BUSINESS STRUCTURES

Phil Shephard & Ben Walker - Inspire CA

MADE EASY

Your 6 Keys to Understanding

Business Structures and how to set

yourself up!

© 2014 Inspire CA Pty LtdFeel free to share this eBook with your friends, followers and colleagues as is.

inspireca.comInspire CA is an accounting firm with a passion for constantly developing entrepreneurs and

business owners.

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One of the most important decisions a business owner needs to make (after the name of the business of course!) is the choice of business structure.

In fact, getting this choice right is so important that we begin the analysis of every potential client with their proposed business structure and we then work out from that point.

C H O O S I N G Y O U R B U S I N E S S STRUCTUREThe choice of how to structure your business depends on a number of factors:

1. The type of business you operate;

2. Y o u r p e r s o n a l fi n a n c i a l circumstances;

The Basics

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CHAPTER 1

One of the most important decisions a business owner needs to make (after the name of the business of course!) is the choice of business structure. In fact, getting this choice right is so important that we begin the analysis of every potential client with their proposed business

3. How large you intend to grow the business; and

4. Whether you are building the business to operate or to sell.

See the table on the next page for a comparison of the most common business structures.

Each st ructure has advantages , disadvantages and responsibilities which

need to be considered before making a decision.

While it is possible to change the structure as the business grows or your circumstances change, getting the structure right in the first place can avo id any unnecessary tax and administration costs. We explain this more in Chapter 6.

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A basic comparison of the most common business structures is

provided below:Sole trader Partnership Company Trust

Cost to establish and operate Low Medium High High

Complexity Simple Moderate Complex Complex

Limited Liability No No YesYes (with a corporate Trustee)

Do I receive full profits made from the business? Yes No No No

Can I employ staff? Yes Yes Yes Yes

Do I have to pay myself superannuation? No No Yes No

Can I change the legal structure easily? Yes No No No

Ability for tax planning e.g. income splitting? No Limited Limited Yes

Is it easy to raise capital? No No Yes Yes

Is it easy to dissolve or exit? Yes Yes No No

Many sole traders choose to trade under their own name but this is not a requirement.

A sole trader can register a business name with the Australian Securities and Investments Commission (ASIC) and trade using this name instead.

A sole trader is essentially just the individual in business for themselves ‒

they retain complete control of the business operation.

There is no division between business assets or personal assets, which includes any assets jointly owned with another person (such as your house or car).

Your liability is unlimited which means that personal assets can be used to pay

Sole Traders

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CHAPTER 2

Establishing a business as a sole trader is the simplest form of business structure. It is relatively easy and inexpensive to start and maintain.

business debts. The individual is also responsible for remitting the tax on any business profits made at their marginal income tax rates.

After your first year of business profits the Australian Taxation Office will enter you into the pay as you go (PAYG) instalments system.

The PAYG system requires regular payments of preliminary tax based on expected profits for the following year.

Any excess tax paid as a result of this will be refunded on lodgement of your income tax return.

PRO’S AND CON’S OF RUNNING A BUSINESS AS A SOLE TRADERAdvantages of Trading as a Sole Trader

• Easy and inexpensive to establish and maintain; Complete control of your assets and business decisions is retained by individual;

• Fewer reporting requirements;

• Any losses incurred as a result of business activities may be offset against o t h e r i n come e a r ned ( s u ch a s investment income or wages), subject to satisfying certain conditions;

• You a r e no t c ons i d e r ed an employee of your own business and are free of any obligation to pay payroll tax, superannuat ion contr ibut ions or workers’ compensation on income your draw from the business;

• Relatively easy to change your legal structure if the business grows, or if you wish to wind things up.

Disadvantages of Trading as a Sole Trader

• Unlimited liability which means all your personal assets are at risk if the business operation gets in trouble;

• Little opportunity for tax planning ‒ you can’t split business profits or losses made with family members and you are personally liable to pay tax on all the income derived;

• Business debts and losses cannot be shared;

• Requirements to pay preliminary tax on business income which may not have been earned;

• Limited access to additional capital for business growth;

WORD OF WARNING AGAINST TRADING AS A SOLE TRADERAt Inspire CA, we strongly recommend business owners avoid operating as a sole trader.

Even a business which is not generating sufficient income to require a great deal of tax planning can still expose the owner’s personal assets to significant risk.

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In order for a partnership to exist the partners must have the intention of making and sharing profits, as well as an understanding that they will each act on behalf of the other in all business dealings.

When establishing a business under a partnership structure, a formalised partnership agreement spelling out the rights, responsibilities and obligations of each partner is a good idea, although it

is not necessary for the partnership to exist.

In the absence of a partnership agreement The Partnership Act of 1891 sets out the various rules that govern the conduct of partners.

The act places joint liability on all partners for debts and obligations incurred by the business during their involvement in the partnership. Partners

Partnerships

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CHAPTER 3

A partnership is a common and relatively inexpensive way to set up a business. It involves 2 or more co-owners (the partners) participating together in a business operation.

are obligated to keep their co-owners properly informed.

