What is the perfect structure for your business? Peter Bembrick outlines the advantages and disadvantages for each of the main types of business structure.
Identifying the best structure for your business from the start can help avoid the cost and difficulties of changing it later.
There are a number of considerations when deciding on the right business structure, such as who will be involved and the type of business being run. Some of the main business structures include sole trader, partnership, joint venture, company and trusts.
Sole Trader
Perhaps the simplest type of business structure, an individual simply carries on a business without setting up a separate legal entity. The business can be in the individual’s name, for example, Jim Jones: Electrician, or use a registered name such as Bright Spark Electrical.
The advantages to being a sole trader include low establishment and ongoing operating costs, and the structure is easy to understand and manage. Sole traders have relatively easy access to capital gains tax (CGT) concessions if the business is sold (including 50 percent discount and small business concessions). There’s also straightforward methods for succession planning, as the business can be left in a will.
There are some disadvantages, too. Because the business is not a separate legal entity, there’s no asset protection or limitation of liability. And your business income is taxed at the individual’s marginal rate (currently up to 48.5 percent). If services are provided by a sole-practising contractor to a single client, they might be regarded as an employee in certain circumstances.
Partnership
A partnership is usually an informal arrangement between two or more individuals (or entities). Generally there is an agreement setting out the roles and responsibilities of each partner. Like a sole trader, a partnership is not a separate legal entity. This means each partner owns an interest in every partnership asset, and each partner can be liable for debts and other obligations.
Partnerships were traditionally used by professional practices such as accountants and lawyers, although regulatory changes have increasingly allowed these professions to form companies and trusts in addition to, or in some cases instead of, a partnership.
Partnerships are also widely used by tradespeople, where it is common to carry on business through a ‘husband and wife’ partnership with one spouse undertaking most of the work for clients, while the other does the administration and bookkeeping. In these situations, the ATO generally allows business income to be split 50-50 for tax purposes as long as all documentation (such as invoices and bank accounts) reflects the fact that there is a partnership.
Like a sole trader, partnerships have lower establishment and ongoing operating costs than other entities, and this structure is simple to understand and manage. Allowing income to be split between partners for tax purposes makes this an attractive structure, as does the relatively easy access to CGT concessions on sale of shares in the business (including 50 percent discount and small business concessions).
Business owners looking to enter a partnership need to be aware that this structure generally offers no asset protection or limitation of liability, except where one or more of the partners is a company or trust, and business income is taxed at individual partners’ tax rates. Also, partners are jointly and severally liable for partnership debts.
Joint Venture
As with a sole trader and a partnership, an unincorporated joint venture is not a separate legal entity. However, the parties involved share in the output of the venture rather than the business profits. For example, unincorporated joint ventures are commonly used in property development, and represent a ‘looser’ connection than a formal partnership arrangement. Often the joint venture arrangement exists solely for a particular development project.
For tax purposes, each party is treated as carrying on a business in its own right, and the share of the revenue and expenses from the joint venture is included in each party’s individual tax return.
The advantages and disadvantages of such joint ventures are broadly the same as for partnerships.
Company
Registered companies are the most common and well understood entities for carrying on a business. A company is a separate legal entity and includes corporations, public companies, and proprietary limited organisations (Pty Ltd).
There are around 1.5 million companies registered in Australia, and a large number of these are small and medium businesses.
As companies are now permitted to have a single shareholder/director, even the smallest business can choose to operate through a corporate structure. At the other end of the scale, public companies can either list on a stock exchange or remain unlisted. Many medium and larger businesses that operate as an unlisted public company may plan, at the appropriate time, to raise additional capital for expansion by listing on the Australian Stock Exchange (ASX).
Advantages:
• provides asset protection and limitation of liability for owners
• business income is taxed at the corporate rate of 30 percent
• profits are retained and accumulated in the company
• franked dividends allow shareholders credits for company tax paid
• corporate groups can utilise benefits of tax consolidation regime
• easily understood and accepted by prospective financiers
• can raise additional capital by listing on a stock exchange.
Disadvantages:
• relatively high establishment costs and ongoing operating costs
• more complicated structure
• loans to shareholders may result in deemed dividends
• more difficult to access CGT concessions on sale of business
• companies can’t claim 50 percent CGT discount on sale of assets
• succession planning can be more complicated and involved.
