These notes are derived from Kevin Munro and Greg Vale, ‘Business Structures’ (Practice Paper No CC201, College of Law, July 2015) [201.15]–[201.125].

Choosing a business structure

Different business structures available

  • No separate legal entity:
    • Sole proprietor
    • Partnership
  • Separate legal entity:
    • Company
    • Trust:
      • Discretionary
      • Unit
    • Superannuation fund
  • Combination of types:
    • This will have different outcomes/consequences for ownership, taxation, liabilities and later sale.
    • Partnerships in NSW can now incorporate.
  • Joint venture

Considerations when advising on a business structure

  • Whether it’s a new or existing business.
    • If new, the current structure.
  • The nature and type of
    • the business,
    • existing/expected income, and
    • existing/expected expenses.
  • The number of individuals currently participating in the business, and their capacity and future expectations.
  • Relationship between participants (such as whether it’s a family business).
  • Current financial commitments and the need for finance.
  • Client’s objectives in terms of ownership, taxation, liabilities and later sale.
  • Control of the business.
  • Assets and liabilities of the business and individuals operating it.
  • Family law issues.
  • Duties and taxes:
    • Stamp duty.
    • Income tax.
    • Capital gains tax.
    • Goods and services tax.
    • Land tax.
    • Payroll tax.
    • Superannuation guarantee charge.
  • Estate planning issues.
  • Superannuation.
  • Limited liability.
  • Professional/industry requirements.
  • Commercial knowledge, complexity, administrative costs and compliance.
  • It is rare that a legal advisor will be given the opportunity to start from scratch.
    • If a client already has companies as entities owning assets it is likely that the appropriate entity is either an existing company or a new company.
      • A trust would be more appropriate to hold appreciating entities, but consistency is more important.
      • A group of companies can easily distribute profits and losses among the group.
      • The client is also likely to be more knowledgeable about companies than other structures and will have resultant commercial advantages.
  • Alterations to an existing entity may have significant change-over costs.

Characteristics of a good structure

  • Flexibility to accommodate changing circumstances with minimum consequences.
  • Adequate asset protection of the principals.
  • Cost minimisation, especially of tax.
  • Efficient distribution of profits.

Sole proprietor

  • A sole proprietor is a natural legal person.
  • There is no separate entity; registration of a trading name does not create an entity.
  • Run by an individual as an individual.

Advantages of a sole proprietorship

  • Simple to establish and terminate.
  • Simple to control.
  • Minimal reporting requirements.
  • Taxed at the personal rates of the sole proprietor; tax losses may be offset against other income.
  • Ability to claim 50% capital gains tax discount for individuals.
    • If a sole proprietor has held an asset for at least 12 months they will only be liable to pay tax on half of the capital gain.
    • If the asset is an equity interest in a small private company or trust the discount is subject to passing anti-avoidance provisions.
  • Sole proprietors are not employees.
    • No need to take into account amounts drawn from the business in respect of ‘compulsory employee’ superannuation contributions.
    • No payroll tax or workers’ compensation liabilities.

Disadvantages of a sole proprietorship

  • Unlimited liability for debts and negligence.
  • Cannot simply allocate or split the income.
  • Salaries paid to family members are limited by the Income Tax Assessment Act 1997 (Cth), especially ss 26–35.
  • Required to substantiate business deductions for ‘fringe benefits’.
    • This restricts the level of deductions for motor vehicle and travel expenses.
    • Many people will be unable or unwilling to comply with the requirements.
  • Limited flexibility in tax planning.
  • Under Pay As You Go (‘PAYG’) a sole proprietor is liable to pay tax in quarterly instalments.
  • Business ends when the sole proprietor ceases working on retirement or death.
    • Unless the sole proprietor can identify assets of valuable which are transferable to a third party, the business ceases without any benefit from goodwill.

