdings.
Selecting your business structure between a Pty Ltd company or a discretionary trust can be tricky. Considerations about the pros and cons need to be fully understood in order to make an accurate assessment of the suitability of each option. Each individual business owner’s situation can differ from one another and therefore, there is no best option, only what is most suitable based on the business goals and what stage the business is at. At Box Advisory Services, we always recommend that you consult a relevant accounting advisor to make sure you are making the most suitable decision for your business.
Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note however, that the information is intended as a guide only, providing an overview of general information available to contractors and small businesses. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal or tax advice. You should, where necessary, seek your own advice for any legal or tax issues raised in your business affairs.