There is no one ultimate tax structure that is best for all types of businesses. With so many different tax rules and commercial considerations to take into account, the best tax structure for your business is not necessarily the best structure for another business. The taxpayer who commences or purchases a business usually cannot afford an elaborate tax structure. Whilst they believe the business will succeed they must be careful in early years conserving cash until the business is up and running profitably. So a tax structure should be built over time to take into account the taxpayer’s financial circumstances and the actual growth in that business. As the business expands so should the tax structure.
A tax structure may start with a single entity, such as a company or trust. Other entities are added as the business grows
Whatever your situation, we at Coull and Prior will carry out a complete review of your business and assets and provide you with a written Report on the structure you should have to maximize the safety of your home and family asset.
The building process involves initially establishing the basic structure and then ‘adding’ to it as required. Generally, additions will occur as the business grows and new assets are acquired or the business changes. In order to choose the basic structure it is important to consider a number of factors including the client’s circumstances and their plans for the future (both personal and business). Below is a checklist of factors that should be considered when selecting the basic structure. The checklist is followed by a matrix that compares each of the five main business structures. Following the matrix is a number of checklists of the advantages and disadvantages of each of the five main structures. Suggestions for particular types of structures are made later in these notes under the topic headings “Sole practitioner”, “Structures for arm’s length parties” and “Structures for investments”.
1. Does the principal have a spouse, de-facto partner, or children? What are their ages and personal tax rates and the age and personal tax rate of the principal?
Full details of the principals personal circumstances need to be know, if, for no other reason, to determine to whom income can be passed to minimise tax. The age of children is important to determine, whether, and how much, income can be passed to them. The older the principal, the more likely superannuation is an issue. If one of the aims is to maximize superannuation contributions, the principal will need to be an employee, and therefore the business owned in a separate entity, which can employ the principal. How close the principal is to age 55 is relevant for the small business 15 years and retirement exemptions.
2. What is the current tax status and potential liability status of these immediate family members?
For asset protection purposes, individuals who may be sued or who have significant liabilities should not own assets. They should also not own interests in entities in the structure.
3. Are there any other people, such as close relatives, who are to be part of the business?
There may be parents, cousins etc, who may be involved in the business or, who the principal may wish, to benefit from the business. Alternatively, there may be someone who is willing to own the assets separately from the principal and the business structure for asset protection purposes.
4. What assets do the principal and their family own?
The business structure should protect any assets that the principal already owns from the creditors of the business. So if the business collapses, the principal’s personal assets, such as the family home, will not be lost as well. If the principal owns significant assets, the business should be operated through a separate entity.
5. What debt does the principal, and the principal’s family, currently have?
If the principal, or any member o the principal’s family, have significant debt, then the business should be protected from that personal debt by being operated in a separate entity.
6. What type of business is it?
Full details of the type of business need to be obtained to determine what type of income is being derived; business income or personal services income. If it is personal service income, then the operations of the structure will need to comply with the new alienation of personal services income rules in Divisions 84-87 ITAA 1997 if those provisions apply. If they do not apply the structure should still comply with the ATO’s rulings IT 2121, IT 2330, IT 2503 and IT 2639. If business income will be derived, there is much greater scope for legitimate income splitting. Ascertaining the type of business will also determine the GST implications. For example, it might be a business that makes input Taxed supplies and therefore input tax credits may not be available. This information will also determine who should be registered for GST and whether or not GST grouping is desirable.
7. Will the Business have any offshore activities?
If the answer is yes, then there may be scope for offshore tax planning. As offshore tax planning is expensive, the size of the business and its anticipated profit are also very much factors to take into account when considering offshore tax planning.
