Advice for Business
When commencing or acquiring a business or deciding to reorganize your business, you usually have a choice in deciding which type of structure you will use for business operations.
The primary issues for most people when commencing a business are:
- Protecting personal assets from business assets;
- Choosing a tax effective structure; and
- Planning for business succession and retirement.
You also need to be aware of the Personal Services Income (PSI) rules which could operate and remove any tax benefit gained from diverting personal services income into a business structure.
If you decide to operate the business in your own name, you are a sole trader. If you decide to join with another person or persons and share profits and losses at an agreed ratio, you will be operating as a partnership.
Other business structures include companies, discretionary and fixed trusts and unit trusts.
A sole trader operates a business or invests under his or her own name or registered business name. The sole trader makes all purchases of equipment, rents premises and employs the staff necessary to establish the business.
The sole trader derives all the income and is liable for all costs.
The profit is declared as income in the sole trader's individual Tax Return. Tax is paid at individual rates of tax.
The sole trader can be considered to have the following advantages:
1. There are minimal costs involved in administration of the business structure.
2. All monies earned by the business are the property of the sole trader.
3. The sole trader has complete control of the operations of the business.
4. The sole trader may plan for his/her retirement by contributions to a "Self Employed" Superannuation Fund which are tax deductible.
The sole trader has the following disadvantages:
1. It is costly and sometimes difficult to draw on the technical expertise of others.
2. The sole trader is personally liable for all business debts and thus may find personal assets have to be used to satisfy business debts.
3. All income of the sole trader is subject to taxation in the hands of the sole trader.
4. The business is terminated or sold on the death of the sole trader.
Individuals or companies may form a group of up to fifty (50) natural persons or companies to enter into a partnership and pool assets and expertise as well as sharing the cost associated with the business. It is not necessary for the partners to contribute capital equally or share equally in the distribution of profits, nor is it necessary that the services provided by individual partners be in the same proportion as their share of income.
The partnership is required to lodge a Partnership Tax Return. However, tax is not imposed on the partnership. Instead the partners must declare their share of income in their personal Tax Returns. Tax is assessed at individual rates.
A partnership has the following advantages:
1. Certain partners may contribute the capital of the business while others partners provide the necessary technical expertise.
2. It is possible to share profits and losses amongst the partners in the most efficient manner for superannuation, cash flow, tax planning and general business operations.
3. Each natural partner may plan for their retirement by contributing to a "Self Employed" Superannuation Fund.
The disadvantages of a partnership:
1. Each of the partners are jointly and severally liable for all debts of the partnership. Thus if a partnership, which has 50:50 capital and income sharing ratio in all respects, incurred a liability of $100,000 then normally each partner would be expected to contribute $50,000. However, should one partner become insolvent, then the other partner would become responsible for the total amount due of $100,000.
2. The ability to share profits or losses referred to above is not discretionary between years. A presumption would exist that profit ratios between partners would be maintained from year to year.
What is a Company?
A company is a separate legal entity that has it's own existence and it's own tax laws. Provided the annual statutory reporting requirements are met and any taxes owing are paid, it can live forever. Companies have many of the rights and obligations that an individual has, but also have many laws unique to themselves, especially in tax law. A company can own assets, borrow money etc.
How a Company Works
Advantages to using a Company
||Directors: control and are responsible for the Company. NOT necessarily the owners. |
Company: is a legal entity i.e. it exists independently of directors and owners, and "holds" the assets.
Shares: the company is divided into portions called a share. Shares are ownerships rights i.e. if you own shares you own a part of the company.
Shareholders: own the shares. i.e. own the company.
NOTE: the shareholders cannot be used for the wrong doings of the company - the company itself can, and the directors can, but not the shareholders.
Limitation of Liability - Subject to action which may be taken by creditors or the ATO if directors carry on business while the company is unable to pay its debts, or act negligently, the liability of shareholders is limited to the amount they have subscribed for their shares.
Permanency - A company can have an indefinite life. Shareholders may come and go, but the company continues unless there is a decision by shareholders (or creditors if the company can't pay its debts) to liquidate the company. Business operation is therefore not dependent on the continued presence of an individual.
Multiple Ownership - Multiple Ownership of the company can be easily accommodated by the issue of any number of shares. Rights of individual shareholders can also be varied by the issue of different class shares.
Lower Tax Rates - Whilst an individual's highest tax rate (including Medicare levy) is 46.5%, companies are taxed at a flat rate of 30%.
