Chapter 3 -Business Structures
There are various types of business structure that can be set up to run your business. Some are cheap free and simple, others cost more to set up but have definite advantages in the long run. When looking at Business structures you need to consider:
- Initial Set Up Cost
- Asset Protection
- Income Tax Implications
- Sale of Business Capital Gains Tax Implications
- Wind up of the Business Implications
- Ability to bring in new investors/partners
- Implications if something were to happen to one of your partners or shareholders.
Although we will work through the different types of businesses below, it is recommended that you seek the advice of your accountant before choosing an entity structure.
No matter what type of structure you create, you still need to register for an Australian Business Number (ABN) and potentially a business name. It is common practice for banks to require the ABN number prior to opening a bank account and they will require the business name registration if you want that name on the documentation.
Basically a sole trader is you. This is the quickest and easiest structure to set up. It is simply a matter of you deciding that you are going to go into business on your own, setting up an ABN or Australian Business Number, and starting to trade. If you want to trade in a different name to your own with a business name, then you need to register this with the Australian Securities Investment Commission (ASIC). The process for this is explained in chapter 4 – Licencing. Keep in mind something as simple as Bill Smith Electrical needs a business name because it is not simply your own name.
The Pro’s and Con’s of being a Sole Trader are:
|Quick & Easy to Set up||Income tax rate is your marginal tax rate|
|You are the sole decision maker||No Asset Protection as it is in your name|
|Capital Gains can be reduced by 50% if you own an asset for greater than 12 months||You cannot bring in other investors without a change of structure|
|Small Business CGT Exemptions Apply||Business Name Registration Required|
|No Ongoing Regulatory Fees|
So the bottom line is that while a sole trader is quick and easy to set up, the biggest issues are income tax rates and asset protection.
When operating as a sole trader, all liabilities rest with you. This means that every action that you take with customers, suppliers, staff, ATO and the world in general provides them with your personal guarantee. If something goes pear-shaped, those people are entitled to sue you for damages, which means that any other assets that you personally own are on the line in your business. That’s pretty scary.
Income Tax Rates You will need to prepare an annual taxation return for yourself and you will be taxed on the net profit of the business irrespective of whether or not you spent the money. This is in contrast to other structures where you would only be taxed on the money that you draw from the business by way of wages or dividends. Furthermore, depending on the level of profitability, individual tax rates may result in you paying a lot more tax than say a company where the tax rate is fixed at 30(28.5% for small businesses). Unlike other structures, annual financial statements are not required but it is advisable to do so to support your annual tax return.
A Partnership is a common-law agreement between two parties. Generally it refers to two individuals however it can be other entities such as trusts or companies. It is not essential that both parties are the same type of entity.
A partnership itself is free to create but because you never know when things may go pear-shaped, I highly recommend that you set up a partnership agreement from day one. Legal fees are required for this but the insurance that it provides you with in the event of a nasty split or the death of one party, far outweigh the costs involved. It is possible but not advisable to add a partnership agreement to a partnership after the partnership has been created.
Closure of partnerships can create animosity between partners. A good partnership agreement will solve this problem. Another compelling reason to have a partnership agreement is to cover the situation where the partnership looks to sell the business in the future. It is normal practice to require the general agreement of both partners. While this seems difficult, it is essential that partners act in the best interests of both themselves and the other partners at all times.
As with a Sole Trader, a business name registration is required through ASIC.
The Pro’s and Cons of a Partnership are:
|Free to setup||You should have a partnership agreement which is costly.|
|Capital Gains can be reduced by 50% if you own an asset for greater than 12 months||You must have majority agreement on decision making|
|Small Business CGT Exemptions Apply||No Asset Protection if the partners are individuals|
|No Ongoing Regulatory Fees||Both Partners are jointly and severally liable for the actions of the other partner|
|If you bring in new partners there is a capital gains event|
|Business Name Registration Required|
Like a sole trader, a partnership carries the same if not more risks in regard to asset protection and taxation.
As mentioned in the Cons, both parties are jointly and severally liable for actions of the other party. This means is that if one partner enters into a contract on behalf of the partnership, the person that he/she has contracted with is entitled to seek repayment or recourse from the other partner. Generally whilst the partnership is running well this is not an issue but should things turn bad, it means that you may be responsible for debts that have been created by your partner without your knowledge. And again, your personal assets will be exposed to this risk.
Keep in mind that you still need to prepare an annual tax return of the partnership and you should still create financial statements for this partnership. The reason for this is that Financial Statements show not only the money that has been contributed by each partner but also their share of the profit, their drawings and the balance left owing to them. It is also important to note that each individual partner is required to show the income from their partnership in their own tax returns each year. Profits made in partnerships are taxed regardless of whether or not the partner has drawn those profits at year end.
