When you’re scaling or setting up your business structure, it can be difficult to decide whether a company or a trust is the right choice for you. Understanding the pros and cons can help you make more informed decisions about your assets.
There are several legal and financial aspects to consider when planning your business structure. Two of the most popular choices are to incorporate as a proprietary limited company, or to establish a unit or discretionary trust.
It’s important to understand that neither option – company or trust – is the inherently superior choice. Rather, it’s about selecting the structure that best suits your circumstances and goals. Unfortunately, there’s no golden answer when it comes to what always works best. It’s about what will work best for you.
In this post, I’ll break down some of the various advantages and disadvantages of each structure, and when each choice might be appropriate. While this is by no means an exhaustive list, it should help you make a more informed choice on one of the biggest decisions that your business will face.
Proprietary Limited Companies
One of the key functions of incorporating your business as a Proprietary Limited (Pty Ltd) Company is that establishes your business as a separate legal entity to yourself. This limits your liability and protects your personal financial assets – like your house and car – from any business debts you may acquire.If you do choose to incorporate, you’ll be a shareholder in your company. You can choose to be the sole shareholder of your business, or elect to have multiple shareholders – although they will have a say in future business decisions. In fact, there are several regulations you will have to follow if you decide to become a company. These rules are set out in the Australian Corporations Act, and the way your company is internally organised should be stated in your Company Constitution and your Shareholder Agreement.
Because of this stricter regulatory environment, investors and institutional lenders generally prefer dealing with companies over trusts. If you’re just starting to build your business, and you plan to raise money through external investment or debt financing, this could mean that a company structure is the most practical choice for you.
From a taxation perspective, setting up and running a company is less complex than establishing a trust, and much more scalable and secure than continuing as an individual. Currently, larger companies pay tax in Australia at the fixed corporate rate of 30%, while businesses with an annual turnover of less than $50 million pay tax at the discounted rate of 25% (based on 2021-22 rates)
Compare this to the highest marginal tax rate of 45% for individuals, and you can see how incorporating your company can have a big impact on your bottom line. A downside is that, unlike trusts, companies are generally not eligible for the 50% discount on the Capital Gains Tax. If there’s a share sale by an eligible taxpayer during the exit phase, then you may be able to access the CGT discount, but that situation is relatively rare.
Companies are usually the more tax-effective choice when your generated income will be retained to fund ongoing working capital requirements. Conversely, trusts are generally taxed at a significantly higher rate when their profits are retained. If you’re running a trading business, this means that a company is more likely the way to go.
If your business doesn’t match these circumstances, then it might be worth considering a trust. However, there’s more than one type of trust out there, so make sure you choose the one that best fits your business goals.
Discretionary Trusts and Unit Trusts
A trust is one of the oldest legal structures still in use, and can offer a more tax-effective way to run your business. Essentially, running your business through a trust involves assigning a trustee as a kind of overseer to your business. This trustee owns and operates the business assets, distributes the business income, and complies with obligations outlined in your trust deed.
One of the key differences between trusts and companies is in the way they handle profits. Companies are taxed on their profits at a fixed rate, but they are free to retain and reinvest them as they wish. Trusts, however, must regularly distribute their profits or face being taxed at a much higher rate.
This is both the biggest advantage and biggest drawback of trusts, depending on what you want to do. It’s very tax-effective for asset accumulation and investment portfolios, because your income can be organised and distributed to beneficiaries in a way that significantly minimises taxation. However, if you require working capital, or if you’re trying to expand or grow your business, it can be a serious struggle to overcome the requirement to regularly distribute your profits.
The way that the profits of a trust are distributed is what marks the difference between a Discretionary Trust and a Unit Trust.
- A Discretionary Trust gives the trustee discretion over how much capital is distributed to each beneficiary. The trustee can pay one beneficiary 70%, one 20%, and one 10%. Depending on the trustee’s discretion, this could change each time there’s a distribution.
- A Unit Trust divides the trust’s capital into fixed parts, called units. Capital is distributed to the beneficiaries in proportion to the units that they hold, similar to how shares function for shareholders. If you have 30% of the units, you’ll receive 30% of the profits. These proportions generally remain fixed throughout each distribution.
Discretionary trusts are common amongst family businesses, where people are generally more comfortable with each other, and are happy for their trustee to exercise discretion. When a business is operated by two or more independent individuals, it’s generally considered more sensible to establish a Unit Trust, to increase financial transparency and prevent disputes over profit distribution.
Finally, trusts are not separate legal entities the same way that companies are. The trustee is the legal entity that owns the assets and enters into contracts on behalf of the trust. If you choose to appoint a corporate trustee – rather than an individual trustee – you may be able to further increase your asset protection, but this is subject to the terms laid out in your trust deed.
In general, a trust could be considered a more complex and customisable structure than a company. It can offer you increased privacy and significant tax advantages. However, the added complexity means it will be harder to attract investors, and the profit distribution rules mean that trusts aren’t suitable for every business model.
Ultimately, the choice of whether to incorporate a company or establish a trust is yours alone, but it’s certainly not an easy decision.
With so many intersecting factors at play, it’s strongly recommended that you seek legal and financial advice before pursuing either course of action, to make sure you understand which business structure best suits your goals and circumstances.
Disclaimer: This advice is general in nature and does not take into account your personal objectives, financial situation or needs. You should consider whether this advice is suitable for you and your personal circumstances. We strongly recommend seeking out professional advice before acting.