A vehicle for trading a business
A trading trust is where a trust is used to conduct the trading of a business. A trust isn’t an entity (because it is a relationship) but it can nevertheless become a vehicle for conducting a business and it may be useful for asset protection and confidentiality. Trusts also have benefits that include taxation flexibility and control without ownership.
The trading trust is a very popular device for small to medium enterprise in Australia. In its 2015 Report Business Set-up, Transfer and Closure the Productivity Commission estimated that there were 254,511 trading trusts in Australia.
Trading trust definition
A trust is a legal device by which one person holds property for the benefit of another person. The first person (the trustee) is under an equitable obligation to deal with the property for the benefit of the second person (the beneficiary). If the relationship is an express trust it will be governed by the terms of a trust deed. At law there are three essential elements of an express trust:
- A trustee;
- Trust property; and
- A beneficiary.
A trading trust is a trust over goodwill and business assets and the trustee is the legal person responsible to creditors. A trading trust is usually a discretionary trust, whose trustee is a company, that is used to trade for the benefit of the beneficiaries. As with a non-trading trust, a trading trust separates legal ownership of assets from beneficial ownership and control. The controllers of the business are the owners and their family who exercise a controlling mind through their appointment as directors of the trustee company.
A trust isn’t a legal person (like an individual or a company is) so you can only contract with the trustee company and, if it’s a trading trust, this is usually a $2 company.
What documents are required to form a trading trust?
If the trustee of a trading trust is a company the following documents need to be prepared:
- Company constitution; and
- Trust deed (unit trust or discretionary).
The company constitution and trust deed may be obtained from “off the shelf” providers but may need to be amended to take into account the individual circumstances of the business.
Other documents that may be considered necessary include:
- Shareholders or unit holder’s agreement
- Loan agreement and general security agreement
Agreements between beneficiaries may be necessary to resolve potential disagreements or deadlocks in the future. Trust deeds do not include provision for resolving arguments about the future direction of the trading business, for example. A shareholder’s agreement between beneficiaries would include provisions for resolving deadlocks without having to start litigation.
A loan agreement may be necessary for the recognition of monies advanced to the trustee company by beneficiaries. If the lenders want to have a priority position they will need to also enter into a general security agreement with the trustee company.
It is unlikely that you will be able to purchase these documents “off the shelf” and you will need to engage a solicitor to prepare bespoke documents and register security interests.
Businesses don’t always succeed and if it fails the trustee company could be placed into insolvent liquidation. In a liquidation scenario the following evidence may need to be given to the liquidator to persuade them that there is a valid trust:
- A trust deed
- Separate books of account for the company and the trust
- A separate ABN for the trust
- A separate tax file number for the trust
- Bank statements that evidence the trust name
- Minutes of the company that evidence the trust
- Trust tax returns
- A register of beneficiaries or unit holders
If a liquidator isn’t persuaded that there is a valid trust any advantage that the beneficiaries would have from a trading trust structure could be lost.
A trading trust gives control without ownership
The key benefit in establishing a trading trust is that the assets of the trustee are held separately to the trust’s assets. A corporate trading trust gives the beneficiaries two levels of protection:
- Limited liability through the corporate form; and
- The holder of the property (trustee) having title but no beneficial interest in the business assets.
The trustee, however, has a right of indemnity over trust assets and this may mean that in a liquidation scenario the liquidator can draw upon trust assets to meet liabilities. This right of indemnity is created by equity law and the Corporations Act.
One of the main advantages of trading trusts is that pre-tax income flows through a trust and the trustee (in a discretionary trust) can distribute income between beneficiaries tax effectively. There could be savings based upon the different marginal tax rates of beneficiaries.
What is the risk to controllers and beneficiaries of the trading trust?
If the owners are directors of the trading trust company they owe duties under the Corporations Act. This includes a duty not to trade whilst the company is insolvent.
There are some narrow cases where beneficiaries were found to be legally liable for trustee debts:
- Hardoon v Belilios: Where a beneficiary gets all the benefit of the property they should be liable to indemnify the trustee for loss
- JW Broomhead (VIC) Pty Ltd v JW Broomhead Pty Ltd: Builder who traded through a unit trust failed and beneficiaries were found to be liable for liabilities incurred
- Mclean v Burns Philp: A heavily geared trust was deliberately used to hide assets from creditors
It should be noted that the right to recover from a beneficiary is limited and there is generally no right to indemnity from the beneficiary of a discretionary trust.
What are the risks to creditors of trading trusts?
The risks to creditors of dealing with a trading trust are:
- There are insufficient trust assets to pay all creditor debts
- There is a provision of the trust deed that excludes the scope of indemnity for all creditor claims
- The trustee has breached the trust deed and has lost its right of indemnity from trust assets
- The directors of the trustee company are also assetless and cannot pay out any claims that a liquidator makes against them
Creditors have a limited right of subrogation which can give them access to trust property. Unfortunately, creditors need to rely on the somewhat obscure law of equity and an equitable remedy that can only be obtained through the Courts.
The best protections for creditors are listed below.
5 ways to protect your business from dealing with insolvent trading trusts
If you are contracting with or supplying to a trading trust you face increased credit risk. There are at least five things you can do (other than being paid up front) to reduce your credit risk.
1. Do a credit check on the directors and the trustee company
There are all sorts of useful information you can get from a credit check and you’ll find out the following negative indicators:
- Defaults with other credit providers
- Rejections for credit applications
- Winding up petitions or bankruptcy petitions
- Years trading
- Associated businesses
2. Get a director’s guarantee at the start
The best way to protect yourself against trading trust risk is to make sure that the proprietors of your new customer are personally liable for any debts they accrue. There are specific provisions, such as an “all monies clause” or a “continuing guarantee clause” that should be included in your customer credit application to limit your recovery risk by ensuring your guarantees are enforceable in changing circumstances.
3. Make sure your terms and conditions cover you
Your standard terms and conditions of trade should contain a provision like:
“Where the Applicant is a Trustee, the Applicant shall be liable on the account and in addition, the assets of the Trust shall be available to meet the payment of any monies payable”
You want to avoid a scenario where you rely upon the liquidator of a liquidated trustee company to chase the trust funds but this may be the fallback in an extreme case.
4. Establish a credit limit from the start
If you set a credit limit early and then police it the credit risk you have will be capped at your credit limit. The last thing that you want is a continually deteriorating running account.
5. Watch out for Phoenix companies
If there is evidence of phoenix activity you would be best off requiring the new client to pay upfront and avoid giving credit. If you want to learn more about phoenix activity read our blog post: What is phoenix activity?