Disadvantages of using a Company
Complexity - Companies are regulated by the Corporations Act, which is administrated by the Australian Securities and Investments Commission (ASIC). Directors must comply with duties and obligations as outlined in the Act which, among many other things, requires financial accounts to be prepared annually and annual returns lodged with ASIC. Returns and notifications have to be lodged with ASIC and substantial penalties accrue if lodged late.
Capital Gains Tax - The 50% discount on CGT for assets held for greater than 12 months for individuals is not available to companies. Whilst the tax rate may be lower companies will be subject to tax on full gain of assets sold, with indexation frozen as at 30 September 1999.
Distributions - Any distributions of income or capital to the shareholders during the lifetime of the company will be taxed as dividends.
Liquidation - Any distribution to shareholders on the liquidation of the company (except gains from sale of pre-CGT assets) will be treated as taxable dividends.
Loans to Shareholders - Any loans or payments made by a private company to its shareholders or associates which remain unpaid at the end of the financial year will be treated as unfranked dividends for taxation purposes unless a loan facility agreement is in place.
What is a Trust?
A trust is a separate legal entity that also has its own common and tax laws. Because a trust is an entity on its own the people who benefit from any distributions made by the trust (the beneficiaries) cannot be held liable for the actions of the trust. The trust owns the assets and because there are no shareholders (unlike a company) there is no "owner" of the trust.
The major advantage a trust has over a company or individual is income splitting (income splitting means simply that you can divert income to people in lower tax brackets).
The recommended way to set up a trust structure is to have a $2 company as trustee and you would be the director of the $2 company.
How a Trust Works
Benefits of using a Trust
- The Trust can claim any expenses that are incurred in running the business or investment.
- The Trust spends before it pays tax.
- Liability is limited.
- The Trust diverts income to any beneficiary (i.e. those with the lower tax rates) and the Trust can change the proportions of income distributed each year.
- Because a Trust cannot die there are no capital gains tax or stamp duty costs - assets can be passed on generation after generation with no tax implications.
- Assets are protected. Nobody can take the assets because the Trust owns the assets.
- Upon the sale of an asset the beneficiary of the Trust pays the reduced rate of capital gains tax.
Income Splitting Dad's highest income is in the 46.5% tax bracket.
Mum's income is in the 30% tax bracket.
Child No.1 is less then 18 years old.
Child No.2 is a full time student and is 18 or older.
As mentioned above, income splitting is a major feature of a trust. Consider the following examples:
In this scenario, if the trust made a $30,000 profit the income would be diverted to Child No.1. Child No.1 can receive a tax-free distribution of $3,000 worth of income per annum.
Because they are a minor (i.e. under 18 years old) any income above $3,000 per annum would be taxed at 66.5%! The remainder would be diverted to Child No.2 who has only $5,000 worth of income.
PERSONAL SERVICES INCOME
Commencing from 1 July 2000 (1 July 2002 for PPS payees) a new regime applies in relation to personal services income is defined as income gained mainly as a reward for the personal effort or skills of an individual whether or not it is gained by the individual or by an entity (company, partnership or trust) and whether or not it is paid under a contract. Such income could include salaries, professional earnings, contract income wholly or principally for the labour or services of a person, income derived by a professional sportsperson or entertainer and consulting income.
The personal services income, which has been earned by an entity, must be included in the income tax return of the person who has provided the services subject only to the following deductions:
Normal work related expenses;
Entity maintenance deductions such as filing fees, accounting fees etc;
There is an exemption from this requirement if the income is earnings of a personal services business.
If the entity passes the Results Test it will be taken to be conducting a personal services business. To pass the Results Test the entity must:
Receive income in return for producing a result;
Be required to supply plant and equipment or tools of trade (if any) needed to perform the work: and
Be liable for the cost of rectifying any defect in the work performed.
If the Results Test is not passed further tests are available provided 80% or more of the personal services income in an income year does not come from one client,
In this event the entity need satisfy only one of the following tests:
Unrelated Clients Test. The entity has two or more unrelated customers or clients and work is gained though advertising to the public.
Employment Test. At least 20% of principal work is undertaken by an employee (who could be an associate).
Business Premises Test. The entity has exclusive use of business premises, which are physically separate from the service provider's home and also separate from the client's premises. If these tests are not met or you are uncertain whether they can be met it is possible to apply to the ATO for a Personal Services Business Determination. Such an application would certainly be appropriate where the business is commenced during the income year or whether the current year is not representative.
Kevin P Scambler & Associates