Thursday, October 31 2013
Understanding trusts…if that’s possible
At their heart trusts are relatively simple but at first glance their function and purpose can be utterly confusing. I am going to give my best shot at explaining trusts but if you find yourself confused you are not alone.
I think the best way to understand a trust is to actually have one and see it in operation, but not everyone has that luxury. The important point to make at the outset is that trusts will not be for everyone.
So what is a trust?
The trust deed spells out the powers, responsibilities, and limitations of the trustee. The trustee can be either a person or a company. In short the trustee is generally expected to manage the assets of the trust for the benefit of the trustees.
Perhaps the most common form of trust is the discretionary trust. A discretionary trust means that the trustee has complete discretion how any income or assets of the trust may be distributed to the beneficiaries. The set up of this structure is best explained by way of an example.
Bill and Jane Smith wish to purchase an investment property using a discretionary trust. They establish a trust called “The Smith Family Trust” with a company (Smith Investments Pty Ltd) as trustee. Both Bill and Jane are shareholders and directors of Smith Investments Pty Ltd and are also beneficiaries of the trust. The trust has all the powers of a natural person.
So in essence Bill and Jane have complete control over the investment property and complete say over how any benefits coming from that investment can be distributed.
But why would Bill and Jane choose a trust structure?
For example let’s say you owned your home in your personal names but your investment property was owned through a trust with a company as trustee. Your tenant in the property slips on the stairs and decides to sue you for personal injury.
In general terms the tenant would only be able to sue the trust and the company as trustee and would not be able to pursue your personal assets. If the property was worth $250,000 and the loan against the property was $260,000 then this would not make the trust an attractive target and may kill off any action. If however the investment property was owned in your name then this would open the door to your personal assets.
This remains an area of contention and the laws on this are being reviewed all the time. So whether trusts remain a safe haven remains to be seen. In any case it would be wise to have landlords insurance with adequate public liability to protect you from such an event.
A trust may also allow for a more tax effective distribution of assets to your family or other beneficiaries upon your death.
Referring to our example again. If Bill was a high income earner and Jane was not working then all income from the trust could be directed towards Jane so that any income is taxed at a lower marginal rate. Again if the trust sold the property and made a capital gain, that gain could be directed towards Jane.
It can also provide an opportunity to defer payment of tax which can be of benefit to your cashflow.
Types of trusts
The discretionary or family trust
This means that income can be distributed in one way in one year and in a different manner the next. Providing complete flexibility in managing tax.
The unit trust
This structure may be appropriate where a number of friends or family wish to buy or develop a property but will be contributing differing amounts. Those who provide a higher level of equity would receive a larger number of units.
The difference here however is that there is no discretion as to how income can be distributed. Any income earned by the trust must be distributed to beneficiaries according to the number of units they hold.
The hybrid trust
Income can be distributed to beneficiaries according to their unit holding or at a later date income can be distributed at the trustee’s discretion. For example in the case of a capital gain.
Asset protection, greater flexibility with tax planning…all sounds good. But before you get too excited there are some potential downsides.
There can be a number of ways around this depending on your personal situation.
Using your business
For example if you have a profitable business which is operating through a trust you can establish a separate trust for property investment.
It is then possible to divert profits from the business trust to soak up losses in the investment trust. For example if your business trust made a profit of $100,000 and the investment trust made of loss of $10,000, then the business trust could distribute $10,000 to the investment trust to absorb the loss.
The business trust would then only need to distribute $90,000 to the beneficiaries.
A hybrid trust
A hybrid trust can also be effective. Under this scenario you borrow funds in your name which you use to buy units in the trust. The trust then pays cash to purchase the investment property. As long as the property is rented the trust should then be cash flow positive as it is not carrying the major expense of interest.
Surplus income from the trust is then distributed to you, which can be offset against the interest on your loan.
If you have a company as trustee then there will also be ongoing ASIC fees, and fees if you make any changes to directors or shareholders.
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