Becoming a sole proprietor

  • Generally fast and simple.
  • Usual practice to register for an Australian Business Number (‘ABN’).
    • ABNs are unique 11 digit numbers identifying a business to the government and community.
    • A tax file number is needed to register for an ABN.
    • Registration is not compulsory but it will allow the sole proprietor to:
      • facilitate a single business activity statement,
      • confirm the business identity to others when ordering and invoicing,
      • avoid having other businesses withhold amounts from payments received,
      • claim GST credits,
      • claim energy grants credits, and
      • register a business name with the Australian Securities and Investments Commission.
    • Registering for an ABN is administered by the Australian Tax Office.
  • ABN registration does not automatically result in registration of a business name; this is done separately.
  • Business names are registered under the Business Names Registration Act 2011 (Cth).
    • National system of business name registration replaced state and territory registers in 2012.

Costs of being a sole proprietor

  • Business licence costs are available from the NSW Office of Fair Trading: http://fairtrading.nsw.gov.au.
  • Application for national registration can be made online via ASIC: http://www.asic.gov.au/bn-apply.
  • Search of the Australian Business Licence and Information Service is needed to check whether any licences or permits are required: https://ablis.business.gov.au/pages/home.aspx.
  • A sole proprietor will need to manage cash flow to meet quarterly PAYG and GST payments.
  • Other costs include accounting costs for income tax returns and periodic GST returns.

Ongoing compliance requirements

  • No specific legislation regulating sole proprietors.
  • There may be a liability to comply with legislation specific to their business.
  • Sole proprietors may be required to pay a business name renewal fee and to comply with:
    • specific business licences, or
    • rules adopted by professional associations.

Partnership

  • At common law a partnership is an association of individuals or entities for the purpose of carrying on a business venture or activity in common with a view to a profit.
    • Restated in Partnership Act 1892 (NSW) s 1(1).
  • Definition under tax law is much wider: an association of individuals or entities carrying on business as partners or in the receipt of income jointly.
  • Partnerships are regulated by the Partnership Act 1892 (NSW).
  • Subject to agreement partners:
    • share equally in the capital and profits of the partnership, and
    • may each take part in the management of the partnership business.
  • The legislation includes numerous other default provisions which apply unless agreed otherwise.
  • Maximum number of partners is limited by Corporations Act 2001 (Cth) s 115.
    • Maximum is usually 20, but exceptions exist — s 115(2):
      • 50 partners are allowed for:
        • actuaries,
        • medical practitioners,
        • sharebrokers,
        • stockbrokers,
        • patent attorneys,
        • trademark attorneys, and
        • certain collaborative scientific research partnerships.
      • 100 partners are allowed for:
        • architects,
        • pharmaceutical chemists,
        • veterinarian surgeons.
      • 400 partners for legal practitioners.
      • 1,000 partners for accountants.
  • Partnerships are not separate legal entities.
    • All assets are owned by partners jointly or in proportions set out in the partnership agreement.
    • Contracts and agreements entered into by the partnership is to be executed by all partners unless provided for in the partnership agreement.

Advantages of a partnership

  • Relatively inexpensive to form.
  • Provides for combined labour, expertise, management skills and financial skills of partners.
  • Advantages are the same as for a sole proprietor where the partners are themselves individuals.
    • A major difference is that income is more easily split between family member partners.
  • For income tax purposes a partnership is treated as a separate entity.
    • Partnership completes and files a tax return.
    • The return determines the income of the partners.
    • Partners’ shares are taxed at the personal rates.
  • Losses are not trapped in the partnership entity and can be used against other income of the partners.
    • This is the main reason for selecting partnerships in tax-driven investments.
  • It is possible to structure a partnership with the flexibility to vary profits/losses between the partners on an annual basis.
    • The share can be varied so that partners receive 99% and 1% of profits/losses respectively an an alternate basis.
    • These should be clearly documented and established otherwise the Commission of Taxation may apply various anti-avoidance provisions.
  • Allows tax preferred amounts (eg, tax incentives, tax-free capital gains) to be passed through the partners.
  • Partners can access the 50% capital gains tax discount.
  • Capital can be increased or withdrawn without restriction.