While a partnership is a separate business operation to the partners involved, having its own Australian Business Number (ABN) and Tax File Number (TFN), all the business profits are taxed in the hands of the partners at their respective marginal tax rates.

P R O ’ S A N D C O N ’ S O F PARTNERSHIPS AS A BUSINESS STRUCTUREAdvantages of a Partnership:

• Easy and inexpensive to establish and maintain should the partners exist;

• Fewer reporting requirements;

• Any losses incurred by the business may be offset against other income earned (such as investment income or wages) subject to satisfying certain conditions;

• Partners are not considered an employee of their own business and are free of any obligation to pay p a y r o l l t a x , s u p e r a n n u a t i o n c o n t r i b u t i o n s o r w o r k e r s ’ compensation on income drawn from the business;

• Relatively easy to change your legal structure if the business grows, or if you wish to wind things up.

Disadvantages of a Partnership:

• Unlimited liability which means all personal assets are at risk if the

business operation gets into trouble; Some of the control of business assets and decisions is relinquished;

• Business debts and losses cannot be shared with anyone except the partners;

• Requirements to pay preliminary tax on business income which may not have been earned;

• Limited access to additional capital for business growth;

W H A T D O W E T H I N K O F PARTNERSHIPS?While a partnership can allow a business access to addit ional capita l and knowledge (if the partners are both individuals rather than companies and trusts), each partner exposes their personal assets to an unlimited level of business risk.

We recommend business owners avoid operating partnerships involving two or more individuals.

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This is usually because they believe they understand the way this structure works. Business owners are generally aware that a company owns the business assets and provides protection for their personal assets against business risk.

However, there is far more to consider when picking a business structure than asset protection.

A brief summary of the Benefits and issues of using a company is outlined below.

Companies

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CHAPTER 4

Unlike a sole trader who essentially is the business, a company is a separate legal entity with directors who run the business and shareholders who own it. When business owners are interested in restructuring their business operations, the most commonly considered option is a company.

P R O ’ S A N D C O N ’ S O F STRUCTURING YOUR BUSINESS AS A COMPANYAdvantages of a Company Structure

• Companies can be owned and run by one person;

• Shareholders are not responsible for company debts unless they sign a personal guarantee;

• Easier to attract capital because of limited liability;

• Companies can operate globally and own properties;

• Companies pay a flat 30% tax on every dollar of profit regardless of home much money is earned.

Disadvantages of a Company Structure

• Relatively expensive to establish and register;

• Compliance costs are generally higher and record keeping requirements are more strict;

• Shareholders may have difficulties in recovering their investment because of limitations on who can buy shares;

• Funds taken out of the company as a salary or wage attract the usual PAYG w i thho ld ing and superannuat ion obligations;

• Companies that hold CGT assets do not receive the 12 month 50% CGT discount on disposal.

DIVISION 7ABusiness owners who are considering operating through a company structure must give due consideration to Division 7A.

Division 7A essentially seeks to prevent directors and shareholders of private companies from taking the company’s profits for personal use. Individuals or entities that take ‘Drawings’ from a pr ivate company have unt i l the lodgement date of the company’s income tax return to either repay the funds in full or enter into a suitable loan agreement with the company.

Failure to do so will result in the amounts being treated as an unfranked dividend which will need to be included in the shareholder’s income tax return for the year.

As you can imagine if the sum taken from the company is significant, this can result is a substantial tax bill.

CONSIDERING RESTRUCTURING INTO A COMPANY?Business owners looking to shift their business operations from a sole trader structure into a private company can experience a number of benefits.

However, there are also a number of key differences and potential issues that must be understood and carefully managed.

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Trusts are a common structure choice for family businesses as it enables the various family members to become beneficiaries of the Trust that is operating the business. While the trust is not a separate legal entity it is a separate entity for tax purposes.

The trustee must apply for a Tax File Number (TFN) for the trust and lodge an annual income tax return.

If a company trustee is used, the trust offers all the same asset protection benefits as using a company structure, along with the additional benefits of using a trust. A trust that has individuals acting as trustees exposes the trustees

Family Trusts

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CHAPTER 5

A trust is a structure wherein a Trustee (either an individual or company) carries on the operations of the Trust on behalf of the beneficiaries. The actions of the Trustee are governed by the Trust Deed, which details the rights and obligations of all parties.

(the individual, or individuals) to same levels of business risk as a sole trader.

Broadly speaking there are two common types of trusts that you will encounter when making your business structuring decision: Fixed Trusts and Discretionary Trusts.

DISCRETIONARY TRUSTSA Discretionary Trust is the most flexible form of business structure for a family trust.

No single beneficiary has a fixed interest in the trust’s property or the trust’s income.

The trustee has complete discretion in the distribution of funds to each beneficiary.

