The goal of this article is to explain the three main benefits of setting up and activating a family trust. A family trust aids in planning and control of the succession of assets; tax planning; and asset protection. The two parties in a family trust are the beneficial owners of the trust, called the beneficiaries; and the lawful owner of the trust called the trustee.
The use of the trust allows the trustee to distribute annual income and other assets directly to the beneficiaries of the trust at the sole discretion of the trustee. That means that methodologies available to the trustee as to how he or she can manage income distribution are very flexible. As such, you may wish to establish a family trust in conjunction with setting up and operating your company’s business.
A properly established and managed trust can aid in protecting personal assets. A trust is a stand-alone legal entity that can contain and control assets, including the rights to tangible and intangible properties. If you set up a trust containing your personal assets, under the law you are no longer considered as the owner of those properties or other valuables in the trust. As the trustee, you are only deemed to be the legal owner of the possessions “on behalf of” the beneficiaries of the trust.
Many people are surprised to learn that once your assets have been placed inside the trust, your creditors no longer have access to those in-trust properties. They are protected by the trust even during bankruptcy proceedings against you, generally. As a consequence, the founders of a commercial firm often use a family trust to “hold” their company shares as opposed to holding the shares in their personal capacity and under their personal name.
It is important to select a competent and trustworthy trustee.
Who May Be a Trustee?
A trustee can be a natural person or a legal person, such as a corporation, a law firm, or a charity. A trustee may also be a group of people or separate entities acting together to manage the trust, such as the adult family members of a minor beneficiary. A trustee or group of trustees acting in their individual capacities are jointly and severally liable for the debts of the trust. For that reason, most trustees act as trustees through their corporate entities, using their corporations as an additional shield to any liability. Such an arrangement affords supplemental advantages to asset protection.
Take this example, for instance. Say a person or persons acting in their individual capacity takes out a loan to invest on behalf of the trust’s beneficiaries in an internet start-up research firm that promises a cure for the Covid19 virus (Coronavirus), but before testing is complete, the virus miraculously resolves itself, and thus there is no immediate need for the cure, the start-up goes out of business, and the trustees can no longer repay the loan. The trustee(s) are now directly liable to the lending institution which could possibly seize the family’s yacht to repay the loan.
Whereas, had the same trustees obtained the loan through their corporate entity acting as the trustee, their personal assets would not be at risk and the corporation (acting as a corporate trustee) would provide the individual trustees with an extra layer of protection to the individual trustees.
A trust is yet another tool that you and your accountant can use to aid in tax planning. Accountants often seek avenues to distribute income to beneficiaries who have lower incomes and are therefore in a lower tax bracket, thereby reducing the effective or overall tax rate on the trust itself. Because the assets are “spread out” over multiple individuals (say, the legal owner of the trust and his or her four children as the beneficiaries of the trust) this substantially reduces the applicable tax rate as compared to taxing the full asset amount to a single individual. Just these few examples make it abundantly clear why trusts are such valuable tools to employ when planning your company’s business and tax strategies.
Where Shareholders Directly Manage and Operate the Business
Suppose a family business does not employ a trust, but instead operates through a company which has two individual shareholders. Then you may expect the following scenario to unfold.
- First, approximately 30% tax rate will be applied to the profits of the company if it is a “small business”, defined as one which earns less than twenty-five million dollars;
- The two individuals will be taxed at their personal marginal rates if company profits are distributed as fully franked dividends to the two individual shareholders;
- After receiving the benefits of the franking credits, both individual shareholders will probably fall prey to the top-up provision of the tax code, which imposes a tax differential between the shareholder’s personal tax rate and the firm’s tax rate up to 45%; and
- Because the top-up tax rate can rise up to 15 or 17.5% based on whichever corporate tax is applicable because the maximum personal marginal tax is currently 45%.
Dividends that a commercial firm has already paid taxes on are called franked dividends, which are then entitled to a franking credit. Shareholders who subsequently hold those shares may benefit from the applicable franking credit for the tax amount the firm has previously paid.
2. Where a Trust Operates the Family Business
In contrast, suppose a family trust is the owner of the shares of the business enterprise, then:
- The two adult children of the two owners will count as beneficiaries and a 32.5% marginal tax will be applied to them;
- Both adult children will enjoy the fully franked dividends; and
- Neither child would be subject to the top-up marginal tax of 2.5 or 5%, depending on whether the 27.5 or the 30% corporate tax rate is applicable.
For all this to work properly, it would require declaring a Family Trust Election which would allow the franking credits to filter through the trust to the beneficiaries.
Care should be taken to stay far away from triggering the anti-avoidance rules which are euphemistically referred to as reimbursement agreements. This rule requires that the transaction cannot be merely a distribution on paper, but the business owners must actually receive the funds.
One of the most important attributes of a family trust is that although you may no longer own the assets of the trust, you can still control the assets. Additionally, the assets of the trust are no longer part of the trustee’s estate upon his or her death. Therefore, the trustee will not be subject to being taxed on the assets within the trust (e.g. a Death Tax).
It is customary that the trust deed contains provisions that spell out specifically the terms of succession of the assets of the trust. If these are not included in the trust deed, the trustee could pass the day-to-day control of the assets of the trust following the death of the trustee by bequeathing the shares in the corporate trustee.
It is critically important, therefore, that you not only have a broad and general knowledge of the overall benefits of a Family Trust, you must also be minutely aware of some of the potential tax and succession pitfalls that lie awaiting your every management decision surrounding the operations of the Family Trust.
There are several excellent reasons to set up a Family Trust within your company. They include tax planning; asset control; asset protection; transferability of assets; and succession planning and control.
Again, a key element of operating a trust structure is to safely hold assets, and there are several methods to do this. Which method is the best for you and your company depends on your individual circumstances and overall tax portfolio. For these and other reasons, it is advisable that you pursue legal, corporate, tax and estate planning advice from knowledgeable experts. The business experts at Lord Commercial Lawyers can offer you professional guidance and planning. Visit them at their website or contact them directly. Someone will be available to answer your questions.