Key considerations in choosing a business structure

Forsyths Accounting mackay accountants

FORSYTHS have advised small business for over 60 years and we know how the various structures work best and the problems small businesses encounter as they grow.

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The following is a more detailed explanation of some of the tax and non-tax related considerations in choosing an appropriate structure. As the business owner you need to determine which considerations are most important to your circumstances and that will usually result in the best business structure to use.

As professional and product liability claims continue to rise in both their frequency and value, the ability to limit and quarantine exposure to liability is of prime importance.

Insurance against liability to both external and internal parties has become a feature of modern day commerce. However, the extent of liability claims often exceed the insured limits, exposing business people to devastating financial drains.

It is an indisputable feature of modern day business, that concerns of liability have a discernible impact on business decision making and structuring.

A sole proprietor has ultimate control over their business affairs. They may use business equity for personal non-business purposes, such as security for a housing loan (although the interest is not deductible), and may use business assets for personal use (subject to an apportionment of business deductions).

In practice, the distinction between business and personal affairs often becomes blurred; particularly when a single bank account is maintained and record-keeping becomes sloppy.

Within a partnership, control is shared, and effectively one partner’s activities directly impact upon the other partners. Strong internal controls and procedures need to be adopted and their adherence ensured. Partners in large public accounting and legal firms are potentially exposed to enormous risk from the activities of each other; the carelessness of one partner can severely affect the business and personal financial position of all concerned. Although agreements of indemnity may be entered into between the partners themselves, in relation to external parties, “joint and several” liability persists.

The control structure of companies is prescribed to a large extent by the Corporations Act 2001. A special feature of a company is that the controllers may be persons other than the employees or owners. In practice, the controllers of small to medium companies will also have majority ownership, and may even constitute the principal employees. The privileges associated with limited liability and the recognition of employee status of equity holders, are granted in return for compliance with statutory safeguards and enhanced disclosures to external parties.

Trusts represent somewhat of a compromise between the company and sole proprietor. In relation to discretionary trusts, ownership and control become harder to define. A trustee is subject to general law fiduciary duties and specific statutory obligations. The activities of a corporate trustee are also governed by the Corporations Act.

Ownership is not a static concept in business arrangements. However, it is perhaps one of the most overlooked areas of business planning. When people are in the process of creating the structure through which they intend to conduct their business, concern over the ability to transfer all or part of their interest in the venture is often the furthermost thing from their mind.

In practice, the ownership of a business structure is seldom static. Consideration should always be given to how well a particular entity, or combination of entities, will accommodate the transfer of interests in the future. Attention should be paid to the most likely form of transfer, and the most likely transferee — for example, will it be a transfer to a person who is already a participant in the venture, a family member, or will an outsider be approached?

The use of a company enables the relatively efficient transfer of clearly defined rights. At the other extreme, the use of a discretionary trust may create uncertainty as to exactly who has an interest in what and when. It must be remembered that it is exactly this type of indeterminacy that also makes a discretionary trust such a useful business entity. The transfer of an interest in a discretionary trust is usually affected by the transfer of shares in the corporate trustee. This is a very indirect form of transfer, and may not be particularly satisfactory if an “outsider” were acquiring an interest.

If an entity does not accommodate the efficient transfer of interests, a completely new structure may need to be adopted to achieve the desired change in ownership. The creation of a new structure is likely to require the realisation of all the assets and liabilities of the business, instead of only that portion of the net assets you wish to transfer. This may result in excessive transaction costs and the realisation of accrued capital gains. An alternative to transferring all of the old business to a new structure is to create another entity, and run it in conjunction with the old structure. This approach is often adopted when two or more professional practices wish to merge. However, this approach is complex to administer, and the “doubling-up” of structures is inefficient.

The term “succession” is used here in the context of being able to pass the business to another person or group of people before death (as distinct from estate planning). The succession may concern ownership or just control.

Companies provide for a clear division between ownership and control, in the form of shareholders, appointed directors and executive management. A trust may clearly provide for a split in effective ownership and control via the appointment of a trustee or appointor, and the identification of various beneficiaries.

It is very difficult for a sole proprietor to pass anything other than absolute control and ownership over their business.

The documentation of a partnership should provide detailed procedures for the retirement and admission of partners, and the transfer of interests in the partnership. The partners must decide whether or not the value of goodwill will be recognised in relation to interests in the partnership, and must decide whether a separate value is to be attributed to a partner’s interest in the service entity (if the service entity is a discretionary trust, of which the beneficiaries constitute the partners at any point in time).

Estate planning refers to the arrangements set in place to accommodate the passing on of the business structure to persons specified in the will of a deceased person.

After the general abolition of death duties, death has become one of the most effective, albeit unpleasant tax planning strategies (next to divorce!). One of the last things on your mind when writing a will is how to save tax for your children and their children, and this probably explains the relatively small number of people taking advantage of the tax breaks surrounding death and estate planning.

Australia applies a progressive taxation system to personal income. This statement does not refer to the imaginative nature of our law, but to the fact that we employ increasing marginal rates of tax, i.e. the more money a person earns, the greater the portion of any additional income that must be paid in tax.

As each individual must apply the same progressive scale of tax rates to their individual income, for a given sum of income, the more persons through which this income may be distributed, the lower the overall tax paid. This is the principle of “income splitting”.

The introduction of Div 6AA from 1 July 1987 effectively removed the advantages of utilising a discretionary trust or other means to stream large amounts of income to minors. “Unearned income” of minors is taxed at the top marginal rate over a relatively insignificant tax-free threshold.

However, the introduction of Div 6AA did not completely destroy the effectiveness of income splitting. Opportunities still exist for income splitting between family members over the age of eighteen, and income splitting between minors via testamentary estate planning. Utilising the tax-free thresholds of these individuals may still provide significant tax advantages to a family unit.

It must be noted that when income is allocated to a family beneficiary, the distribution will only be effective for the purposes of reducing taxation if the beneficiary becomes absolutely entitled to the income. In the case of child beneficiaries, there is always the concern that they may demand payment of the accumulated distributions upon reaching the age of eighteen. The parents of these children receive the distributions in the capacity of trustee, and are under a legal obligation to ensure the distributed funds are prudently invested or applied for the benefit of the children.

The simple answer to these concerns is that children are extremely expensive to look after and provide for. It is unlikely that trust distributions of $400 per annum could not be properly applied for the benefit of the child. However, it is advisable that documentation be maintained, recording to what purpose these distributions have been applied. For example, part payment of school fees, provision of health care or investments for the future. If such documentation is not maintained, parents of uncooperative children may be hit with an unpleasant demand come the child’s eighteenth birthday!

Distributions of trust income to adult beneficiaries must also result in the beneficiaries becoming absolutely entitled to the income or assets.

In summary, it is important that all parties to the arrangements fully understand the extent of their respective rights and entitlements.

A business is never static. Planning for change is a vital element in structuring a business. A business may grow, expand overseas, merge with a competitor, divest assets and return capital to its owners. All of these possibilities must to some extent be anticipated and planned for. The realisation of taxable capital gains and the impost of stamp duty on asset transfers are the predominant taxation hurdles to restructuring.

Company Trust Partnership Sole trader  Company Specific