Should I use a company or trust for my startup?
One of the critical decisions you must make when starting your business is which legal structure to use. While there are a wide range of options available (see here for our brief review), the two most common business structures are a company and a trust.
This article explains how companies and trusts work, and the important features of each.
Both come with considerable advantages in terms of asset protection, limiting liability and tax planning. Of course, each has its own disadvantages that must also be carefully considered. The ultimate answer of ‘what structure is right for me?’ depends on the nature of your business, your objectives and your unique circumstances.
It is crucial that you speak to a lawyer or accountant to help you in making this choice and setting up your structure, as these are highly complex legal instruments that carry consequences if misused.
What is a trust?
A trust is not a separate legal entity. A trust is the relationship between the trustee and the beneficiaries, whereby property is held and managed by the trustee for the benefit of (‘on trust for’) the beneficiaries. This means that the trustee has legal ownership of the trust assets, while the beneficiaries are entitled to the benefit of the assets. Consider the simple example of an office building in a trust. The registered proprietor of the building is the trustee, while the beneficiaries would get the rental income.
In addition to a trustee and beneficiaries, a trust will involve a settlor and an appointer. The settlor is the person who sets up the trust in the first place; the appointor is responsible for appointing (and if need be, removing) the trustee.
The most important element of a trust is the trust deed. The trust deed, which is created by the settlor, will identify the various parties and detail their rights and obligations. One of the main functions of the trust deed is to describe how the trust property is to be used. A trustee is bound by the trust deed, as well as general trust law and fiduciary law.
Although a trust is not a separate legal entity, it is a separate entity for tax purposes. It will have its own Tax File Number (TFN) and lodge an annual income tax return. As we shall see, tax is one of the main drivers in the choice of a trust or company for a business structure.
On a practical level, the trustee is the most important part of the trust. It is the trustee who manages the trust assets and it is the trustee who is responsible for the gains and losses of the trust. And for a discretionary trust, it is the trustee who decides how the trust income is distributed to the beneficiaries.
A trustee can be an individual or a company (‘corporate trustee’).
The Benefits of a Trust
There are two types of trust. Under a unit trust, each of the beneficiaries are entitled to a fixed share of the trust income. So if Jim and Jill each own one of a trust’s two units, and the trust generates $100 income in 2017, they each get $50.
Under a discretionary trust, the trustee decides each year how to distribute the trust’s income to its beneficiaries. The trustee may choose to distribute the bulk of the income to one particular beneficiary, or may choose to exclude a beneficiary entirely.
This flexibility gives trusts one of their main advantages: tax planning. The trustee (you, let’s say) would distribute the trust income (ie the profits of the company) to those beneficiaries (eg, your spouse or other family members) who have a lower marginal tax rate.
There are other, more complex tax benefits in a trust, such as the capital gains discount. These can be quite significant. They are looked at in more depth here.
If your business is run through a trust, the trust asset is the business and the trustee will essentially run the business. You (or a company you run) would be the trustee and the beneficiaries would be yourself and whoever else you choose.
If you appoint a corporate trustee, this means that you as an individual will not be liable when things go wrong. The corporate trustee would be liable—and it would only be able to claim from the trust assets, not from you or any of the other beneficiaries.
In terms of protecting you from liabilities that you may incur in running your business (recall the example of Max the engineer being sued), liability will be limited to the trustee. If the trustee is a company, liability will be limited to the assets of the company. If the trustee is an individual, he or she will have the same personal liability as a sole trader.
Easy to ‘transfer’ assets from generation to generation.
Because the beneficiaries of a trust enjoy the benefits of the trust assets (eg, rental income) without having legal ownership of the assets, it is relatively easy to ‘transfer’ assets from generation to generation. If the beneficiaries of a trust are the settlor’s children and grandchildren, they will enjoy the benefits of the assets without those assets having to be transferred.
One of the great innovations of the law is that a company is a person. It can enter into agreements, incur debts, and make decisions. It does so through its directors, who direct the company on behalf of the company’s shareholders. The shareholders own a share in the company, but they are not liable for the company’s debts or any other liabilities. Only the company is liable and only its assets are at risk.
It’s easy to think of a company as a national behemoth with thousands of shareholders, but a company can be an attractive option for you and your start up. You would be a director, and the shareholders would be you and whoever you wished to benefit. (As a start up, you would set up a private company, which requires a minimum one director. Public companies require at least three directors. There are other important differences, which are explained here).
Let’s see how this may look in practice. We’ll focus on an example that showcases one of a company’s biggest advantages: limited liability
Max Sharp is a civil engineer. Property developers hire him to make sure their buildings are safe and structurally sound. Max is worried that the nature of his work may expose him to personal liability if he is sued. To protect his home and other assets, he sets up a company and operates his engineering business through the company. He and his wife, Mary, are the directors and only shareholders. As directors, Max and Mary run the company and, as shareholders, they receive dividends.
The company has no assets other than some office equipment. If Max is negligent and his clients want to sue, it will be the company they sue and liability will be limited to the assets of the company. Max’s home will be safe.
The above example is of course not limited to professionals who are at risk of being sued for malpractice. Any debts incurred by a company in the running of the business are liabilities for which the company, not you, are responsible. Jim the Jeweller who operates his business through a company will not be personally liable for the debts he incurs when running his business.
Although asset protection is one of the main advantages of a company, running your business through a company will allow you to easily offer equity to investors and demonstrate transparency and accountability. There are also tax benefits to running your business through the company (as opposed to operating as a sole trader), as corporate tax rates may be lower than your marginal tax rate; if your company’s profits are reinvested in the company, it will pay just the lower rate.
Be aware that the costs of setting up a company are not insignificant, and ensuring regulatory compliance with ASIC and other relevant bodies can consume some of your start up’s precious resources.
So what’s better?
As we’ve seen, trusts and companies offer important advantages. The question of which one is the right one for your needs requires you to think about your growth plans, your risk profile, your tax needs and other considerations.
While it can be a tough choice, having the right legal structure for your business can be one of the most rewarding moves you make in your start up’s early life.
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