A Partnership of Trusts or a Hybrid Trust
By James Shattock
A Partnership of Trusts or a Hybrid Trust - which would be right for you?
It is important for your business or investments to be set up properly from the start, with the most appropriate structure for your circumstances. No-one wants to spend a lot of money setting up one particular type of structure, only to find out a few months or years down the track that a different type of structure or entity (say, a unit trust rather than a company) should have been used.
There are many issues to be considered in deciding on the most appropriate structure for you, and we recommend that detailed advice first be obtained from your advisers (including accountants, lawyers and financial planners).
Nevertheless, we wish to outline and compare here two popular structures, namely hybrid trusts and partnerships of discretionary trusts, as people often appear to confuse the two and request one when the other structure may be more appropriate for them.
We accordingly set out below a summary of the main features of each of these structures, as well as a summary of their main respective advantages and disadvantages.
If you decide that a Partnership of discretionary trusts is more appropriate for you, then we can certainly assist you, as we have a Partnership of Trusts agreement precedent that has been developed by lawyers and tax specialists (we can also assist with incidental documentation, including establishment of discretionary trusts and companies).
If, however, you decide that a Hybrid Trust better suits your circumstances, then we can refer you to other lawyers/tax specialists who can assist you further (while we do not provide a Hybrid Trust, we can provide different types of unit trusts, including fixed and non-fixed unit trusts that allow for different classes of units, and unit trusts that are fixed for NSW land tax purposes).
Finally, we note that Hybrid Trust arrangements have been attacked by the Australian Taxation Office in the past, and they have (in some cases) been used to try to obtain unreasonable tax advantages. It is for this reason that we do not provide a Hybrid Trust deed, although this is not to say that a Hybrid Trust should never be used. Hybrid Trust arrangements have their advantages (as set out below), although a degree of caution should be exercised with this type of structure.
What is a Partnership of discretionary trusts?
A partnership of discretionary trusts is simply a partnership in which each partner is a discretionary trust (actually, each partner is the trustee of a discretionary trust). This is to be contrasted with a normal partnership of individuals. Rather than each individual being a partner in the partnership, each individual’s discretionary trust is the partner. This structure therefore generally allows for each partner to be entitled to a fixed percentage of the income and capital of the partnership, but each partner can then distribute their own share of that income (or capital) as they see fit (and a discretionary trust partner would generally have full discretion as to the distribution of its own share). This is discussed further below.
Note that, despite being described as a “partnership of discretionary trusts”, it is possible to admit other entities (e.g., individuals or companies) as partners of the partnership without amending the partnership agreement, although some of the advantages of using a trust may not be available.
An agent or manager is sometimes used to act on behalf of a partnership of trusts. This is done predominantly for administrative ease.
What is a Hybrid Trust?
A Hybrid Trust is basically a combination of a discretionary trust and a unit trust.
The trustee of a hybrid trust generally has the power to distribute income and capital among the beneficiaries as described in the deed, as in a standard discretionary trust.
However, a hybrid trust generally also allows for units in the trust to be issued, as in a standard unit trust, entitling the holders of the units to receive at least part of the income and/or capital of the trust in proportion to the number of units that they hold.
Hybrid trusts accordingly include the features of both discretionary trusts and unit trusts in the one trust, although there are various different types of hybrid trusts.
Advantages/Disadvantages of a Partnership of discretionary trusts
Asset protection - Each partner in the partnership is jointly and severally liable for the debts of the partnership. However, as each partner is a discretionary trust, the personal assets of the individuals are generally protected.
Fixed interest – Each principal, through their discretionary trust, has a fixed interest in the capital and income of the partnership. Should there be a dispute or should the business fail, each discretionary trust will be entitled to a share of the profits and capital according to its fixed interest in the partnership.
Flexibility of distributions – The trustee of each discretionary trust can distribute the trust’s share of partnership income among the trust’s beneficiaries in any way it wishes. Thus, tax can be minimised by distributing income to those beneficiaries on the lowest tax rates, including any corporate beneficiaries.
Small business CGT concessions – For partnerships, where an asset is sold, the capital gain arises in the partner. Therefore, whether or not a particular partner satisfies the relevant conditions to obtain the small business CGT concessions should have no effect on the ability of another partner to satisfy the relevant conditions.
Tax-free distributions – It is generally easier for tax-free distributions to be made through a partnership of discretionary trusts, as compared to a unit trust or a company.
Independence – Each partner trust is effectively independent of the others. A partner trust can sell its interest in the partnership without affecting the tax position of the other partners, although in practice it may be difficult to find someone to buy their interest. New partners can be admitted easily by simply becoming partners in the partnership, although there may then be tax implications for the existing partners.
Employment benefits – The individual principals can be employed by the partnership and obtain the benefits of salary packaging, employer sponsored superannuation, etc.
Cost – A Partnership of discretionary trusts obviously entails additional costs (i.e., in the establishment of the separate discretionary trusts (unless they are already in existence), corporate trustees, corporate agent, etc).
Advantages/Disadvantages of Hybrid Trusts
Asset protection – Hybrid trusts provide a certain degree of asset protection, especially if a corporate trustee is used.
However, unit holders of a hybrid trust will not have the same degree of asset protection as a beneficiary of a discretionary trust, because the holder of units in a trust holds valuable property (which entitles the unit holder to a proportion of the income and/or capital of the trust).
Fixed interest – In a Hybrid Trust, the holders of units generally have a fixed entitlement to income and/or capital, while the trustee still has some discretion in relation to the distribution of income and/or capital (i.e., as there may also be beneficiaries that are not unitholders).
Flexibility of distributions – As stated above, in a Hybrid Trust, the trustee generally has some discretion in relation to the distribution of income and/or capital (while there may also be unitholders that have a fixed entitlement to income and/or capital).
Capital gains tax – With a Hybrid Trust, there may be the ability to issue and redeem units without triggering CGT, and also for CGT to only be assessable in the hands of beneficiaries (although this depends on how the trust deed is drafted and detailed advice should be sought). However, there is a real risk that the CGT small business concessions may not be available, as the entitlement will generally need to be assessed at the hybrid trust level (rather than at the beneficiary level). In addition, when establishing whether there is a ‘significant individual’ of a non-fixed trust, the trustee must have regard to the distributions of income and capital during the income year, but if a beneficiary’s entitlements to income and capital differ, the smaller entitlement applies. This could mean that the hybrid trust will not be able to access the small business concessions.
Tax-free distributions – Similarly to a Partnership of discretionary trusts, it is generally easier for tax-free (or low tax) distributions to be made through a Hybrid Trust (especially to beneficiaries that are not unitholders), as compared to a unit trust or a company.
Entry/exit of new parties – It is comparatively easy for parties to enter or leave a Hybrid Trust, although there are tax issues to consider (including a possible risk of resettlement). Also, Hybrid Trusts can be wound up relatively easily.
Employment benefits – Individuals associated with the trust/beneficiaries can be employed by the trust and obtain the benefits of salary packaging, employer sponsored superannuation, etc.
Cost – Hybrid Trusts are relatively low-cost (in particular, they do not require the establishment of separate discretionary trusts, as would be required for a Partnership of discretionary trusts, although it may be beneficial for the unit holders to be discretionary trusts or companies).