SME Finance – Trust Lending
Business Finance Professionals who work with SMEs know the importance of business structure. There are numerous options for a SME in establishing (or re-establishing) the legal structure under which they operate. Choosing an appropriate structure needs to take into account both the current and future requirements and goals of the SME.
The most basic structure is where a self-employed individual operates as a sole trader. Armed with an ABN the business trades under the name of an individual (or trading name owned by the individual). However, there is no legal differentiation between the individual and the business and therefore, little personal protection.
To overcome this lack of protection, SMEs can choose to set themselves up as a company. A company structure provides a clear separation between the individual owners of the business and the business itself, providing a significant degree of protection. However, this type of structure does not afford potential tax benefits to the owners.
Given, these limitations, an increasingly common structure for SMEs, is a trust structure.
Usually, in a trust structure, the SME establishes a company to own its assets on behalf of an individual or a group of people. This person or group are the beneficiaries of the trust, and the company is the trustee. The trustee is bound by the trust deed which sets out the rules, by which the trustee must abide. Primarily the trustee directs the distribution of SME profits to the beneficiaries.
Borrowing through a Trust
There is no issue for a trust to be a borrower.
When borrowing through a trust, the borrower is the trustee company and typically the company directors would be required to give personal guarantees. For Business Finance Professionals and SMEs, a somewhat contentious issue to be aware of is that some lenders go further, requiring any adult beneficiaries of the trust also to give personal guarantees even if they are not involved in the SME.
An advantage of having a company trustee is the ability to change the directors of the trustee company, affording the SME the option to change the person controlling the trust without incurring any transfer costs.
There are three reasons SMEs would use a trust to acquire business assets – to protect those assets; to minimise tax; and estate/succession planning.
The main attraction for using a trust is asset protection.
Because the beneficiaries do not legally own the assets of the trust, those assets cannot be touched to satisfy the personal liabilities of the beneficiaries. So, if one of the owners of the SME defaults on private debt, their creditors will not be able to access the SME assets, as they are in the trust.
Under Capital Gains Tax law, individuals get a 50% reduction from capital gains made on the sale of assets. This exemption applies to the beneficiaries of trusts but not to shareholders of companies. Therefore, it is more attractive for a SME to hold assets in a trust rather than directly in a company.
For discretionary trusts, trustees can distribute SME income between beneficiaries and take advantage of using marginal tax rates. Income splitting can save overall tax payable.
Trusts also provide the advantage of facilitating the tax-free passing of assets between generations. SME owners can effectively transfer assets to others before death by using trusts, as long as they are structured to do so.
Types of Trusts
There are a variety of trust structures available, and Business Finance Professionals and SMEs need to be aware of how lenders treat each of the trust structures. Some lending policies concerning trusts are quite prescriptive and costly. Some lenders direct all trust loans to their commercial lending area, which may not provide the best result for the SME, due to additional fees and higher interest rates.
A discretionary trust is the most common trust used by SMEs. They hold the assets of the businesses for the benefit of providing asset protection and tax planning for beneficiaries. As mentioned, income and assets from the trust can be distributed to the beneficiaries as the trustee sees fit (at their discretion), as long as they follow the trust deed rules.
Family trusts are a type of discretionary trust that provide the most borrowing options while offering asset protection.
SMEs will usually use unit trusts when the business owners are not related or when there is a blend of family members and non-family members.
Similar to owning shares in a company, a unit trust divides assets into a number of lots, called units. The number of units held determines an individual's entitlement to income distributions, capital gains and voting rights. Unitholders can be individuals, companies or even discretionary unit trusts.
The advantage of a unit trust over a discretionary trust is that the beneficiaries’ interests in the assets and income of the trust are known and defined, and easily transferred.
However, the tax benefits are not as flexible as in a discretionary trust, because any income distributions made must be in proportion to the beneficiaries’ unit holding. If the unitholder is a discretionary trust, they may be able to achieve the same or similar tax benefits.
In terms of asset protection, unit trusts don't offer the same levels of protection as a discretionary trust. A beneficiary’s unit holding is defined, and if a unitholder becomes bankrupt, then their units are treated the same way as any other asset and can be sold to pay creditors.
Self-Managed Super Fund (SMSF) Trust
SMSFs are specific trusts that individuals set up to manage their superannuation. Like any superannuation fund, SMSFs can accept employer contributions and additional personal contributions. The difference with SMSFs is that the trustee has control over the investment assets of the superannuation fund.
Therefore, SME owners, who have a SMSF may be able to use this trust structure to borrow funds and purchase assets that are appropriate for both the SME business and the superannuation fund. A typical example of this would be commercial property used as business premises.
For a SMSF to borrow to acquire a commercial property, it must establish a Security Custodian Trust Structure. The Security Custodian Trustee must be a company, and the directors and shareholders of the Security Custodian Trustee Company must be the trustees of the SMSF (for individual trustees) or the directors of the company (for SMSF company trustees).
The borrowing process to purchase a Commercial Property for a SMSF would be: -
The SMSF trustee applies for and secures the loan
The Security Custodian buys the Commercial property on behalf of the super fund and holds the property as an asset in trust for the SMSF
The SMSF has a beneficial right but not an obligation to acquire the property at a future date on repayment of the loan
The loan is against the purchased commercial property. The debt is usually serviced from rental income from the property, although SMSFs can use other income
The loan is limited in recourse with the lender's rights only related to the debt over the property. That is, there is no recourse to other assets of the SMSF, the trustee or the security custodian.
Despite this, many lenders attempt to get more security via acquiring directors’ guarantees. Alternatively, lenders will offer lower LVRs and/or higher interest rates.
There are pros, cons and conditions when purchasing commercial property through a SMSF:
100% of the funds in a SMSF can be invested in commercial property if a member of a fund runs a SME, helping SMEs minimise business overheads and maximise cash flow.
Instead of paying rent to a landlord, SME owners are paying rent to their SMSF
Tax on income (rent) and capital gains (sale of the commercial property) are tax effective in SMSFs – 15% on income and 10% on capital gains (provided the property is held for more than a year).
Rent must be at market rates and paid on time, just as if you were paying it to an external landlord
The property must be independently valued
The property can't be used as security for personal or business loans. Its sole purpose is to provide retirement benefits to the members of the SMSF.
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