An entrepreneur starting a new business has a choice to make – how should she structure the business legally. In Australia, there are actually four alternatives to choose from: sole proprietorship, partnership, company or trust. The reasons for choosing a company or trust often include limiting legal liability, protecting personal assets, or ease of sharing or transferring ownership. And, in the wake of recent caps on superannuation contributions, more financial planners are recommending family trusts to hold savings that cannot be put into the superannuation system. What are these structures? How do they work in a purely Australian context? And what problems or challenges might arise when a US taxpayer tries to do exactly what her Australian neighbour would find optimal?
This is the fourth instalment in our series of posts discussing the ways US tax laws constrain the investment choices of US taxpayers living in Australia. These are the areas we will be covering:
- Real Estate
- Australian Managed Funds
- Australian Shares
- Business Ownership Structures
- Investing in the US
- Record keeping
This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action.
The disclaimer above is particularly apt for this topic. While writing this post, I found myself in a rabbit warren of rules, details, and complexity. It is too easy to get lost in all the detail – so the focus of this post is on giving a broad overview rather than delving into all of the nuances. This is an area where personally tailored professional advice is essential.
For Australians starting a business, the ATO website is not a bad place to start looking for information. This overview video will introduce you to the main concepts.
In addition to taxes, there are two concerns that are addressed by using a company or trust: asset protection and estate/succession planning. The idea of asset protection is to make sure that non-business assets (such as principal residence) are not put at risk should the business be unsuccessful. Both companies and trusts can be used to ensure that business creditors only have a claim on the assets of the business. Companies also make it easy to transfer ownership of the business – either as an exit strategy or for estate planning – through a sale of shares in the company. Trusts are a natural estate planning tool and can be used to protect family assets in the event of a beneficiary’s personal bankruptcy or marriage breakdown.
So, what are the differences between using a corporation or a trust? To form a company, the founder(s) transfer assets to the company in return for shares. Shareholders are generally entitled to elect a Board of Directors, which oversees company activity and hires management to run the company. In a small start-up, the founder usually wears many of these hats simultaneously. A company is a separate taxpayer and pays tax on income at a rate of 27.5% or 30% depending on size. Income can be retained inside the company , or distributed as dividends. To the extent that the income inside the company is taxed in Australia, the company will be able to distribute franked dividends, and shareholders (owners) will receive a credit for the Australian tax paid by the company. Dividends, however, are all ordinary income and companies do not receive any discount on long term capital gains like individuals do. There are costs to setting up the company, maintaining separate accounting records, documenting board meetings, and reporting to ASIC.
A trust is created by transferring assets to a trustee and is governed by a trust deed which specifies how much discretion the Trustee has in managing the assets and distributing income. The trust deed will specify the trust’s beneficiaries – that is, the people or entities that are entitled to distributions from the income or assets of the trust. For tax purposes, a trust doesn’t generally retain income – income is distributed to the beneficiaries. So, while a trust will file a tax return and may be required to pay tax on behalf of some beneficiaries, it doesn’t generally pay tax on its income. Instead, income is taxed to the beneficiaries on their individual tax returns. Income distributed to beneficiaries retains its character – that is, capital gains can be distributed and taxed as capital gains on the beneficiary’s tax return. The trust deed can give the trustee discretion to stream income to specific beneficiaries in order to minimise the overall tax liability of the beneficiaries. Trusts are often recommended when structuring a family-owned business, or as a tax-advantaged way to own investments that cannot be placed inside superannuation (which is more important with the new lower caps on super contributions).
A trust where all of the beneficiaries are in a single family can elect to be treated as a Family Trust, which gives even more flexibility. However, care must be taken when beneficiaries include minors, as children under 18 are generally taxed at the top marginal rate on passive income. As always, tax rules change over time. Current Labor proposals will limit the effectiveness of Family Trusts for some.
Still confused? This video explains the difference between a company and a family trust:
Of course, all of this is what a purely Australian financial planner or tax adviser would advise an Australian client. But, once you add a US connection into the mix, the advice will be very different. The US tax code is extremely xenophobic – almost everything “foreign” requires either time-consuming intrusive disclosure or punitive tax treatment, or both.
So, that Australian company that protects assets and perhaps allows income to be retained at a 27.5% or 30% tax rate? On a US return Form 5471, will be required at a minimum. This is the form that tripped up a Canadian resident recently (discussion at Isaac Brock Society). Form 5471 is required if you are a US taxpayer (citizen, resident, green card holder) and you are either the direct owner of 10% or more of a non-US corporation, or you are an officer or director of a non-US corporation which has a US shareholder who owns 10% or more of the company. The actual disclosures required vary depending on how much of the company you own. Furthermore, the rules are even more complex if the company is a “Controlled Foreign Corporation (CFC)” under US tax rules. An Australian company would be considered a US CFC if the sum of the ownership of all US persons owning 10% or more of the corporation adds up to more than 50%. So, if the company is owned equally by 9 shareholders (11.11% each), 5 of whom are US persons, then the corporation is a CFC. However, if the company were owned equally by 11 shareholders (9.09% each), they could all be US persons and the company would not be a CFC (assuming that there’s no relationship between the shareholders). If the company is a CFC (which is highly likely if it’s a business you’re running yourself), then you need professional help as you have fallen into one of the most complex parts of the US tax code, known as Subpart F. The Subpart F rules will tend to undo any tax planning achieved by creating the corporation. 
US tax rules for trusts  depend on who provided the assets for the trust – in the US this is called the Grantor of the trust. If the grantor retains control, then US tax rules disregard the trust and all income is reported on the Grantor’s individual tax return. Most Australian Family Trusts would probably be classified as Grantor Trusts for US tax if the grantor is a US taxpayer. And, since the trust is constituted under Australian law, it is a Foreign Grantor Trust, and would be required to file Form 3520-A as well as Form 3520 each year. Again, these information returns generate very high penalties if they are omitted from a US tax return. Foreign Grantor Trust status will negate all of the Australian tax benefits of establishing the trust. Self-Managed Superannuation Funds (SMSFs) would also be treated as Foreign Grantor Trusts , completely undoing the tax benefits provided under Australian law.
I’m well over a thousand words, and I’ve only scratched the surface. If this post gives you an idea of the complexity involved, then it will have served its purpose. Australian residents who are subject to US tax rules would be well advised to seek professional help (ideally someone expert in both US and Australian tax law) if they have any of the structures mentioned in this post. In the next and final post in this series, I’ll cover some of the considerations and difficulties of investing directly in the US, as well as a brief recap of the record keeping required for all of the types of investment covered in this series.
 Australia’s rules around Family Trusts allow a much greater degree of tax planning than similar rules for US domestic trusts.
 Australia does not have the same mutual collection agreement with the US that Canada has. Furthermore, Canada will not collect on behalf of the IRS if the taxpayer was a Canadian citizen when the tax liability arose.
 There are some who argue that all superannuation, including SMSFs, should be treated as Social Security for US tax purposes, and is therefore exempt from US tax under the Australia / US tax treaty.