Disadvantages of a partnership

  • Unlimited liability for the business and debts, whether incurred without authorisation.
    • A limited partnership can reduce the liability of limited partners to the capital contributed.
      • But the tax implications that flow as a result of limited partnerships being treated as companies in tax law may outweigh this advantage.
  • Capital gains tax disadvantages — tax laws treat partners’ shares as representing a direct fractional interest in the partnership assets.
    • If a partnership asset is sold, each partner is treated as having disposed of an asset represented by their percentage interest.
    • Gains from disposal are not include in the partnership income, but the individual partner’s income.
    • As a result some partners may hold an interest in the partnership property as a pre-CGT asset and others as a post-CGT asset.
  • Partnership cannot pay wages to an individual being one of the partners — amounts paid to partners are not deductions in the same way as payments to employees.
  • Potential problems can arise in relation to retirement and admission of partners.
  • Potential for disputes and breakdown in the mutual trust of partners.

Establishing a partnership

  • Written agreement not required but recommended.
  • Partnership agreements define rights and obligations of partners.
  • Partnership bank account should be opened and all income and expenditure passes through it.
  • Unless proper names of partners are used, a business name should be registered.
  • Ownership of assets and all obligations should be in the name of all partners.
  • A proper set of financial accounts detailing income, expenditure, capital contributions and drawings should be kept.
  • TFN and ABN should be obtained, and consideration of GST registration requirements.

Costs of a partnership

  • Standard partnership agreement costs between $500 and $1,500 in legal fees.
  • Other costs include accounting costs for income tax returns and periodic GST returns.

Ongoing compliance requirements of a partnership

  • Must comply with the Partnership Act 1892 (NSW).
  • May also be required to comply with specific business legislation, licences and rules adopted by professional associations.

Companies

  • Separate legal entity capable of holding assets in its own name.
  • Two main participants are shareholders and directors.
    • Shareholders are the owners and put capital into the company.
      • Shareholders have an interest in the company but no direct link to its assets.
      • Shareholders have no say in day-to-day management.
      • Shareholders have the right to elect the directors.
      • Shareholders do not own the assets, but are not liable for its debts.
      • Companies must pay liabilities from their own resources.
      • Shareholders are only liable to contribute the unpaid amount of any shares they own.
    • Directors have day-to-day control of the company.
      • They manage the company for the benefit of the shareholders.
      • A number of obligations and duties are imposed by the Corporations Act 2001 (Cth).
      • Directors are not ordinarily liable for a company’s debts.
      • Directors may be liable for breach of duty to prevent insolvent trading.
      • The corporate veil may be lifted under other statutes and in some circumstances common law.

Advantages of a company

  • Separate legal entity with perpetual succession and limited liability.
  • Incorporation is often quick and efficient.
  • When borrowing a company benefits from ‘commercial familiarity’ and its capacity to grant security interests over owned assets, including future property.
  • Companies are now more competitive given profits are no longer taxed at both the company and shareholder levels.
  • Contributions by a company to employee’s superannuation funds can be claimed as a tax deduction.
  • Companies can make tax-deductible retirement payments to all employed family members.
  • Losses may be transferred from one company in a group to another where there is 100% common ownership.
    • Requires a parent-subsidiary situation.
  • Opportunity to employ principals and use the FBT rather than having to substantiate fringe benefit expenses.
  • Some ability to split income among family members:
    • Employment of family members.
    • Issue of different classes of shares.
  • Shareholders liable to pay tax on their dividends under the PAYG instalment system.
    • Where the company has paid tax on the dividend amount, the shareholder’s tax liability is reduced.
  • Companies offer the ability to obtain CGT deferral where formed to replace existing family entity structures.
  • Company tax rate is 30% (or 28.5% for small businesses trading as a company).
    • Tax rate hasn’t changed since 2002/2003.
    • Rate is much lower than the highest marginal tax rate for individuals (45%).
    • No requirement to distribute profits; profits can be accumulated in a company.
      • Enables a taxpayer to structure their affairs so that tax is paid at a maximum rate of 30% and defer further liability indefinitely.
  • Ownership in assets may be transferred in certain circumstances without significant duty costs.
  • Share buy-back and reduction of capital provisions provide greater flexibility in cancelling shares or reducing paid-up capital, making companies less rigid entities.

