Even though discretionary trusts are more complex compared to other business models, it’s a popular option for those looking for flexibility, asset protection and control in their family business. In this article, we’ll go through the benefits and drawbacks of discretionary trusts to help you understand why they’re often suitable for family businesses.
What is a discretionary trust?
Discretionary trusts are also known as family trusts.
Operating your business through this structure requires an appointed trustee who owns and operates business assets. The trustee also distributes business income to beneficiaries of the trust – usually other family members involved in the business. The trustee must comply with the trust deed, which is a legal document specifying the rights and obligations of all parties.
A trust is not a legal entity in its own right but is considered a separate entity for tax purposes. Consequently, a trust is required to have a Tax File Number (TFN) and lodge annual income tax returns.
Advantages of a discretionary or family trust
Here are the main benefits of operating your business through a trust.
Income and capital distribution
In a discretionary trust, a trustee has control over how much income or capital to pass on to each beneficiary every time a distribution takes place. This could lead to tax planning opportunities where more money is distributed to the beneficiary with lowest marginal tax rate.
Capital gains discount
A discretionary trust can benefit from a capital gains discount when disposing trust assets held for more than 12 months.
Creditors of beneficiaries cannot lay claim on business assets because these assets are owned by the trustee rather than the beneficiaries. There is also further scope for asset protection by having a company act as a trustee.
Discretionary trusts have fewer regulatory requirements to follow compared with companies. In terms of tax, beneficiaries report trust distribution on their individual tax return and pay tax at their individual tax rate, making compliance relatively quick and simple.
Disadvantages of a discretionary or family trust
Below are the main disadvantages to operating through a trust.
Income must be distributed
Profits must be distributed every financial year – the trustee is liable to pay tax at the highest marginal rate on any amounts that remain undistributed. This restriction makes it inefficient, from a tax perspective, to retain profits for working capital.
Losses could be trapped
As only profits can be distributed to beneficiaries, losses are trapped in the trust until they can be offset against future income.
When an individual rather than a corporate trustee is used, the trustee can become personally liable for some trust debts.
Trusts are more expensive to establish and maintain. You’ll likely need advice from accounting professionals when distributing profits to ensure compliance with the trust deed, or if you’d like to vary the terms of the trust deed. Because of their complexity, it can be difficult for a trust to borrow money.
A final word
POP Business has helped many family businesses establish their discretionary or family trust. For affordable tailored advice to help you maintain your trust, take a look at our accounting membership service which offers on-demand support and access to our business experts. Get in touch with POP today!