Choosing your business structure
Sally Preston
What are the options when deciding on a business structure? How do you choose which one to use? Is there a right or wrong answer? We hope to shed some light on these questions below.
What are the options?
You may consider using one or more of the following:
Company
Trust
Partnership or joint venture
Operate as a sole trader
What are the key considerations when deciding on a business structure?
The choice of business depends upon a variety of factors and when you decide on your structure you may find that some of these factors compete with one another. This means that there may be trade-offs when deciding on the structure for your business.
Generally, the main factors to consider are:
Whether there are unrelated parties who will be investing in the business or assets and what type of entities will the ‘investors’ be?
Protecting valuable assets (such as real estate) from claims against the operating business risks.
Protecting non-business assets (including loans to related parties) and accumulated profits.
Taxation benefits.
Relevant taxation issues, such as:
o What type of income will be generated and how – with this be from the owners' efforts mainly, or from multiple employees, or from the sale of goods.
o How do you intend to be paid?
The type of assets being held such as real estate and depreciating assets.
The tax rate for different companies in the group and how these will interact with one another.
Future transactions:
o Whether new investors are likely to be brought into the business in the future?
o Will a future buyer be willing to acquire shares/units rather than business assets?
o Ability to access the general 50% discount and small business CGT concessions.
Flexibility.
Simplicity.
Below is a high-level explanation of each type of structure, with some of the pros and cons of each one for you to consider.
1. Company
There are several different types of companies and the two main ones you would probably be aware of are “Proprietary Limited” companies – usually privately owned. Then there are “Limited” companies which are often listed on a stock exchange.
One thing to be aware of is that a company is a separate legal and tax entity. This means that for your purposes you need to look at it as a separate being from you. The corporation's law and the company constitution govern how the company is to operate. In particular with things like paying dividends, issuing shares etc.
For tax purposes treating it separately is important when you interact with the company. For example, if you were to draw money out of the company without paying it as a dividend, there can be tax consequences.
Company - advantages
·It is a separate legal entity so can enter into contracts itself.
Companies offer limited liability and the shareholder’s liability is generally limited to any unpaid amounts on the shares.
Generally, shareholders and directors are not exposed to business risks unless they have provided personal guarantees.
If shares are owned by a discretionary trust, there may be flexibility to distribute dividends to different beneficiaries.
A company structure allows a full or partial change in ownership of the entity (shareholders have a fixed interest).
A company can reinvest profits back into the company without the fear of anti avoidance or shareholder loan tax laws (Division 7A) applying.
Company - disadvantages
Higher set up costs when compared to other structures.
Greater regulatory compliance i.e. ASIC
Directors may be exposed where they are subject to statutory risk. It is for this reason that the entity holding any shares in the company is different from the person who is the director.
Requires a greater understanding of business and your responsibilities as a director.
Capital gains issues - Companies are not the best entity to acquire capital assets that are likely to appreciate in value.
There may be taxation issues for shareholders when profits (including capital profits) are paid out of the company.
The changes to the small business CGT concessions where the CGT event happens in relation to the shares have resulted in:
o added complexities in determining whether clients are eligible for the concessions; and
o careful structuring considerations, such as the use of holding companies (in particular owning shares in more than one company).
Tax losses will be trapped in the company.
If a shareholder dies, the company's assets and liabilities will not form part of the estate. If the shares are held by an individual, they will.
Issues to be aware of with the small company tax rate (25%)
Not all companies can access the lower tax rate. It depends on the activities and the nature of the income generated by each company.
Where a company generates more than 80% of its income from passive sources such as an investment portfolio, rental in income, and interest, it will still generally be subject to the 30% tax rate.
So, the lower tax rate is generally for companies carrying on an active business with an aggregated turnover of less than $50m. Note that this turnover test adds up all the connected and affiliated members of the company so it’s not just its own income.
2. Trusts
A trust is an obligation imposed on a person or other entity to hold property for the benefit of beneficiaries. While in legal terms a trust is a relationship not a legal entity, trusts are treated as taxpayer entities for the purposes of tax administration.
The trustee is responsible for managing the trust's tax affairs, including registering the trust in the tax system, lodging trust tax returns and paying some tax liabilities.
Beneficiaries (except some minors and non-residents) include their share of the trust's net income as income in their own tax returns. There are special rules for some types of trust including family trusts, deceased estates and super funds.