Disadvantages of a company

  • Tax losses are trapped within the company.
  • Tax preferred amounts (tax free capital gains and tax incentives) received by the company will be subject to tax on distribution to shareholders.
  • Commercial costs in maintaining a corporate entity can be significant — annual filing fees, accounting fees and accountability compliance.
  • Principals become employees, giving rise to exposure to payroll tax and compulsory superannuation for principals who are employees.
  • No entitlement to the CGT discount concession.
  • Shareholders have limited involvement or control over decision-making and management.

Establishing a company

  • Outline for registering a company is in Corporations Act 2001 (Cth) s 117.
  • Lodge application for registration with ASIC.
    • Must contain specific information.
    • A fee is payable.
    • Before lodging an application
      • check the proposed name is available, and
      • obtain written consent of each person proposed to be a director, secretary or member.
  • ASIC registers a company upon receiving the application and fee, which involves ASIC:
    • Providing an Australian Company Number (ACN).
    • Registering the company.
    • Issuing a certificate of registration.
  • The company comes into existence on the day of registration and remains in existence until deregistered.
  • New companies can be registered fairly quickly.
  • Newly-registered companies need to obtain a TFN and ABN, and register for taxes such as GST.
  • Business name may need to be registered if doing business under a different name.

Directors and shareholders

  • Proprietary companies require at least one shareholder and one director.
  • Single-director companies are often used in family businesses.
    • Only the family member who is the director is bound by the obligations in the Corporations Act 2001 (Cth).
    • For asset protection, a married couple could have one spouse as director and the other as owner of assets.
  • Single-director companies may have problems if a director dies suddenly and unexpectedly.
    • There would be no-one to authorise corporate acts until the deceased had been properly replaced.
    • Replacing a sole director may take some time, especially if they were also the sole shareholder.
    • It may be better to have two directors with separate shareholdings.
  • Shares are a CGT asset; their transfer to another shareholder at a late date will likely have tax consequences.
  • It may be undesirable for individuals to own the shares given they have the ‘value’ of the company.

Ongoing costs of a company

  • Each company has an annual review date, usually its anniversary of registration.
  • Soon after the annual review date ASIC issues an annual statement and invoice for the review fee.
  • Multiple companies in a business structure can lead to significant review fees.
  • Other costs include accounting costs for income tax returns and periodic GST returns.

Ongoing compliance requirements of a company

  • A company and its officers must comply with the Corporations Act 2001 (Cth) which
    • places many duties on directors,
    • requires certain formal meetings take place, and
    • requires certain documents to be lodged with ASIC.
  • A company may also be required to comply with specific business legislation, licences and professional rules.
  • Companies must comply with other legislation relating to industrial relations, retail leases, factory and shop laws, workers’ compensation, holiday and log service leave, superannuation, income tax, FBT, payroll tax and local government laws.