8. Will the Business have significant assets?
If the business will have significant assets, then for asset protection purposes, it is best to have the business held by one entity and the business assets held by a separate entity. Personal assets should be held separately from the business entity as well, for the same reason. If the business fails, then the personal and business assets should be protected. The business assets will need to be held in an entity that is connected with the business entity so that they continue to be active assets. If they are not active assets, the small business CGT concessions in Division 152 will not be available. This is not relevant for depreciable plant and equipment as it will not be subject to CGT on sale. It is relevant for other assets, such as the business premises. If the business assets are held in a separate entity, that entity can lease the business assets to the business entity. But beware of the possible application of Part IVA. (The anti-avoidance area of Tax Act)
9. Who will be the principals in the business?
If the business is to be conducted by two or more independent parties, then the range of structures available is limited. The structure must be one in which each party has some sort of fixed interest so that if a dispute arises, it can be easily dismantled with-out there also being a dispute over each party’s share. If there are three or more independent parties, then a single entity structure is unlikely to provide a controlling individual to enable the small business CGT concessions to be obtained in the future. If these concessions are important, a multiple entity structure, such as a partnership of discretionary trusts, should be considered. If the business is to be operated for the benefit of only one family, a greater range of entities are available. A single, family discretionary trust may suffice and electing the trust to be a family trust, if required, may not be a major obstacle. Individual family members owning fixed interests may not be necessary or even desirable.
10. How is the business to be financed?
If the principal intends to finance the business by way of an interest free loan and a discretionary trust is being considered as the operator of the business, the trust deed should give the trustee power to create and issue units (thus making the trust a hybrid trust) so the principal can subscribe for units instead of making an interest free loan to overcome the non-commercial loans rule should it ever be reintroduced. Note from 1st July 2004 such interest free loans are likely to constitute an equity interest under the debt/equity rules. Also, if the business is financed outside the trust, the deductibility of interest may be an issue. If financing is to be by way of equity, an entity will need to be established in which investors can easily purchase a portion – such as a trust with units or a company with shares.
11. Does the principal intend to withdraw much money from the business in the early years?
If the principal intends to withdraw money from the business on a regular basis, then the structure must accommodate this. This could be done either by way of payment of a salary, return of capital, or by providing a loan to the principal. If the principal intends to borrow money from the entity, they must be aware of Division 7A ITAA 1936 for companies. Trusts currently have no such restrictions unless there is an unpaid present entitlement to a company at the time the loan is made to a shareholder of the company.
12. Are some principals to receive an additional distribution of profits or capital?
If so, the entity will need to allow for this. For example, preference shares in the company or preference units in the unit or hybrid trust. However, the dividend streaming rules must be taken into account.
13. Are discretionary distributions of income or capital required?
If so, a company will not be the appropriate entity given the anti-streaming laws and franking credit trading laws. A trust provides the greatest flexibility in this area.
14. Does the principal have a good understanding of tax structures and tax generally?
If the principal does not have a good understanding of tax structures and tax generally, then a simple structure should be used. Any entity which the principal does not understand, should not even be considered even though it may be best fortax purposes. A tax structure is only effective if it is operated properly. If a principal does not understand the tax structure, the principal will not operate it properly, and therefore the tax benefits will not be obtained. Further, the incorrect operation of a tax structure can lead to significant tax problems. For example, if the minimum repayment is not made on a S.109N ITAA 1936 commercial loan, the whole loan can be treated as an unfranked distribution and is fully assessable in the hands of a taxpayer. If particular distributions are not made to an individual, there may be no controlling individual of the entity and therefore, the small business CGT concessions will not be available. In both these cases, significant extra tax will be paid.
15. Does the Tax payer have the discipline to run a more complex structure properly?
Not only must a client understand how each entity in the structure works, but must also have the discipline to run the structure properly and to treat each entity as a separate entity. The principal cannot simply treat an entity’s bank account as an extension of the principals own bank account. A more complex structure can be extremely tax effective, however, if it is not run properly, or one mistake is made, significant extra tax can be payable.
16. If the business is to be operated for the benefit of just one family, who are to be the owners of the business? Must they have their own equitable interest in the Business?
If each owner is to have their own fixed interest in the ownership of the business, A trust with units or a company with shares may be required, or possibly a partnership. If the owners need only control the business, but need not have a fixed interest in its ownership, then a discretionary trust, with the owners acting as trustees, may also suffice.
17. Are new partners to be admitted in the future?
It is more difficult to admit partners into a discretionary trust than it is into a partnership, company or trust with units. Also, some entities such as a company, can admit a new partner by issuing shares, without triggering a CGT liability.
18. What is to happen if one of the principals wishes to leave the business?
Where independent parties are involved, there should be a separate shareholders’ or unit holders’ agreement (or something similar) that includes a buy out mechanism as well as a restrictive covenant to protect the business.
