Compliance Issues: Trading trusts

CATHERINE GOULD: When properly set up, trusts can offer significant asset and creditor protection advantages.

In March this year, Inland Revenue issued a warning about the dangers of income splitting, using a trading trust or possibly a company.

It said it would look closely at situations where a person, particularly a professional or skilled person, operated through a trust or a company and paid him or herself a salary or wage at a level lower than what they would earn if they were self-employed, distributing the balance income to family members on lower tax rates.

The warning follows a recent battle fought in the courts, involving a dentist who transferred his dentistry practice to a trust. The dentist continued to work in the practice, engaged by the trust as an employee and paid a salary of $80,000.

The trust derived the income from the practice, after deduction of expenses, including salaries.
This income was distributed to the beneficiaries of the trust, being the dentist's wife, children and grandchildren.

Inland Revenue considered the structure was a tax avoidance arrangement, with the result that the dentist should have derived (and paid tax on) all of the income from the dentistry practice, instead of the income over and above his salary being distributed and taxed to persons other than the dentist (those persons being on lower tax rates).

The court held that although the dentist had sound business (non-tax) reasons for structuring his business this way, there was also a more than incidental purpose or effect of tax avoidance, because the salary he was paid by the trust was artificially low in the circumstances.

In the end, more of the income (although not all) was attributed to the dentist, and less to the trust (and its beneficiaries).

Operating your business through a trust is popular for a variety of reasons. When properly set up, trusts can offer significant asset and creditor protection advantages. Trusts also have tax benefits.

Income of the trust that is distributed to beneficiaries during the year it is earned or in the following six months is taxed at the beneficiary's tax rate. If it is not distributed in this way, it is taxed at 33 per cent, and can then be distributed to beneficiaries tax-free.

There are obvious advantages where income would be taxed to a person at 39 per cent to divert the income through a trust so that it is taxed to beneficiaries who could be on a tax rate as low as 19.5 per cent. Companies can also be used for similar reasons and to similar effect (although the advantages are not as significant).

Inland Revenue has other strings to its bow to counteract tax advantages obtained in these types of situations. The "personal services attribution rules'' are a specific anti-avoidance mechanism designed to ensure that people performing services do not use interposed entities to avoid the highest personal tax rate of 39 per cent.

The rules can apply in certain circumstances to attribute the income derived by the interposed entity to the person who actually provides the services. Also, under the ``minor beneficiaries rules'', trust distributions to minors under 16 years of age in certain circumstances will be taxed at 33 per cent instead of the minor's tax rate. This is a specific rule designed to prevent the diversion of income to minors on low tax rates in certain situations.

If you are considering operating a business through a trading trust or a company owned by other family members, get advice. These structures can be tax effective. You should ensure that there are legitimate reasons for the arrangement, and that salaries generating the income are set at reasonable levels.

*Catherine Codd is a senior solicitor in the Auckland office of Buddle Findlay.