As with a Sole Trader, you will be taxed on your share of the partnership profits at individual tax rates which could be punitive.
Company (Proprietary Limited Company – Pty Ltd)
A company is an entity that is set up in accordance with the Corporations Act and is a legal entity in its own right. A company has shareholders who are the investors in the company and directors who are responsible for the day-to-day running of the company. It is possible to have a single shareholder or single director company however generally that is not recommended because should something happen to that director it would make it extremely difficult for the company to continue to trade and for the beneficiary of that shareholder to maintain something of value.
It is important to remember that a company is an entity in its own right as distinct from the shareholders. As such, it is able to buy and sell land, borrow, employ staff, and generally invest in any enterprise that it wishes.
|Asset Protection for Shareholders||Initial Set up Fee and Ongoing Regulatory Fees|
|Small Business CGT Exemptions Apply||No 50% CGT Exemption|
|Tax rate 30% (28.5% for small business)||Directors Guarantees remove asset protection|
|Imputation Credits on Dividends||Limited Flexibility with Profit Distributions|
|Business Name Registration not required|
Because the company is a legal entity in its own right it generally means that liabilities of the company stay in the company. Whilst this seems like a great idea, it is important to keep in mind that banks and major suppliers will most likely require a Directors Guarantee. Furthermore, if the directors knowingly allow the company to trade whilst it is insolvent, they will be liable for any losses incurred by the creditors
Set up and Regulatory Fees
A company has a setup fee which is usually set up by a third party provider and includes a payment to the Australian Securities and Investment Commission (ASIC) as well is their fees for setting up the company. Company names can generally be anything that the investor requires provided that it has not been registered or used before and it is not illegal or offensive. It is possible to change company names once they have been set up, there is a fee to ASIC for such a change and generally if the company has already set up bank accounts then the bank will require new accounts to be set up rather than changing the account name. Companies have an annual fee to ASIC which is required to be paid; this fee is paid 12 months after the initial set up date of the company. A company can also have a separate trading name the same as an individual or partnership, it simply needs to be registered with ASIC as previously mentioned.
Taxation and Financial Statements
Under Corporations Law, Annual Financial Statements must be prepared for a company, and the ATO requires an annual taxation return to be submitted. Unless otherwise approved by ATO, the annual financial year is 30 June. The cost of preparing the financial statements and tax return will depend on the complexity and size of the business and will vary from accountant to accountant. Unless you have an existing relationship with an accountant, you should “shop around” but bear in mind that “cheapest is not always best”!
Companies are taxed at a fixed rate of 30% on profit. This is reduced to 28.5% for small businesses. Dividends paid to shareholders out of taxed profits come with a tax credit or imputation credit which can be used to offset tax in the individual’s name
The best way to show this is to look at the numbers. Say a company pays Bill Brown a dividend of $10,000 which has been franked (meaning the company has paid tax on this income):
Imp Credit 4,285
Taxable Income 14,285
Tax payable by Bill (say 19%) 2,714.15
Less Imp Credit (4,285)
Refund to Bill 1,570.85
If Bill has other income which puts him in a higher tax bracket then his refund may be reduced or he may need to pay the difference between the tax payable and imputation credit. These are all issues to be considered before paying dividends.
The important fact here is that Bill receives a credit for the tax paid by the company so the income is not taxed twice!
When a company sells all or a portion of its business, any profit (Capital Gain) is taxed on the same basis as any other income at 30% (28.5% for small businesses),however currently there are some generous Small Business CGT Concessions available. These concessions are not as generous as those available to individuals and individual beneficiaries of trusts.
If you are creating a company with a business partner (wife or family members included), it is suggested that you create a shareholders agreement at the time of this company set up. This agreement will regulate the actions of each individual partner/shareholder and in addition, provides instructions on inter alia:
- payment of dividends
- appointment of shareholder directors and their roles and responsibilities
- sale of shares
- monetary and other matters to consider in the event of a winding up of the company or a falling out between shareholders.
There are various types of trust structures but the most commonly used types of trust structures are family or discretionary trusts and fixed trusts. Before discussing the various types of trusts and their role in tax planning and profit distribution, there are a few of terms that you need to know:
Settlor – person who gives the trustee the money to invest on behalf of the beneficiary.
Trustee – person who is responsible for looking after the investment of the beneficiaries.
Beneficiary – the person or entity that is entitled to a share of the profit of the trust.
Appointer – the person who has the ability to change or remove trustees (generally the primary beneficiary).
The basic logic behind a trust is that the settlor gives the Trust (trustee) something, usually money, to invest or look after on behalf of a beneficiary. Whilst this might be confusing what this actually means is that the trustee is responsible for investing money that the trust receives from the settlor on the behalf of the beneficiaries.