Trusts

  • NOTE: this deals with trusts as a business structure, not trusts in general.
  • A trust exists when the holder of a legal or equitable interest in certain property is bound by an equitable obligation to hold that interest for the benefit of another person or persons, or for some other object or purpose permitted by law.
    • The holder is the trustee.
    • The legal or equitable interest in the property is the trust property.
    • A person who benefits is a beneficiary.
  • A trustee may hold separate interests in the trust property for separate beneficiaries.
  • It is common for trustees to hold
    • the trust property for the benefit of one or more beneficiaries, and
    • the income of an estate for one or more other beneficiaries.
  • All transactions are undertaken by the trustee.
    • This is a personal obligation.
    • Trustees can be personally sued.
    • A trustee sued in that capacity will often have a right of indemnity as against the trust assets.
  • Trustees can enter into transactions on behalf of the trust under the trust instrument.
    • In the absence of a trust instrument, the Trustee Act applies.
    • It is preferable to have a written deed of trust.
  • Two main types of trust: unit trust and discretionary trust.
  • The trustee will usually be a company for the benefits of limited liability; an individual trustee’s assets may be at risk.
    • It is preferable that the trustee company owns no other assets.
    • These combined facilitates asset protection provided the directors of the company conduct themselves appropriately.

Advantages and disadvantages of a unit trust

  • The trustee holds the trust property and income which it derives for the unitholders who are members of the trust.
  • The trustee may be an individual, several persons, a company, or any combination.
  • The interest of the beneficiaries is that the united held confer a proprietary interest in all the property of the trust estate.
  • It is possible to vary the interests of the unitholds by varying the rights attaching to the units.
  • It is possible to issue units which have rights only to the income or different classes of income of the trust, or capital, or capital gains, or any combination.

Advantages of a unit trust

  • Similar to companies in many ways; unitholders subscribe to equity on units and principals may be employed.
  • Unit trusts need not pay taxes; unitholders incur tax on taxable profits derived by the unit trust.
    • Advantage in joint venture arrangements because it allows for the unitholders to offset tax losses.
  • Tax-free capital gains and tax incentives if properly structured.
  • Opportunity to stream different forms of income to different unitholders.
  • 50% CGT discount is available to all trusts in relation to disposal of assets.
    • Can be claimed at both the trustee and beneficiary level.
      • Trustee can choose to accumulate the capital gain or distribute it to a beneficiary who can then claim the discount.
  • Hybrid trusts can be created by crossing a unit trust with a discretionary trust.
    • Obtains an advantage in terms of flexibility as to how income is applied.

Disadvantages of a unit trust

  • Tax losses cannot be distributed to the unitholders.
    • Trusts should be structured so that losses are incurred at the unitholder level.
  • No opportunity to defer a capital gain through CGT roll-over relief provisions when assets are transferred into a trust.

Advantages and disadvantages of a discretionary trust

  • Trustee has a discretion as to who to distribute or apply the income and capital of the trust.
  • Beneficiaries only have the right to be considered by the trustee.
    • No right to demand a share.
    • No equitable interest in the property.

Advantages of a discretionary trust

  • Settlor may settle property on a trustee and the trustee directs the flow of income and capital to beneficiaries in accordance with the trust deed.
  • Limited liability can be achieved with discretionary trusts provided that the trustee itself does not own assets.
    • Corporate trustees should not carry on any other activity if possible.
  • Flexible, and therefore popular for family-run businesses:
    • Easy income splitting opportunities (can be varied from year to year).
    • Trustee can be empowered to apply different forms of income as provided in the trust deed.
    • Can obtain an optimum tax position each year as income can be distributed to family members on lower marginal tax rates.

Disadvantages of a discretionary trust

  • Tax losses are trapped in discretionary trusts.
  • Not possible to ‘gear’ an investment into the trust by a beneficiary; inappropriate for negative gearing purposes.
  • Commercial disadvantage as they are not well understood.
    • Possible increased costs incurred when borrowing funds as a financier will often insist that their lawyers review the trust arrangements.
  • Care is needed when changing provisions of a trust deed; this could inadvertently lead to ad valorem duty and exposure to CGT.
  • No entitlement to the tax exempt threshold for land tax purposes.
  • Generally inappropriate for joint venture investments; the interests are not defined and commercial risks can arise.
  • Care is needed in appointing a trust as a beneficiary of another trust; ensure that the vesting dates do not infringe the perpetuity rules or else the original trust may be void.