Les Allen examines trading trusts and questions why they were so heavily promoted in the first place.

Trading trusts, until the mid 1990s, were a rarity. Most family trusts were passive, owning property or shares but not directly involved in business.

That all changed when trading trusts were heavily promoted in some quarters as the panacea for all evils. Generally they consisted of a standard family trust used in a different way, with a company as trustee. The trading trust could carry on any kind of business and in most cases was far more active than a traditional family trust.

They have now been around for so long that there’s been more than enough time to examine their strengths, and their weaknesses.

Why have one?

First, we were told that a trading trust would protect assets. That is clearly not the case, as the person setting up the trust is almost always the only person willing to be the director of his corporate trustee. The director will then have statutory duties under the Companies Act (eg, to make sure that it does not trade recklessly) and equitable duties under trust law as well, to the trust’s beneficiaries. There is ample case law showing that those duties can be quite onerous.

Secondly, trading trusts have been used quite successfully by many property developers trying to avoid the notorious associated persons tax rules, but this is unlikely to be successful in future as those rules have been made even more rigid as from the 2009/2010 tax year.

Thirdly, we were told that trading trusts would minimise tax. But have they? Often they distribute their income to family trusts, or to individuals. Where the income is passed on to beneficiaries that are 16 years old or less, $1,000.00 is tax exempt but the rest is taxed at 33%. Any tax retained by the trust is also taxed at 33%; lower than the 38% tax rate that would otherwise have been incurred in many cases if the dividends had earned the income instead.

Where trading trusts have been successful it is generally because they have been able to distribute income to beneficiaries who are over the age of 16 and who are on a 19.5 tax rate, or to charities. Certainly some trading trusts have distributed large amounts of income to charities completely free of tax, but one suspects that they are few and far between. They are sometimes used to distribute income to overseas beneficiaries (without the imputation credit problem that a company would have).

Trading trusts seem to have been so popular partly because at seminars in the 1990s they were heavily promoted to accountants. They found that they were able to set up trading trusts with little or no involvement by lawyers, as in most cases no property had to be transferred to the trust (unlike traditional family trusts, which can require a considerable amount of legal paperwork when assets are transferred to them).

It is no surprise that most of the leading trading trust cases are on doctors, orthodontists and dentists, as trading trusts tend to work best for high income earning professionals with relatively low business risk.

Problem Areas

Perhaps the problem is not trading trusts in themselves, but the way in which they have been used, sometimes inappropriately. Some of the problems encountered are:

• Clients (and some professionals!) are often confused by the fact that they have a company and a trust. They really don’t understand how the two fit together. At one stage there was confusion over whether the trust or the company should hold the bank account, file GST returns and issue tax invoices. This has largely been ironed out, but there is still plenty of confusion in some quarters.
• Some of the trading trusts set up over the last 10 years are now collapsing for financial reasons, often after making trading losses. As those losses are trapped within a trading trust, they will not save any tax at all for the individuals involved. Admittedly most companies have the same problem, but loss attributing qualifying companies don’t. (Limited partnerships only have the problem to a certain degree.) There is nothing worse than making losses without saving any tax.
• Recently we encountered two completely different situations in which two businessmen had used joint trading trusts. Strangely, neither trust deed said that the trust’s assets and income had to be divided on a 50:50 basis. In fact they were both bog standard trust deeds. Neither dealt in any way with the issue of control, or division of income, or showed how a dispute between the two directors and settlors might be resolved. This was left to the constitution of the Corporate Trustee, which was not exactly a model of drafting either. In one case we found that the two businessmen had traded on blissfully for 5 years without even signing the trust deed on which their entire business was based.

Some advisers seem to be intoxicated by the enticing prospect of forming a new trading trust for their clients. It is important that in the process the universal key issues are kept in focus:

1. Is this type of structure the best available in terms of control?
2. If there is a dispute between the parties, is there an appropriate way to have it resolved, or will there be an impasse?
3. Is it tax effective?
4. If the business fails then, particularly in a small to medium business, can its tax losses be utilised?
5. Will your lifestyle assets be protected?

Above all the structure needs to suit your situation and the documents must be tailored to meet your needs. Please contact Les Allen or Andrew Simpson in Gaze Burt’s city office, or Michael Hockly in our Albany office, if you would like to review your current structure.