When setting up or purchasing a new business, the focus is often on expected profitability and future growth. These are critical issues and require the focus of the business owner however, of equal importance is the structure of the business. Business structure has a direct impact on the amount of tax that will be paid, both on annual profits and the capital gain on any future sale. The right structure can also provide substantial asset protection for the business owner.
Business structures can include one or more, or a combination of the following types of entities:
- Sole Trader
- Partnership or Joint Venture (individuals, companies and/or trusts)
- Private Company
- Trust (unit, hybrid or discretionary) with individual and/or corporate trustees
(Note that these entities are separate entities for tax purposes but partnerships and trusts are not separate legal entities, the legal entities being the partners in a partnership and the trustees of a trust)
When choosing the right business structure the following key factors should be considered:
- Anticipated future growth
- Industry in which the business will operate
- Prospects for the future sale of the business (not all businesses are saleable)
- Asset protection
- Tax effectiveness
Let's focus on asset protection and tax effectiveness because the principles apply no matter the business.
Asset protection is arguably the most important factor to consider. Without adequate asset protection being built into a business structure, in the event of failure, everything may be lost. By everything, it's not just everything in the entity carrying on the business, but also the personal assets of the owner and even assets held in other entities in the owners' group.
Consider a Case Study of a couple who purchased a small business some years ago. The husband and wife had accumulated some assets in their personal names including equity in their family home. They had previously worked as employees and this was their first business purchase. It was recommended to them that they establish a discretionary trust to purchase and operate the business. Money was a bit tight at the time due to the purchase of the business and so they opted to act as trustees themselves rather than incur the cost of incorporating a private company to act as trustee. They both wanted to be owners of the business and so both were appointed as trustees.
The profitability of the business was not a good as originally anticipated. Due to declining profit and insufficient cashflow, a GST and PAYG Withholding liability owing to the ATO gradually increased over time. In the end it had increased to a level that was impossible to repay and the business had to be closed. As noted above, the trustees of a trust are the legal entities. Therefore, the husband and wife were both liable for the unpaid debts of the business, including the substantial ATO liability. The end result was that both of them were forced into bankruptcy and lost their family home. Sadly, the result could have been much different.
Only one trustee is required for a trust, so had only one spouse been appointed as the trustee, it would have protected the assets held by the other spouse, including half of the equity in the family home. Even better, had a company been incorporated to act as trustee, the company would have been liable for the debts of the business rather than the individuals. The assets held by the individuals would have been protected and they would not have been forced into bankruptcy. This sad but true case study illustrates how critical it is to build in appropriate asset protection when selecting a business structure. The small additional cost that may be incurred is really a one-off 'insurance premium' in case something goes wrong.
The income tax levied on business profits is a significant cost but can be minimised if the appropriate structure is chosen. The right business structure should address as many of the ongoing income tax issues as possible including:
- Effective income tax rate that will be levied on business profits
- Accessing the business profits to fund personal consumption
- Accessing the business profits to fund investment
- Ability to reinvest profits in the business to fund future growth
The wrong business structure can result in higher tax consequences due to the inability to split or stream income and inability to reinvest profits back into the business or outside of the business tax effectively.
It is also important to consider the potential future sale of the business. If the business is saleable, the appropriate structure can minimise the capital gains tax applicable to the future sale. The wrong structure can result in a substantially higher capital gains tax burden and the inability to access the profit from the sale without incurring further capital gains tax or income tax.
When considering the purchase or establishment of a business, it is crucial to obtain quality advice very early in the process so the right structure for your current and future needs can be put in place. Please call your Hanrick Curran advisor or speak with Nathanael Lee on 07 3218 3900 for further details.