When creating a trust, it is advisable to have a company as Trustee. This puts an extra entity between you and your business which assists in protecting your assets. This is also really handy if you need to change trustees for some reason, Another advantage is that if you have individual trustees then you need to set up new bank accounts & transfer any property over to the new trustee whereas if you have a company as trustee, you simply change the directors. This is really important for family trusts where businesses are to be passed down generations.
All trusts are set up with a legal document being a Trust Deed. Trust Deeds regulate what the trustee can and cannot do with that money but generally trusts are able to invest that money as seen fit for the benefit of the beneficiaries.
This deed needs to be set up by a legal practitioner or a third party trust supplier. The costs of these vary depending on whether you want a standard off-the-shelf or something that is totally structured for your family environment.
Types of Trusts
Let’s look at family or discretionary trusts first.
A family trust is generally set up to create wealth for the beneficiaries of this trust. The beneficiaries of the trusts are generally related to the primary beneficiary. This means that the wife, children, grandchildren, parents, grandparents, aunts and uncles of the primary beneficiary are generally able to receive distributions from this trust. Often companies within the family group can receive distributions from trusts as well (depending on the deed). The trustee is responsible for deciding who within the family group receives a distribution. This means that the trustee needs to look at the profits of the trust prior to 30 June and determine who that profit is to go to. Both family trusts and discretionary trusts are generally discretionary in nature, the only real difference being in that one is called discretionary and the other called family.
Say the Smith Family Trust was set up with the following information:
Settlor – Mr Accountant
Settlement Sum – $10
Trustee – Smith Enterprises Pty Ltd
Primary Beneficiaries: Bill & Mary Smith
This means that Smith Enterprises is to invest the $10 for the good of Bill & Mary Smith. In reality Bill & Mary Smith wanted to buy the local take-way business and contributed $150,000 for the purchase. At the end of the year the business had made a profit of $50,000. The Trustee, Smith Enterprises must decide prior to 30 June who to allocate this to. As Bill was working at the Council, they decided to allocate $400 to each of the kids and the Balance to Mary.
|Flexibility to distribute profits||Distribution needs to be decided prior to 30 June each year|
|Asset Protection||Cannot bring in investors other than immediate family|
|Tax rate depends on each beneficiary||Financial Statements must be prepared|
|No Ongoing Regulatory Fees (unless you have a company as trustee)||Business Name Registration required|
|All CGT Rules Apply providing beneficiary is a natural person|
Unit trusts or fixed trusts are set up a bit like a company. This means that individual unit holders have a fixed entitlement to the trust profit. The trustee is generally unable to change this distribution from beneficiary to beneficiary. Otherwise, all trusts operate in the same way and the same pros and cons apply.
There are trusts available that are a mixture of fixed and discretionary trusts, there are also trusts available that limit distributions to bloodlines, however this is outside the scope of this book and should be discussed with your accountant to achieve the right result for your individual situation.
There are no further ongoing fees for trusts other than preparation of financials and tax returns, however if the trust does have a business name then then will be an annual fee for this service, this will be discussed further in licensing and registration.
A Trust provides asset protection to the beneficiaries as action can only be taken against the assets of the trust, not against individual beneficiaries. The Trustee is ultimately responsible for settling of debts but is able to use the trust assets to do so. Keep in mind that if the Trustee has given personal guarantees then they may be personally liable to settle debts. A Trust provides better asset protection than a sole trader or partnership and is similar to a company.
It is important to note that as trusts are not generally taxed in their own name, there are no tax credits on the distributions flowing through to beneficiaries in the same way that company dividends do. If a Trust invests in a company and receives dividends with franking credits then that credit does flow through.
As trusts are entities in their own right, they are able to invest money or buy businesses. Capital gains exemptions are generally available to beneficiaries and all unit holders subject to strict ATO regulations based on distributions in past years. This means the trust structure, if used correctly, is an extremely useful vehicle for operating businesses and maintaining access to the small business CGT concessions.
|Entity||Ease of set up||Setup fees||Limited liability||Ongoing registration fees||Marginal tax rate||CGT exemptions||Financial statements required||Annual tax return|
|Company||8||Yes||Yes(2)||Yes ASIC||30% (28.5%)||Limited||Yes||Yes|
- Partnerships technically have no setup fees however a partnership agreement is suggested.
- Whilst companies and trusts have limited liability, should directors or trustees give personal guarantees then there may be a liability on them individually. Also note that where companies trading insolvently, directors may be liable. New ATO regulations regarding outstanding PAYG, GST, and superannuation may also be attached to individual directors or trustees.