Solid foundations: What's the best structure for your business?

Are you paying more tax than you need to? The right financial structures are what your business clings to for growth, but the wrong one could be choking it.

Structuring your business in the correct way can save money. Getting it wrong can be costly and changing it down the track may not be easy. Family business is a broad term without a definition but the most common business structures are: sole trader, partnership, company and trust.

While it’s never too late for a business to rework its tax and protective structures, it can be a difficult and costly procedure. Ideally the advice and planning should be sought when the business is being set up. The reality for many family businesses is that they’ve been around for decades and when the next generation takes over they take over all the structures too. Below you'll find what your business structure means for you and how it lines up next to the other options.

Each structure has its own particular advantages and disadvantages as the tax, accounting and legal considerations of each vary.

Sole Trader

Tax treatment

  •  Taxed at sole trader’s marginal tax rate (0-46.5 per cent).
  •  Business loss can offset other income.

Advantages

  •  Simple and low-cost to set up and run.
  •  For income below $140,000 average tax rate less than 30 per cent (company rate).

Disadvantages

  •  No ability to split income with other family members.
  •  Owner could lose personal assets to creditors, as liability is unlimited.

Partnership

Tax treatment

  •  Each partner’s share is taxed at their marginal rate (0-46.5 per cent).
  •  Business loss can offset other income.
  •  Capital gain event on exit from partnership.

Advantages

  •  Fairly simple structure.
  •  If each partner’s share of income is below $140,000, the average tax rate is less than 30 per cent (company rate).

Disadvantages

  •  Profits must be split in partnership profit-sharing ratio.
  •  Less flexible than company or trust.
  •  More complex tax and legal issues when partner exits or enters partnership.
  •  Partners could lose personal assets to creditors as jointly and severally liable for all debts of the partnership.
  •  Good legal advice required re: partnership agreement to avoid future disputes between partners.

Company

Tax treatment

  •  Flat rate of 30 per cent on profits.

Advantages

  •  Company is a separate legal entity.
  •  Individual shareholder liability is generally limited to their share capital.
  •  Business profits can be retained in company or distributed to shareholders as dividends with potential franking credits to offset personal tax.

Disadvantages

  •  All income and capital gains taxed at 30 per cent.
  •  Can be more costly to set up and maintain.
  •  Loans to shareholders from company can be deemed dividends.
  •  More difficult to access CGT concessions on sale of underlying business or assets.

Trust

Tax treatment

  •  Profits distributed to beneficiaries taxed at beneficiary marginal tax rate (0-46.5 per cent).
  •  Profits retained in trust taxed at 46.5 per cent.
  •  Losses quarantined in the trust.

Advantages

  •  Considerable flexibility in a discretionary trust in the way profits are distributed to beneficiaries to minimise tax, including ability to stream dividends and capital gains to particular beneficiaries.
  •  Discount capital gain treatment flows through to individual beneficiaries.

Disadvantages

  •  Profits not distributed taxed at 46.5 per cent.
  •  Discretionary trust not suitable where external investors involved, although a fixed trust is possible. (This requires distributions to be made proportionate to unit holding).

The four key considerations when selecting the right structure, or combination of structures, are:

  • How can I best protect my assets?
  • Which will best limit my income tax?
  • Will one lower my capital gains tax?
  • From an administration perspective, which is easiest?

Potential reasons for a restructure

  • For asset protection, it may be advantageous to operate two business entities: one with few assets that incurs all business risks and a separate entity holding valuable assets that takes no risks.
  • A family with spouse and several adult student children may be able to reduce taxes through use of a family discretionary trust.
  • Where the owner currently has significant non-deductible borrowings (e.g. for family home), a restructure may enable funds to be borrowed to acquire the business in a new entity, creating tax deductible debt and allowing repayment of non-deductible debt. This can be particularly effective where small business capital gains tax concession applies to eliminate any potential capital gains liability.
  • Growth, merger or acquisition may require a company or unit trust structure to allow addition of new owners and/or external funding.
  • Succession planning may require a different structure to allow other family members/employees to acquire a share of the business.
  • Improved efficiency or cost minimisation – particularly for smaller businesses that may find a company structure cumbersome and tax inefficient.

The sale or transfer of any business will trigger a potential capital gains tax event. However a capital gains tax liability can potentially be avoided by:

  • Obtaining roll-over relief on transfer to a company or from one company to another.
  • Taking advantage of the small business CGT concessions that can allow a reduction in the taxable capital gain

Other issues to consider on any restructure include potential stamp duty and GST costs as well as the application of the anti-avoidance provisions of Part IVA.

Asset protection tips

  1. While a company structure offers better protection from creditors, trading while insolvent will negate the benefits of incorporation for the directors of the company
  2. When operating in business with a partner, consider key man and/or buy/sell insurance to:
  • Provide a lump sum to help business in the event of unexpected illness or accident of partner; and
  • Enable purchase of partner’s share of business in event of death or permanent disablement through pre-agreed transfer and funding agreement, usually supported by life insurance to finance the settlement.

Care is required in any restructure and professional advice should always be obtained.

David Hunt is a partner at Hunt Professional Group and specialises in tax planning and structuring in family businesses.