The line has been drawn, the camps are divided and the novice investor is caught in middle. The use of companies and trusts as a vehicle for wealth accumulation is an area of great controversy. If you are trying to draw your own conclusion, foraging through the battlefield of polar opinions can prove to be difficult. In one camp, experts advocate the protection and tax effectiveness companies and trusts can provide. Meanwhile, the opposing camp identifies the high cost and administrative burden for their resistance.
Of course in a grey-scale world, these black-and-white opinions do nothing to inform the financially curious. Instead let’s take an objective view of companies and trusts and discuss when they should and shouldn’t be utilised.
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Under Australian tax law, a company is considered a unique and independent taxable entity. The company is entitled to any income or capital gains produced by an asset it owns. It is also liable for the asset’s associated taxes and holding costs. This burden of liability has given rise to the common misconception that a company structure can offer a level of protection. Whilst this may have held some truth a few decades ago, it is most definitely not the case today. A personal guarantee for company liability is often a requirement of directorship. If the company folds, you may be held accountable to its debtors, and so caution is advised.
A signification advantage of owning assets in a company is that the control of the assets can be transferred through the sales of shares in the company. This allows assets to ‘change hands’ without incurring expensive transfer costs and taxes. Furthermore, the issue of shares can provide for joint control of assets, which can be redistributed with more ease than a ‘tenancy in common’ or ‘joint tenants’ agreement.
A company structure also provides access to the flat corporate tax rate of 30% for income produced by company held assets. It stands to reason that if your marginal tax rate is above 30% then a company structure will save you money come tax time.
Unfortunately, this isn’t the whole story. The cost of establishing and maintaining the registration of a company must be considered in your calculations. DIY registration of a company will cost you around $500 initially and $250 annually thereafter. If done through a professional, this cost can blow out well into the thousands. Another consideration is the cost of an accountant for managing the company’s compliance. This amount will vary greatly depending on the accountant used, the net worth of the company, and the complexity of its strategy. However, $750 per asset (p.a.) is a fairly indicative figure for the novice investor with minimal assets.
Finally, we come to the added cost of the company holding an asset. These costs include, but are not limited, to increased corporate banking fees, higher corporate interest rates, and corporate rates on other products (yes, small companies usually pay more for everything). You also may find your company is liable for a goods and services tax (GST), which applies to almost all asset sales except for established residential property.
From what we have seen so far, we can assign a slightly arbitrary, yet illustrative cost of around $2,000 p.a. in extra costs per asset held in the company. The reduced tax rate of a company is between 2.5% – 17.0% for anyone earning more than $37,000. Therefore, it would stand to reason that an asset must create a fair amount of income before you start to recoup these company associated costs.
There are a variety of different trusts in use in Australia, but for the purpose of this book I have narrowed them down to the three most commonly used by investors. They are:
- Unit trusts
- Discretionary trusts
- Hybrid trusts
Whilst self-managed superannuation funds (SMSF) also qualify as trusts and are quickly becoming common, they are not within the scope of this section. Instead, they are explored further in the Superannuation chapter of this book.
Before we explore each individual trust type we will discuss the features common among all three. A trust is controlled by trustees, and the funds from the trust are distributed to its beneficiaries. In most cases, a trustee does not need to be a beneficiary and vice versa. The trustee controls the assets vicariously and has a fiduciary duty to act in the best interests of the beneficiaries. Because a trust is not a separate legal taxable entity, income from a trust is distributed to the beneficiaries and, as a result, the income is taxed at the beneficiaries’ marginal tax rate.
The three main functions of a trust are to:
- Allow the income of an asset to be distributed to a beneficiary and taxed at its marginal rate.
- Allow the transfer of access to an asset, without exposing the trust to transfer costs and taxes.
- Protect assets held in the trust from litigation towards the trustees or beneficiaries of the trust, unless the litigation arises from actions pertaining to the trust.
The biggest drawbacks of a trust are the establishment and running costs. Due to the complexity of drawing up a trust’s documentation, it can be around five times more expensive to establish and run than a company.
As the name suggests, a unit trust is made up of units. The units are assigned a value that represents the value of the assets held in the trust divided by the number of units. A beneficiary of a unit trust owns units in the trust, similar to a shareholder owning shares in a company. The entitlement to the income of the trust is proportional to the number of units the beneficiary owns. The income from the trust is taxed at the beneficiary’s marginal rate, similar to dividends from shares.
Unlike company shares, a unitholder is also proportionally liable for the trust and can be required to pay any shortfall if the trust is wound up/goes broke. On the plus side, this relationship does not go both ways and if a unitholder was to suffer litigation, assets in the trust may not be accessible to a plaintiff. In a unit trust, access to assets can change hands by way of trading units in the trust.
Because there are no units in a discretionary trust, the beneficiaries do not have a fixed entitlement. Instead, the distribution of income is up to the discretion of the trustees in accordance with the trust deed. Distributed income is taxed at the marginal rate of the beneficiary receiving the income. However any income remaining in the trust at the end of the financial year will be taxed at the maximum rate. Access to the assets of a discretionary trust can be transferred by adding or removing beneficiaries from the trust deed. Control of assets can also be transferred by appointing new trustees. Because the beneficiaries of a discretionary trust do not hold units, they are usually protected from and not liable for the assets in the trust.
Hybrid trusts are designed to have the best features from the two trust types above. They do this by displaying all of the features of a discretionary trust with the added ability for trustees to issue units in the trust. The trustees of a hybrid trust can use their discretion when issuing units in the trust in accordance with the trust deed. This differs from a unit trust where the units are bought and sold by unit holders. Because the units are distributed at the discretion of the trustee, beneficiaries are afforded a higher level of protection from the liabilities of the trust.
For the seasoned investor, a company or trust structure can provide a level of protection from liability. It can also assist in the transfer of assets and lower the investor’s tax burden. However, you must remain vigilant and consider the costs associated with these structures. Unfortunately, the costs associated with moving assets into or out of a trust or company mean that you should make your decision before purchasing an asset and stick with that decision for the life of the asset.
Adviser’s Tip: Company and trust structures can be extremely complex. Given the potential costs associated with an inappropriately structured investment, it is important to seek professional advice from a trusted accountant or financial planner.