Trusts
There are two main types of trusts used by businesses: unit trusts and discretionary trusts. A unit trust is a legal entity with a trustee (usually a company) that owns the assets on behalf of a number of unit-holders. These unit-holders have fixed entitlements to the income and capital of the trust.
Advantages:
• offers asset protection and limitation of liability, especially with a corporate trustee that has nominal share capital and no assets
• capital gains on sale of assets eligible for 50 percent discount
• loans to unit-holders generally not treated as deemed dividends.
Disadvantages
• relatively high establishment costs and ongoing operating costs
• more complicated structure, which is not as well understood as companies
• distributions are taxed at unit-holders’ marginal rates (up to 48.5 percent)
• profits retained in trust are taxed at top rate (47 percent)
• more difficult to access CGT concessions on sale of business
• succession planning can be relatively complicated and involved.
Like a unit trust, a discretionary trust is also a separate legal entity with a trustee. However, the trustee owns the assets on behalf of a number of beneficiaries who do not have fixed entitlements to the income and capital of the trust. The trustee therefore usually has absolute discretion in making distributions.
Pote
ntial beneficiaries of a discretionary trust commonly include all members of a particular family, plus any entities owned or controlled by them, and sometimes one or more registered charities.
Discretionary trusts generally work best for smaller, family-owned businesses, and may become impractical if there’s several unrelated business principals. Because it isn’t usually tax effective to retain income in the trust, there will often be a corporate beneficiary (whose shares are owned either by family members or the trust itself), which means that business income is taxed at no more than 30 percent. While further tax may arise when the company pays dividends, dividends can sometimes be ‘drip fed’ in a way that minimises the tax payable.
Advantages:
• offers asset protection and limitation of liability, especially with a corporate trustee that has nominal share capital and no assets
• maximum flexibility in distributions of income and capital
• able to stream different sources of income to different beneficiaries
• capital gains on sale of assets eligible for 50 percent discount
• relatively easy access to CGT concessions on sale of business
• loans to beneficiaries generally not treated as deemed dividends
• succession planning can be easier than with a company.
Disadvantages:
• higher establishment costs and ongoing operating costs than a partnership
• relatively complicated structure, especially with a corporate beneficiary
• distributions are taxed at beneficiaries’ marginal rates (up to 48.5 percent)
• profits retained in trust are taxed at top rate (47 percent)
• may not be as readily accepted by prospective financiers.
Restructuring
Despite careful pre-planning, business owners can still reach a point where the current structure isn’t giving them what they need, and another structure becomes preferable. For example, to facilitate growth (including through a merger, acquisition or public float), and to allow succession planning, improve efficiency in the business operations, improve asset protection, or minimise costs such as income tax.
As with any business decision, it is important to consider all the relevant issues, devise a plan, and then carry out the restructuring plan in the most efficient and tax-effective way possible.
Some tax issues should be considered when restructuring. A CGT rollover may be available. For example, transferring businesses from other structures to a company, or scrip-for-scrip transactions. Also, small business CGT concessions may be available, either in relation to the restructuring or for the future.
Demerger concessions allow the group of ultimate shareholders of a company to separate the ownership structure of certain assets or businesses that were previously owned under the same structure.
Tax consolidation can make restructuring very easy within wholly owned company groups, and creating a tax consolidated group will often be the first step in a wider restructuring plan.
When companies are wound up through restructuring, consider the levels of available retained profits and franking credits, and particularly whether any unfranked dividends will arise. If the company has had tax losses, any significant change in its shareholding can threaten the availability of the losses.
Stamp duty will usually be payable, although an exemption is available in most states for transferring assets between members of a corporate group. Transfers of unlisted shares do not attract duty in Victoria.
For share rollovers (other than companies incorporated in Victoria), it’s sometimes possible to avoid paying duty by redeeming the existing shares and issuing new shares, instead of transferring the shares.
While GST does not apply to transfers of shares, units and partnership interests, GST considerations may arise when transferring business assets (including goodwill) between entities. However, there is a ‘going concern’ exemption, as long as all the requirements are met.
* Peter Bembrick is a partner with accountants and business and financial advisers, HLB Mann Judd, Sydney.
