Question 11 - What’s the Most Appropriate Tax Structure for my Business?
When it comes to selecting the most appropriate structure for your business we always recommend you ‘start with the end in mind’. Australian tax laws are complex and changing your business structure at some point in the future can trigger a capital gains tax event that could prove costly.
Whenever we provide advice on business structures we always take into account issues like:
- Minimisation of Income Tax
- Maximize Asset Protection
- Allow for the admission of New Business Partners or Investors
- Comply with all Legal Requirements in your Industry
- Future entitlement to Discount Capital Gains Tax Concessions
When evaluating the right business structure you need to consider the likely profitability of the business, the current tax position of all stakeholders and the risk profile of the industry. In some cases you might also need to consider if it will be easier to do business in your industry as a sole trader or company. As a consequence, we often find the business structure is a compromise based on the relative importance of these issues.
When it comes to business structures there are a range of options. The most common structures in Australia include sole trader, partnership, company and family (discretionary) trust. Below is a very brief summary of these structures and their tax treatment. Before you make a decision on which structure is the most appropriate for your business circumstances we urge you to contact us.
Sole traders are individuals operating a business in their own right. They can trade under their personal name or a registered business name. Such a business is not an entity separate from its owner and for tax purposes the income of the business is treated as the person’s individual income. The sole trader is personally responsible to pay tax in their own right at the marginal rates for individuals. Some key points to consider include:
- The simplest type of business structure as the individual owns the business
- Low cost option and quick to establish
- No tax or legal separation between the individual and the business
- You maintain control over the business operation and the direction
- If the business is to trade under a business name (other than your personal name) you need to register the business name with ASIC
- Provides minimal asset protection
A general-law partnership is a relationship between two or more persons carrying on a business with a view to profit. Partnerships are governed by state government laws and it is usual to have a formal overriding partnership agreement which outlines the rules by which the partnership conducts its business such as;
- profit-share arrangements,
- arrangements for partners’ salaries,
- admission of new partners, and
- retirement of partners.
A partnership, unlike a company, has no separate legal personality distinct from its members and partnerships are:
- Two or more individuals or entities carrying on business together
- Relatively low cost to establish and quick to setup
- Each partner is jointly liable for the liabilities of the business and each other’s business actions
- Governed by a Partnership Agreement - a written document that is designed to avoid disputes and specifies each partner’s role in the business plus their share of profits
Taxation of Partnerships
For taxation purposes, a partnership is treated notionally as a separate entity. It is an association of persons or entities that carry on business as partners or receive income jointly and it needs its own Tax File Number (TFN).
Although a partnership is not personally liable for income tax, it is still required to lodge an annual income tax return to report its partnership profit or loss. Each partner then includes their individual share of the partnership net profit or loss in their individual tax returns.
A company is a legal entity separate from its shareholders, who own the company. They are governed by Corporations Law which is administered by the Australian Securities and Investments Commission (ASIC). Companies are a separate legal entity and are granted legal status to enter into contracts etc.
A company’s operations are governed by its constitution there are different types of companies;
- Companies limited by shares - the most common type of company.
- Companies Limited by Guarantee, where the members guarantee to pay up to a set amount in the event of the company being wound up.
- No Liability Companies - where the shareholders have no liability.
- Unlimited Companies - where the liability of members is unlimited in the event of winding up.
Companies provide a form of asset protection with limited liability and separates the personal assets of the individual shareholders from the debts of the company.
Limited companies protect shareholders by limiting their liabilities to the amount unpaid on their shares. Limited companies are either ‘public’ (whether listed on the stock exchange or not) or ‘proprietary’ (private limited liability company).
All companies must have at least one shareholder and proprietary companies can have up to 50 shareholders while the number of shareholders in a public company is unlimited. Public companies must have at least three directors, two of whom must be ordinarily resident in Australia. Public companies are also required to appoint a company secretary who must be ordinarily resident in Australia. The company secretary may also be a director. A listed public company is subject to mandatory listing requirements imposed by the Australian Stock Exchange (ASX).
Common to both forms of company are the following conditions:
- Directors must be natural persons.
- A Public Officer must be appointed to satisfy taxation reporting requirements (often fulfilled by the Company Secretary).
- A company must apply to ASIC to be registered and be given an Australian Company Number (ACN).
- A company must have a registered office in Australia with minimum prescribed office hours.
Directors and other officers of a company are subject to duties imposed by the Corporations Law and other legislation. A breach of these duties may result in civil or criminal penalties.
Taxation of Companies
A company pays a flat rate of income tax on its taxable income. The tax rate in the 2014/15 year is 30% but this has been reduced to 28.5% for the 2015/16 financial year.
A trust is not a separate legal entity, but refers broadly to an obligation accepted by a person or persons (the “trustee”) in relation to property (the “trust property”), for the benefit of another person or persons (“beneficiaries”).
Trustees are required to undertake all obligations and transactions on behalf of the trust. As this role carries a legal liability for the activities undertaken, trustees are often companies to limit liability.
A trust deed sets out a trustee’s obligations and the relationship between the trustee, the beneficiaries and the trust property. The most common types of trust are:
- Discretionary Trust
- Unit Trust
- Fixed Trust
- Bare Trust.
Discretionary Trust – In a Discretionary Trust, some or all of the entitlements of the beneficiaries (in any income year) are governed by the exercise of the trustee’s discretionary powers. The trust instrument may specify limits on the extent of the trustee’s discretion. The discretion may include the right to add or remove beneficiaries.
In summary – discretionary trusts are:
- Established by a family member for the benefit of the 'family group’
- Can provide certain tax advantages provided the Trust passes the ‘family control test’ and makes distributions of trust income exclusively to beneficiaries who are within the 'family group'
- The trustee has the discretion on how the trust income is distributed to the qualifying beneficiaries. They don’t have to make distributions in any particular proportion or in the same proportions as they did in previous tax years
- Can assist in protecting the family group's assets from the liabilities of one or more of the family members (i.e. in the event of a family member's bankruptcy or insolvency)
- Provides a mechanism to pass family owned assets to future generations
- Can provide tax benefits in the form of income splitting
- Can avoid potential issues such as challenges to a will following the death of a senior family member
Unit trust – A unit trust is a form of fixed trust whereby each beneficiary (i.e. unit holder) is entitled to trust income and trust property, in proportion to the number of units owned. The trust instrument may permit units to be transferred in the same way as shares in a company. Many investment funds use this type of structure.
Fixed trust – In a fixed trust, each beneficiary enjoys a fixed or predetermined share of the income and/or capital of the trust.
Bare trust – This is the simplest form. It is a nominee agreement whereby one person (usually a company) is the legal owner of an asset but another enjoys the entire beneficial interest in the asset. A common example is where a trustee company has legal ownership of shares, but another person beneficially owns the shares.
Taxation of Trusts
Although in general law a trust is not recognised as a separate legal entity, they are recognised as such for taxation purposes. A trust must obtain its own tax file number (TFN) and lodge an annual income tax return. The trustee needs to register for the TFN in its capacity as trustee.
Beneficiaries must include their share of the trust’s net income in their personal tax return for the year.
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