19. What is to happen in the event of the death of one of the principals?
The shareholder’s or unit holder’s agreement should stipulate whether the deceased estate must sell the deceased principal’s interest in the business to the surviving principals. It should also specify how the purchase price is to be calculated and funded. An insurance based funding arrangement should be put in place in the formal buy out mechanism. See page 149 for an explanation of such arrangements.
20. Must the business structure comply with a professional association or some other similar body?
Some professional associations and government bodies limit the range of entities that may be used or stipulate which people must hold the shares, etc, in the entity.
21. Will the business employ people?
Employers are exposed to claims by employees in respect of unfair dismissal, unsafe workplaces, negligence and other types of claims. There is also potential exposure to action being taken by the ATO and relevant state bodies to recover unpaid group tax, GST, FBT, payroll tax etc. The entity should protect the principals from these types of actions. Note: directors of a company, in some circumstances, can be held personally liable for the debts of the company.
22. What type of clients and customers will the business have?
If the business is one of the provisional services, then the exposure to a professional negligence action is much greater. Some states (eg NSW) limit the liability, whereas other states do not. When establishing a structure, the appropriate insurance should be taken out.
23. Does the supplier of work to the principal specify the types of structures that must be used?
Many contractors are required by the payer to incorporate so that the payer need not worry about the PAYG and SGC obligations. This may limit the type of entity that can be used. The alienation of personal services income provisions in Divisions 84-87 must be considered here.
24. What are the short and long term ambitions of the principals?
The structure must be flexible enough to take account of these ambitions. If the intention of the principal is to establish the business, make it profitable and then sell it as soon as possible, then obtaining the 50% CGT discount and the small business CGT concessions are extremely important. Minimising CGT is the most important factor and the structure must take this into account. If the principal intends to operate the business for a long time, then asset protection and minimizing tax on the ongoing profits takes greater priority and minimizing CGT on the sale of the business takes less priority. In this case, the structure should be tailored to minimize income tax on an ongoing basis and to minimize the tax on distributions to the principal. If the principal intends to expand, the structure must be able to cope with expansion – either with the expansion of the current business or expansion into new businesses. If the principal intends to raise money by way of a public float, then an unlisted public company is likely to be the most appropriate structure so that it can be listed in the future. Note that the laws regulating public companies are much more extensive than those regulating proprietary companies.
25. Is the business expected to make tax losses in the early years?
If yes, a trust will need to comply with the trust loss laws and a company with the carry forward loss rules. In the case of a trust, a family trust election may need to be made. If it is important that the losses can be offset against other income of the principals, then the types of structures available will be limited. In this case, a sole trader or partnership of individuals may be the most appropriate structure, although there are significant disadvantages, such as asset protection. The non-commercial loss rules must also be taken into account.
26. How big is the business, how profitable will it be and how much money does the client have to spend on a tax structure?.
There is no point spending a lot of money on a complex tax structure comprising a number of entities if the savings at the end of the day do not outweigh the cost involved. If the business is likely to be worth more than $5 million when sold then the small business CGT concessions will not be available and the structure need not comply with the requirements of Division 152. If the business is likely to be worth less than $5 million the structure will need to comply with the requirements in Division 152.
27. What are the principal’s priorities? What is the principal concerned about?
The principal’s main concern is generally asset protection and that is what should be focused upon. The principal should be advised to look at the broad picture and not to focus merely on their current business. What is the risk of the principal and/or the business being sued? If it is medium or high then asset protection should be the main priority. As a general rule, tax minimization should never be the main priority. The taxpayer may have other priorities such as provision for family members, sick relatives, charities etc. Depending on the age of the principal their priority may be to increase superannuation. The structure should be tailored to meet the principals’ priorities.
28. Who is to run the structure on a day to day basis? Who is to have control of the structure?
The person who runs the structure on a day to day basis may not necessarily be the one who has overall control or ownership? Some clients want direct ownership, they want to personally own the shares or units. Others do not mind if ownership is by a discretionary trust and they simply have control.
A Special thank you to the NTAA for some material which assisted with the above technical information.
Please book an appointment or call Coull and Prior on 8447 4433 for your appointment to discuss how you can protect your assets – now.