Business Structure Article

Issues To Consider When Choosing A Business Structure

SOLE TRADER
PARTNERSHIP
COMPANY
TRUST

Sole trader

You can trade under your own name or register a business name (Cost less than $100)

Advantages: - Straightforward structure
No agreement with third parties
Cheap to establish and operate
Rollover relief from capital Gains Tax

Disadvantages: - Low flexibility
Quarterly PAYG instalments
Superannuation contribution not 100% deductible
Unlimited personal liability for business debts.

Operating as sole trader minimizes the overhead costs of running a business due to the simple structure

Splitting of income is limited but can be done as follows:

Mrs Red buys the business in her name and EMPLOYS her husband as manager. As the owner she is taxed on the profit after charging her husband's salary thus the income is split effectively. The amount of the split can be controlled by the value of the husband's salary. Correct employment records must be kept and provisions of the Work Cover and Superannuation Guarantee Charge must be observed.

Protection of Assets
Mrs Red can transfer her assets into the husband's name so any liability caused by the business failing cannot be charge against the husband's assets. (This also works in reverse of course)

Business Name Registration
If you use your own name it will not be necessary to register the business name. Should you choose otherwise, then registration is required by law and a fee of currently less than $100 will apply.

Quarterly PAYG instalments
The safe way to control PAYG instalments is to allocate a porion of each months profit to tax and to bank that into a separate investment. When you are assessed the funds will be readily available This process also works very effectively for GST, if you are registered.

Partnership

A written agreement is the normal requirement. This agreement sets out profit sharing %'ages & may provide for salaries to the partners. Partnerships may be between natural persons, Companies, or trusts or any combination thereof. Here we set out detail of person to person partnership only. It is advisable to ask a Solicitor to draw up the agreement although preprinted forms may be obtained from a legal stationer.

Advantages:- Straightforward structure
Cheap to establish and operate
Partnerships pay no tax itself and thus
a Profit is distributed to partners as in the agreement
b Loss is distributed to partners as in the agreement
c Capital Gains/Losses also distributed.

Disadvantages:- Partnership agreement sets a relatively Rigid format
Partners are Jointly & severally liable for each others acts
within the business
Superannuation contribution not 100% deductible
Changes of ownership under the agreement will cause
Capital Gains Tax implications which can be undesirable

Associated Persons.

Family members or persons considered by the ATO not to be a "Arms Length" are defined as Associated Persons.

The ability to pay Salaries, Management fees or the like as a method of splitting income is subject to close scrutiny and careful evidencing of the activity s recommended.

Partnership Share

Similarly, should a partner NOT have full control of their own share of the income arising from it, the ATO may declare the arrangement a "Sham" and apply Part IV(A) to set it aside and tax the remaining partners on the income diverted.

Quarterly PAYG

Also applies. (Refer Sole Trader)

Generally speaking this is the business format considered to be most difficult to control over an extended period.

Company (Pty Ltd)

Because a Company has its own INDIVIDUAL IDENTITY which is separate from your own it is much more complex. This separate identity enables it to be sued and to sue. It is able to own assets in its own name and can use those assets as a base for borrowing.
A company is usually created in one of two formats.

� A standard format with shareholders numbering between 2 to 50 & having 2 or more directors. Any quantity or value of shares may be nominated but only a part of them needs to be actually issued.

� A Single director format which only needs one Director & one Shareholder & which has the same share capital provisions as 1 above.

Advantages
a Generally protection from personal liability
b Lower Tax rate.
c Able to retain after tax earnings
d Trading losses may be carried forward
e Can own a Business/Franchise in its own name
f Superannuation Deductions 100%

Disadvantages
a Cost of set-up between $950 to $1,500
b Some personal liability to Directors
c Rigid distribution of profits in proportion to shareholdings
d Capital Gains Tax position needs great care
e Australian Securities and Investments Commission controls.
f Formality of presentations results in higher annual costs

ADVANTAGES

1a Limited Liability

A Pty Ltd (private) company has liability limited to the value of the issued shares

1b Tax Rate

At present the tax rate is 30% which is less than the top marginal rate of 48.5%. A company does not pay Medicare or similar levies. After paying tax this leaves 70% to be retained by the company.

1c Retained Earnings

These may be distributed to shareholders as dividends in subsequent years. If the company has paid tax on these earnings the Dividend Imputation Credits may be available to the shareholder.

1d Trading Losses
May be carried forward subject to several tests relating to Continuity of Ownership and/or The Same Business test

1e Owning a Business
Contracts which are completed in the Company name generally do not required to be renegotiated if the ownership of the company is passed on by selling your share. After you sell your shares the company still retains its liabilities and assets and the net value of these is generally expressed as the sale value of your shares.

1f Superannuation Deductions.
An individual receives a deduction of 100% of the 1st $5,000 and 75% of the excess, whereas a company gets 100% of the whole sum. Both deductions are subject to aged based maximums.

DISADVANTAGES

2a Set up Cost
Self explanatory

2b Director's Liability
A director may be personally liable to creditors in the following situations:
1 Company continues trading while insolvent [
2 Failure to remit PAYG and some other withholding taxes [
3 Tax offences of the company
[
One method of restricting liability is for one party to hold the shares and the spouse to act as Director. If the spouse has no assets then the effect is to minimise the impact of any liability. Where two families are involved the most simply use of this format is

Your Co. Pty, Ltd

Shareholder 1 Director 1 No Assets
Family One Spouse of Shareholder
Holds Family Assets Family One

Shareholder 2 Director 2 No Assets
Family Two Spouse of Shareholder
Holds Family Assets Family Two

NOT LIABLE TO CREDITORS - ASSETS SAFE LIABLE TO CREDITORS - NO ASSETS

2c Distributions of Profits (Dividends)

Profit is generally distributed in direct proportion to the shareholdings. It is possible, however, to create different types of shares giving each type a different right. Using this arrangement you are able to vary the dividend rates on each type of share. This may differ from year to year.