This makes the Discretionary Trust (with a corporate trustee) a strong and flexible option for a family business. The family members are protected from business risk and the trustee has the discretion to distribute the income in the most effective way possible.

It is important to remember that all of the benefits offered by a discretionary trust for a family business make it a poor choice for businesses where more than one family or group is involved, as neither group of beneficiaries retains a fixed entitlement to property or income.

Advantages of a Discretionary Trust:

• Flexibility with income and capital distribution;

• Broader Tax planning opportunities;

• Access to Small Business CGT concessions;

• 50% 12 month CGT discount;

• Asset protection (if a corporate trustee is used)

• Can pay salaries and wages as well as superannuation;

• Less regulatory requirements than trading as a company.

Disadvantages of a Discretionary Trust:

• Distributions must be in accordance with the Trust Deed;

• Risk of resettlement if changes are made to trust members or trust property without giving consideration to the rules outlined in the trust deed;

• Losses cannot be distributed;

• More of an investment to establish and maintain when compared to Sole traders or partnerships;

• Trustees can be personally liable for some debts of the trust (if individual trustees are used).

FIXED (UNIT) TRUSTSFixed (or sometimes called “Unit”) Trusts are recommended when more than one family or group is involved in the business operation. The interest in the trust is divided into units, similar to shares in a company.

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The Trustee distributes income to the beneficiaries in accordance with their respective holdings in the trust.

This is the key point of difference between Fixed and Discretionary Trusts: The un i ts remove the Trustee ’s discretion concerning the distribution of income.

Advantages of a Fixed (Unit) Trust:

• Fixed Interests provide protection where more than one family or group in involved in the business;

• Asset protection (where a corporate trustee is used);

• Access to Small Business CGT concessions;

• Access to 50% 12 month CGT discount;

• Easy to raise capital by issuing additional units;

• Can pay salaries and wages as well as superannuation;

• Less regulatory requirements than trading as a company.

Disadvantages of a Fixed (Unit) Trust:

• Sale of units can be a CGT event and attract stamp duty;

• Not as flexible as a Discretionary Trust;

• Trustees can be personally liable for some debts of the trust (if an individual trustee is used).

SO SHOULD YOU USE A FAMILY TRUST?Business owners looking to shift their business operations into a trust structure can experience a number of benefits.

We strongly recommend anyone interested in setting up a trust seek professional advice before doing so.

Given the additional requirements of using a trust, we work closely with all clients that use this structure to ensure all their obligations are satisfied and it is used in the most efficient manner possible.

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Quite often clients start business operations with little to no thought about structuring and are confronted with multiple complications a few years down the track when changes need to be made.

INCOME TAXAny profits made on the transfer of items such as plant and equipment or

trading stock between business entities is taxable income in the hands of the entity making the sale. These profits will be reported on the income tax return of the relevant entity and tax will be payable at the applicable tax rate.

If you are transferring out of a company structure, careful consideration must be given to any advances, loans, or

What If I Get It Wrong?

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CHAPTER 6

In order to reinforce the importance of selecting the right business structure, our final article in this series looks at the consequences of getting the choice wrong and the potential costs associated with the transition to a new structure.

intended debt forgiveness by the private c ompa n y t o s h a r e h o l d e r s a n d shareholders’ associates. These amounts could potentially trigger Division 7A and c r e a t e u n f o r e s e en i n c ome t a x consequences for the parties involved.

CAPITAL GAINS TAXCapital Gains Tax (CGT) is a tax charged on capital gains that arise as the result of the sale or disposal of certain assets.

While we cannot hope to cover all of the p o t e n t i a l CGT imp l i c a t i o n s o f transferring various business assets between business structures and the concessions available to manage the tax on these gains, it is important to highlight that Capital Gains Tax must be cons idered when chang ing your business structure.

STAMP DUTYDepending on the state you live in and the type of asset in question it may also be necessary to pay stamp duty on the transfer of assets between business entities.

While most states offer concessions, they do not apply in all cases so you must ensure you have given due consideration to the stamp duty implications on any asset transfers.

ADMINISTRATION COSTS AND BUSINESS INTERRUPTIONWhile not as costly as the other areas of discussion, there are some smaller considerations which may be overlooked

in a “big picture” approach to changing your business structure.

The accounting and legal fees incurred in establishing your new business structure and to wind up the old structure can vary from a one thousand to tens of thousands depending on the structural choice and level of advice you require. This process will involve the creation of the new structure and all the associated registrations.

Your new structure will generally have its own Australian Business Number (ABN) and Tax File Number (TFN). This, in turn, means that you will need to establish new bank accoun ts , upda te a l l agreements with your current staff, customers, and suppliers as well as updating the ABN on your existing marketing material.

During the financial year in which you make the transition between business structures it may be necessary for your accountant to prepare financ ia l statements and income tax returns for both business entities. This will increase the cost of your compliance work for the year.

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