Business Trading Structures
Business Trading structures are conducted through a number of different legal entities. The choice of which structure to make use of will significantly affect the taxing of various transactions. The correct choice of structure can result in significant tax savings each year, as well as minimized legal and economic risks to the owner.
The most common type of trading structures are:
- Sole Traders
There is no single, superior operating structure. The most appropriate structure depends on your individual circumstances and needs. The other factors to be consider are:
- Asset Protection,
- Minimisation of tax, and
- Compliance Costs.
There is a risk attached to every business venture. Therefore one of the goals of most business owners is to limit their personal exposure to creditors. In this regard, at one end of the spectrum are sole traders, who assume great personal risk as they are personally liable for all of the debts of their business. This exposure can put at risk their personal assets if the business is in trouble.
By contrast, at the other end of the spectrum are companies. Company directors are largely protected from creditors except where the director offers a personal guarantee.
Minimisation of tax
The most important consideration is to pay as less tax as possible on your business profits. You can limit your maximum rate of tax to as low as 27.5% on your business profits or be liable for as much as 45% tax depending on which structure you choose.
The other consideration for most business owners is when it comes time to sell your business or when you are just disposing of certain business assets, CGT will likely arise. Choosing a structure which gives you access to the 50% CGT discount and the following small business CGT concessions can make a big difference.
- The 15 year ownership exemption (if your business qualifies, you can entirely disregard the capital gains from the sale of a an business asset)
- The 50% active asset reduction (If your business qualifies, you can reduce your capital gain by 50%)
- The retirement exemption (if you qualify, you can disregard a capital gain up to a certain limit,) and
- The rollover concession (this allows you to defer either all or part of a capital gain from a CGT event).
Note that not all business structures allow you to access the above concessions. But this can put you at a significant disadvantage when a capital gain inevitably arises.
The term sole trader merely refers to the individual who owns the business. All profits or losses made by a sole trader are declared on their individual tax return. The sole trader pays tax on taxable income at normal personal income tax rates.
Control – a sole trader has total control over the business
Goodwill – the sole trader gets to know his or her customers
Ease of Sale – the simply structure means the businesses can be more easily sold
Simple – fewer formalities and legal restrictions
Losses – available as a deduction provided that non-commercial loss provisions are met
Admission of New Partner– a new structure will be required in order to admit a new party into the business
Finance – the sole trader often finds it more difficult to readily access finance
Liability – the sole trader cannot limit liability, although may be able to mitigate it through insurance
Sickness – if the sole trader becomes unwell, who does that work
Limited Life – if the sole trader dies, the business usually ceases
Marginal Tax Rates – if the business is successful, the sole trader may be paying tax at top marginal tax rates
Tax Planning – difficult to split income
A partnership is an association of persons carrying on business as partners with a view to a profit.
A partnership is not a separate legal entity and, as a consequence, does not pay tax. Each partner pays tax at their marginal rates on their respective share of the partnership’s taxable income. If the partnership makes a loss, each partner can claim his or her share of the loss as a deduction against other assessable income, provided that the non-commercial loss provisions are met.
It is usual for the existence of a partnership to be evidenced by a partnership agreement. Among other things, the agreement typically sets out how partnership profits and losses are to be split and how partnership salaries might be paid, if at all. Although partnership doesn’t pay tax, it is still required to lodge an income tax return.
Admission of new Partners – providing the partnership agreement permits, it is usually possible to admit a new partner to the business.
Disposable Interest – it is possible for a partner to dispose of their interest in the partnership without the business ceasing.
Control – partners have control over the partnership business
Tax Planning – there is potential to split income between the partners
Goodwill – small business capital gains tax concessions may be available
Losses – may be distributed
Liability – partners are usually jointly and severally liable for partnership debts.
Marginal Tax Rates – if the business is successful, the individual partners may be paying tax at top marginal tax rates
Finance – can become easier as more than more person is taking responsibility for business debt.
Liability – split normally between partners
Companies used for business entities are governed by the Corporations Laws and classes of companies are:
- Companies limited by shares; (normally private companies used for small – medium sized businesses)
- Companies limited by guarantee (normally public benevolent and charitable organisations)
- Unlimited companies;
- No Liability companies (used solely for mining operations)
A private company is one where the provisions of its constitution restrict the right to transfer its shares, limit the number of members to fifty and prohibit invitations to the public to subscribe for shares or debentures in the company. A company that doesn’t have the above attributes would be considered a public company and may be listed on the stock exchange.
Finance – finance can be raised through the issue of shares
Liability – limited liability (unless a director issues personal guarantees)
Admission of New Parties – by the issue of new shares or the sale of existing shares
Disposable Interest – sale of shares
Research & Development – eligible for R&D concessions
Franking of Dividends – credit for tax paid at the company level given to dividend recipients
Complexity – subject to a raft of regulatory controls
Control – ultimately the shareholders have control over the business
Splitting of Income – limited opportunities
Capital Gains – potential loss of CGT-free benefits on distribution
Loan Accounts – potential for deemed dividends
Losses – cannot be distributed to shareholders
Trusts are setup to hold property or income under obligation for a particular purpose on behalf of other people. There are a number of different types of trusts and these are as follows:
- Discretionary trusts
- Unit Trust (public and private)
- A combination of a unit and discretionary trust (hybrid)
- Fixed Trusts
- Testamentary trusts
A written trust deed is very important. The Australian Taxation Office is very reluctant to accept the existence of any trust that has not had its terms reduced to writing. For tax law purposes, a trust is considered to be a separate legal entity, although this is not the case in general law. The trust is required to lodge an income tax return. If the trust has net distributable income, then that income will generally be distributed to the trust beneficiaries and returns as income by them in their respective income tax returns.
The term ‘family trust’ usually refers to a type of trust that is legally known as a discretionary trust. Discretionary trusts typically have a fully discretionary class of beneficiaries made up of mostly family member’s, however there may be beneficiaries that fall outside the family group for tax purposes. If the trustee makes distributions to persons outside the family group, then the trustee may be taxed at penalty rates on those distributions (49%)
The Parties to A Family Trust
Settlor/Appointor – The settler/appointor is the person who actually creates the trust by donating property to be managed and administered by a trustee. For taxation purposes, the settler cannot be a beneficiary. After establishing the trust, it is usual that the settler then has nothing to do with the running of the trust. The settler/appointor has the right to appoint a new trustee under certain circumstances.
Trustee – The trustee is the person who holds property rights for the benefit of others through the legal mechanism of the trust. A trustee usually has full management and administration rights over the property, but these rights must always be exercised to the full advantage of the beneficiaries.
Beneficiary – All profits from the property go to the beneficiaries, although the trustee is entitled to reimbursement for administrative costs. There is not legal impediment for a trustee to also be a beneficiary of the same property.
The ability to split income between family members in order to take advantage of tax-free thresholds and lower rates or marginal tax among family members
- Asset protection
- Estate Planning issues: and
- Social Security Planning