Example

If the company makes a profit of $28,000
Tax @30% $ 8,400
Profit After Tax $19,600

If there are 12 issued shares of the one types held
Family 1 6 Shares The dividend is $ 9,800
Family 2 6 Shares The dividend is $ 9,800
12 $19,600

If we create a second class of shares and they are held
Family 1 3 "A" Shares The dividend is 10% $ 1,960
Family 2 3 "A" Shares The dividend is 10% $ 1,960
Family 1 Spouse 3 "B" Shares The dividend is 40% $ 7,840
Family 2 Spouse 3 "B" Shares The dividend is 40% $ 7,840
12 $19,600

This last method can give a VASTLY different taxation situation.
Furthermore the dividend %'age can be varied each year to suit.

2 d, e & f

These areas require professional advice as your personal situation is unique.

SPECIAL CONSIDERATIONS FOR COMPANY STRUCTURES

As can be seen from the foregoing a company structure is extremely variable. One of the side effects of this is that they have been used extensively in tax planning. The Tax Office has set in place a number of guidelines to limit obvious abuse and a general overview is set out below.

1 Loan Accounts [specifically those where you owe money to the company

The effect of letting the company pay tax on its income & then not declare dividends is to leave your money in the company. If you choose to withdraw this money and use it personally then you are borrowing money from the company. If you do not have a written loan agreement and pay a market rate of interest on this loan (preferable on a daily balance basis) there is a real possibility that the Tax Office will do one of two things;
� Charge you Fringe Benefits Tax (at the highest marginal rate) on the imputed value of that interest.
� If they believe you are not able or likely to repay the loan they may deem the loan to be a dividend and tax you personally.
�
Neither of these alternatives is desirable as they defeat the tax benefits of using the company format in the first place.

You are advised to get professional advice covering the above point.

Reducing your loan account from the company

� Apply franked dividends against the balance of such a loan account.
� Increases wages to directors/shareholders (keeping them "reasonable" to avoid Sec.109) and applying the balance to the debit balance loan accounts.
� You may sell business assets into the company at market value preferably set by an independent person.

2 Salaries to Directors/Shareholders and/or Relatives (Sec. 109)
A common method of diverting income is the use of paying amounts from the company, typically:

Director's fees
Wages
Management/Consulting Fees
Retirement/Redundancy payments

In all instances payments as above must be reasonable and carefully documented. Sec. 109 is applied where as excessive payment is made after consideration of all the surrounding facts relating to that payment. If the payment is deemed excessive the Tax Office will disallow the deduction to the company and treat the income of the recipient as a dividend. This effectively double taxes the payment. Proper recording procedures and professional advice regarding acceptable value of each payment is absolutely essential.

Trusts

A trust is created where one party [Trustee] holds property] for the benefit of another party(or parties) [Beneficiary]

The Trustee/s may be one or more natural persons or a Company.

The property is held in the name of the Trustee as legal owner and the Trustee applies the income and corpus (Capital) for the benefit of the Beneficiary.

The application of income is controlled by the Deed setting up the Trust.
1 Discretionery Trust -- At complete discretion of the Trustee
2 Fixed Trust -- In specified proportions as set by the Deed
3 Unit Trust -- In proportion to the number of units issued.

An inter vivos trust is a trust created by a living person and a testamentary trust is one that has been created by will.

Benefits: a Income streaming
b Flexibility of Types & distributions (Tax Effective)
c CGT concessions
d Asset protection
e Addition/Removal of benefciaries

Disadvantages: a Unit Trusts (Sec. 160ZM)
b No land tax threshold with discretionary trusts
c Personal exertion income
d Carry Forward status of Losses are unclear at this stage.

Income Streaming

This is unique to trusts and is the ability to receive a number of types of income
and to pass that income type to an individual specific beneficiary. This can be invaluable as the different types of income may have varying tax implications.

In the following example the Interest income may be given to a non-resident, which restricts the tax to 10%. If the Capital gain is given to a taxpayer with carry forward capital losses, the tax payable would be reduced.

Flexibility of Types & distributions (Tax Effective)

Different types of Trusts may be combined to give excellent effect. Consider that a discretionary trust may have been a beneficiary which is a Unit Trust thus the formality of rigid distributions may be observed but the flexibility retained in the Discretionary Trust. This can be made to work in reverse if that particular effect is desired.

It should be noted that distributions may be made by transferring assets without having to realize them.

CGT Concessions

If the trust sells assets after holding them for in excess of 12 months it will benefit from the concessional discount available under Capital Gains Tax and pass this discount on to the beneficiaries. This benefit is not available to companies.

Asset protection

Assets in the name of the trust are NOT YOUR ASSETS and cannot be attacked by business creditors. Care is essential however if you have loaned monies to the trust, as assets may need to be realized by the trust to pay you back the loan. Individual advice is needed in this area.

Addition/Removal of beneficiaries

The Trust Deed may allow alteration to the beneficiaries. This may give rise to serious CGT issues. It is for this reason that the correct structure should be carefully planned before commencing any operations.

DISADVANTAGES

Personal exertion income

Income earned from the personal services of one taxpayer that are redirected through a trust & then distributed to other taxpayers may be reclassified "income from personal services". The Tax Office may divert these back to the taxpayer who performed such services.
Salaries or fees performed by associated persons must have a documented and explainable basis for the payments.

Carry Forward status of Losses are unclear at this stage.

Prior year budget proposals contained some restrictive provisions relating to the transferability of Trust tax losses. No comment is offered on these provisions, as they are not yet law.