If you are undertaking or thinking of entering into a new business venture we set out below some general advice with respect to alternative control entities for a business and their consequences with respect to business holding and dealings. This is of course general advice but you may find it of some interest or benefit.
This also could be of use with respect to your personal actual ownership of say units or shares within those types of structures.
The first consideration is to analyse the status of each possible entity in relation to the following taxes and duties:
- Income tax.
- Capital gains tax.
- Land tax.
There is generally no stamp duty for a new structure. In some jurisdictions duty is payable on Trust Deeds.
The second consideration is to analyse the status of each entity in relation to asset protection.
The third consideration is to consider control of the entity and succession.
The fourth consideration is to consider the flexibility of each structure to change as circumstance might dictate.
The fifth consideration is to grasp the initial and ongoing costs associated with setting up and running the structure.
It will be necessary to rank each of these considerations taking into account the motives and goals that you have in respect of your new enterprise.
A table of ‘pros & cons’ for the different structures can be found/downloaded here.
Trusts are required to lodge tax returns but do not pay tax to the extent the income of the trust is distributed to beneficiaries. The beneficiaries assessed as being entitled to the income of the trust pay tax on that income as their entitlement to that trust income is added to the other income (if any) of the beneficiary. If the trustee does not distribute all of the income, the undistributed income is taxed at maximum marginal tax rates of 46.5%.
The lower company tax rate of 30% allows a tax effective long-term accumulation of income in the company. Eventually the net profits of the company are paid to the shareholders as a dividend and those profits are then liable to tax at the shareholder’s rate of tax but with a credit for the company tax paid. If shareholders have an average rate of tax of less than 30% then they will receive a refund from the ATO. If however shareholders have an average rate of tax in excess of 30%, then additional tax is payable by those shareholders.
It is also worth mentioning that the use of a company structure to achieve a flat 30% rate of tax does not preclude the Commissioner of Taxation from assessing the principal personally if the company’s income is in fact derived from the personal exertion income of the principal. The same applies to partnerships and trusts.
Also the practice of any entity distributing profits by way of wages to family members is regulated by the need to satisfy the Commissioner that the wages paid to such family members is reasonable. Income Tax Assessment Act 1997 – S 26.35 Reducing deductions for amounts paid to related entities.
The lower rate of tax for companies is beneficial only if shareholders are subject to a higher rate of tax. The average tax rate for individuals does not exceed 30% until approximately $105,000.
For the purposes of tax in the table, unit trusts are rated the same as companies. However the trustees of unit trusts are not taxed before dividing the profits amongst unit holders and therefore if units are owned by tax advantageous entities such as discretionary trusts then better tax consequences can be achieved. The unit holders can do their own tax planning. The potential advantages of using a unit trust over a company structure are readily illustrated by a project that is conducted, not by a company, but rather by a unit trust in which one unit holder has losses from other ventures. These losses can be offset against his proportion of the profits of the project without 30% tax having firstly been deducted.
The discretionary trust is the most effective vehicle for the purposes of ‘splitting’ income. Each and every year the amount paid to any beneficiary is at the discretion of the trustee as is the type of income paid to that beneficiary whether it be interest, dividends, capital gain or otherwise. Any beneficiary can be preferred to any other beneficiary.
Unearned income paid to infants is not tax effective as such amounts are subject to the maximum rate of tax to such distributions. Only $3,000 (after low income thresholds) can be paid to such infant beneficiaries before the maximum marginal rate of 46.5% is payable.
Family controlled companies that are beneficiaries of a family discretionary trust provide an opportunity to accumulate excess trust income at a 30% tax rate rather than incur the maximum rate applicable to undistributed income. The benefit of paying such income to a corporate beneficiary has been recently reduced by the ATO treating such distribution as a loan from the company to the trust, which requires the trust to pay interest at prescribed commercial rate and repay the amount in equal instalments over 7 years.
Capital gains tax
The taxable capital gain is added to the total taxable income of the taxable entity and marginal rates of tax then applied.
The taxation of capital gains is however preferential to that of ordinary income because of the existence of numerous concessions including the general 50% discount and the small business CGT concessions. To qualify for the 50% discount the asset must have been owned for 12 months from the date of acquisition to the date of disposal. The 50% discount is available to all taxpayers except for companies.
It is vital to remember the date of acquisition for CGT purposes is the date of the contract, not completion; and the date of disposal for CGT purposes is also the date of the contract, not completion. Further, there are numerous anti-avoidance rules, particularly relating to options which reduce the period of ownership for the purposes of the 12-month holding rule in the general 50% discount.
Partnerships do not pay capital gains tax. Rather, each partner is assessed. Any capital gain in a partnership is included in each individual partners return in an amount equivalent to their percentage interest in the partnership. For these purposes real estate interests are treated as tenancies in common in the respective shares equivalent to the partners’ interest in the partnership assets. The gain is not included in the partnership return.
This means that each partners’ component of the gain is treated in accordance with his circumstances. For some partners the capital gain may be a pre CGT asset whilst for others it may be post GGT and taxable. The 50% discount may be available to some partners and losses from other activities of each partner can be offset against their proportion of the capital gain.
What this also means of course is that a change in the ownership of the partnership asset by the retirement or entry of a partner can have significant CGT implications.
The small business concessions are available to qualifying partners.
A unit trust gets the benefit of the 50% discount and this flows through to unit holders who must reassess whether they are entitled to claim the 50% discount.
The discretionary trust again leads the field in that the capital gain can be ‘split’ and paid to such beneficiaries so as to achieve the best tax result with the availability of the 50% discount. Individuals, partnerships and companies have no such flexibility.