Advantages of a discretionary trust
The main advantage of a trust structure (either in a business or investment context) is the flexibility that it provides. The controllers of the trust have total flexibility in relation to how they distribute income and capital on a year-to-year basis and on termination of the trust.
Subject to the terms of the deed, the trustee can also choose who receives different types of income such as capital gains and franked dividends.
Provided there is a corporate trustee, the parties have much the same limited liability as if they used a trading company structure.
Trusts are entitled to apply the 50% general discount.
Asset protection may be achieved for the potential beneficiaries, as none of the beneficiaries have a specific interest in the trust assets.
Disadvantages of discretionary trusts:
The main disadvantage of a trust structure is the need to distribute all income on an annual basis.
Beneficiaries do not have a fixed interest.
Hard for the business owner (and many advisers) to really understand them!
Unit trust advantages
‘Fixed entitlement’ to income and capital.
Has the advantage over a company that it can still access the general 50% CGT discount on a disposal of a CGT asset.
Unit trust disadvantages
Similar to the discretionary trust all income needs to be distributed each year or face the highest marginal rate of tax to the trustee.
A unit trust has a specific CGT event that arises when the unit holder receive more accounting distribution than tax distribution. This can affect the cost base of the units they hold or result in a capital gain so requires close management.
3. Partnership
In general law – a partnership is defined in terms of a relationship between people carrying on business in common with a view to profit. Must be carrying on a business. For tax purposes – a partnership means an association of persons carrying on business as partners or in receipt of ordinary income or statutory income jointly but does not include a company. Includes mum and dad holding real estate or bank accounts jointly. It is not a separate legal entity and therefore, each partner is jointly and severally liable for debts and obligations incurred while they are a partner, offering limited asset protection.
A partnership is required to lodge an income tax return, however, it does not pay income tax as it is the partners themselves that include their share of the partnership net income/(loss) in their own tax returns. The structure also only offers limited ability to split income if the partners are individuals as the net income or loss must be shared by the partners.
If the partnership disposes of a CGT asset, the partner will report the capital gain (not the partnership). Accordingly, provided that the partner is an individual or trust, it will be entitled to CGT discount if the CGT asset held at least 12 months.
Advantages of a partnership:
Can be used for short term projects as cheaper to set up.
Creates a shared responsibility and purpose.
Governed by the partnership agreement and less external governance.
Simple and flexible.
Disadvantages of a partnership:
There is the joint and several liability of partners. In other words, if any of the partners do not have enough money or assets to pay their share of the debt, the other partners may be personally liable. This arises from the fact that the partnership is not a distinct legal entity.
As it is not a separate legal entity the partnerships cannot own property.
There is generally no asset protection, meaning that the partners’ personal assets may need to be used to repay the business’ debts.
There are some CGT disadvantages. In particular, the law treats an individual partner’s share in the partnership as representing a direct fractional interest in every asset of the partnership.
where there is a change in the membership of partners this will usually alter the partnership agreement unless the agreement stipulates otherwise, affecting the continuity of the business.
It is difficult to transfer an interest in a partnership as compared to transferring shares in a company.
4. Sole trader
This is simply you acting as you. You may have a business name but there is no legal structure surrounding the business. This is the simplest form of starting a business and in some cases, particularly for people in trades, this may be where you start.
Advantages:
Simple – easy to understand, no entity to establish, an individual can register a business name or trade under their own name.
Less regulation around how you operate and less reporting requirements.
On death all assets and liabilities form part of the estate.
Disadvantages
Asset protection – any assets you personally own are exposed to any risk inherent in your business.
The structure needs to change to bring in business partners and in some cases to grow
The bigger you get, it may not appear professional to not be using a more formal structure for example, when employing staff.
There is no ability to manage your tax rates i.e. there is no access to the company tax rate, so all profits will be taxed at your personal marginal tax rates. So if there is a plan to reinvest in the business then tax will be paid on the full amount and then the money reinvested – a company would mean tax is only paid up to the company tax rate and then can be reinvested.
So, which one?
It may be that your structure includes several of the above options. Whilst there is no “wrong” answer, there is often an optimal structure depending on your business circumstances.
It may be difficult to navigate the options on your own, so ideally you would seek the assistance of your accountant and/or lawyer for further guidance.