Losses are trapped in the trust and cannot be distributed to beneficiaries.
The largest part of alot of peoples asset in the equity in their home, which is exempt from capital gains tax on sale. This main residence exemption is not available to companies or trusts. Given this and land tax considerations it is usually recommended that most main residences are in personal ownership.
Companies suffer the further serious setback in that they do not get the benefit of the 50% discount in the capital gain. This is somewhat offset by the companies 30% tax level as against the maximum marginal rate of tax if that is applicable. Losses are trapped in the company and cannot be distributed to shareholders.
Superannuation funds can only claim a 33% discount rate nevertheless the applicable rate is therefore an acceptable 10% if the fund is in fact taxable at all.
The sole trader fairs badly in that the sole trader is liable to the full extent of his assets.
The partnership is in even worse shape in that it is possible to be liable for debts incurred by a partner without the knowledge or authority of the other partners.
Companies protect the shareholders from liabilities of the company in that they are only liable for any amount un-paid on their shares. However their shares are valuable in that they represent the value of the assets of the company and they are available to the shareholder’s creditors.
Directors have several potential liabilities to be concerned about arising from the obligations under the Corporations Act. Directors escape liability for the company’s debts, provided that they conduct the company’s business in an appropriately prudential manner, do not trade while insolvent and ensure that the company meets its obligations and pays such things as taxes – for instance, group tax & GST – as they fall due.
Trust deeds usually indemnify the trustee out of the trust assets but usually specifically deny the trustee (and therefore creditors) access to the assets of the beneficiaries.
The holders of units in a unit trust are usually presently entitled under the trust which gives value to their units just as with shares in a company. This value is available to the creditors of the owners of the units in the trust.
With discretionary trusts the beneficiaries usually have no vested interest in the assets of the trust, any interest usually only arising at the discretion of the Trustee. Beneficiaries therefore usually have no interest of value in the trust and creditors of beneficiaries therefore have nothing against which to recover. With limitations and exceptions the lesser protection applies against applicants under the family provisions Acts and the family law and de facto legislation.
Control and succession
Most people seek to minimise their tax liability, provide for the protection of their assets and retain full control of their affairs.
The sole trader has full control but as seen above has no opportunity to split income and is exposed to creditors to the full extent of his assets. Succession is by way of devolution by will, or by sale or by gift inter vivos.
Partnerships are regulated by agreements or otherwise by the relevant state partnership Act. Income of the partnership must be paid to the partners in accordance with their partnership interests except where a real business is being conducted, in which case profits may be paid to any partner, irrespective of their partnership interest. Succession is usually dealt with in the partnership agreement giving the continuing partners the pre-emptive right to buy the interest of the outgoing partner leaving cash for devolution by will.
Companies are run by their directors. You may well be the sole Director or retain control by appropriate provision in the rules of the Company. However far from being a personal fiefdom the director must run the company in the best interests of the shareholders. In the event that the client is the only shareholder then complete control is his. However, even with a small outside shareholding the remedies in oppression of a minority restrain unfettered decision-making.
The company of course never dies and therefore control requires a mechanism for passing on the Directorship. As Directors are usually hired and fired by the shareholders effective control is vested in the majority shareholders and therefore succession to the shares is the paramount consideration.
Unit trusts usually provide the trustee with wide powers of investment and wide powers to make all business decisions in running the affairs of the trust.
However the trustee is usually obliged to account to the unit holders in proportion to the number of units they hold for the annual profits of the trust and for the capital of the trust on the vesting day which can usually be brought forward from the perpetuity period of 80 years by decision of the unit holders.
Control lies with the trustee and the appointment of successive trustees is dealt with as desired by the parties in the trust deed. In the event that someone owns all of the units in the trust and is the trustee then complete control is his. If not then he is obliged to account to the unit holders in accordance with the deed. He is, if you will, a mere conduit between the business and the unit holders.
The trustee of a discretionary trust on the other hand usually has complete control in that he not only determines the investment policy of the trust but determines what benefits flow to which beneficiaries. The only recourse available to a discretionary beneficiary is to require the trustee to make a decision. With ongoing complete control for the perpetuity period of 80 years and subject only to the normally very wide powers in the trust deed, the trustee has complete control of the business undertaking equivalent to that of the sole trader. Succession is a matter of regulating the identity of the trustee by the trust deed. With the added advantage of maximum income splitting ability and the maximum opportunity for asset protection, it is not difficult to understand the popularity of this structure.
If at any time it is desired to register a new trustee of real property then, in some cases, exemptions from stamp duty are available under chapter 2 Part 13 of the Duties Act 2001.
Hybrid trusts take numerous forms and are so called because they enjoy some of the attributes of each of unit trusts and discretionary trusts dealt with above. So for instance the trustee may be required to account to some unit holders but have discretion in relation to others. There may be a class of persons and corporations related to the unit holder to which income can be paid at the trustee’s discretion. There may be income units and capital units. Hybrid trusts can be fashioned to suit the demands of the client’s affairs and are to be understood by reference back to their parent unit and discretionary trusts.
Of course you should also consult with your accountant or financial advisor.
We strongly recommend that the structure for the business enterprise be put in place before anything is done or signed. It may be expensive to ‘undo’ or change the entity after it is in place or contracts signed.
It is possible under the Corporations Act (s.131) to enter into a contract prior to incorporation of the company, but be aware that the person entering into the contract is personally liable under the terms of the contract if the company is not subsequently incorporated and ratifies the contract.