A key component to business success is ensuring you have the right legal structure for where you're going. In fact it's one of the very foundations of our 3 step strategy with clients. But having the right structure is more than just about tax. In practice I believe there are four areas that need to be considered. In this blog we'll go through each of these areas and provide an example of a common way we structure businesses.
So what are the four considerations that go into structuring? Well here’s mine;
Yes, tax always plays a role in structuring, but to be honest its further down the list than most people realise. That’s because Australia has an imputation and marginal tax rate system. English please Nathan? Oh right.
When you've got a trust or a company, there are only so many ways you can get cash out of these legal structures;
Expenses (wages) and dividends are income in the hands of those that receive them. If you have more income in your personal name, you pay more tax. That's how our marginal and progressive tax system works.
A key point to remember is that a trust or company is a separate legal entity. It's considered a natural person in the eyes of the law. So the cash sitting in the company bank account is NOT yours to take like the cash in your dollarmites account is.
That means the loan you took from the company, needs to be repaid at some point. And a return of capital can't happen every day. The company or trust, can only pay out capital it has received in the first place e.g you're getting back what you already contributed.
Imputation just means that tax credits flow from a taxpayer to the beneficial owner. So when a company pays a dividend to its shareholders, along with the cash the shareholder receives is a credit for the tax company has already paid to the ATO. This system ensures that taxes aren’t paid twice on the same income. Get all the details on how much tax you pay on dividends here.
So based on the imputation system, at the end of the day, tax will be paid at the shareholder level at their marginal tax rates. That’s why the structure that holds the assets/runs the business isn’t that important for tax purposes in the long run (or if you take the cash). It does however have tax deferral benefits that will impact on cash flow, and complexity of your accounting & tax matters, which we will discuss in more detail below.
This deferral is the biggest “tax” consideration in structuring. In theory, most people want to defer as much as possible for as long as possible, but inevitably, they also want the cash out of the business to pay down mortgages, and live their life, and it is precisely when the cash comes out to the shareholders that the deferral benefits are over. A concept either not explained well to people or very well forgotten by them.
There are also ways to utilise the marginal tax rate system to reduce the family group’s income tax. This can be done through the use of various structures such as companies, partnerships, discretionary trusts, and unit trusts, or combinations of these and other structures such as a company being owned by a discretionary trust, or a unit trust being owned by a self managed super fund.
There is almost no limit to how complex and convoluted you can make your group structures, but as mentioned earlier, tax will in the end be paid by the individuals you take the cash at their marginal tax rates.
Cash Flow & Complexity
As mentioned above, the structure chosen, can have implications for cash flow and most definitely will impact on the complexity (or not) of your accounting and tax requirements.
For example, since the ATO changed their mind on the treatment of unpaid profit distributions from trusts to companies on 16 December 2009, it has caused an array of taxation implications that have complicated the tax affairs of many businesses and negatively impacted their cash flow cycle to make the necessary tax and loan repayments required under these scenarios.
This very issue is compounded in groups with more than one company and/or more than one trust (very common in family groups that have been in business/investing for longer periods).
In addition to the income tax and accounting complexity issues, is the day to day administration. Having lots of entities may make you feel all nice and accomplished, but you need to factor in the cost of bookkeeping and accounting fees, not to mention the set up and administration of bank accounts and bank statements, TFN’s/ABN’s, making sure all your BAS are complete & lodged by the due dates, that you’ve put the right entity name on the contracts and agreements etc, and transferring cash around the group doesn’t take 3 days, because you’ve got to transfer it between 5 different banks to get it in the right spot.
So when considering the structure of your group, my advice: keep it simple.
You work hard to accumulate assets right? So you want to do what you can to protect them. That’s just common sense, so that’s what we are doing here. Looking at the risks involved and ways we can protect the assets as much as possible. Now nothing is ever 100% safe, even the tin of cash buried in my backyard could be found. But some structures offer better protection than others, sole traders carry a fair chunk of risk, partnerships in my opinion carry even more - because you are joint and severally liable for the actions of you partner, and who knows what that loose cannon could get up to.
Companies and trusts are both equally as cool in my opinion, but if you have co-directors, again, they can act on behalf of the company and enter into legally binding contracts, access bank accounts etc, so my advice is to always have a shareholders &/or management agreement which dictates who can do what, what everyone’s authorisations limits are etc.
One thing I should clarify here, is that no matter what structure you have, you need to have the appropriate insurances in place for a business of your kind. If you’re in business, you really need an insurance broker to do this for you. Don’t waste your time and risk it (and why would you when they get paid from the insurers?). Just find one who is independent and can (and will) recommend the best policy for your business. If you need a referral to a good one let me know.
Now all of this structuring and insurance will be for nought if you’re negligent. Nothing is going to help you. So don’t do that.
You can also not structure your way out of certain ATO liabilities like superannuation, GST, and PAYG Withholding. If you don't lodge and pay your BAS on time, the ATO can make the directors or trustees personally liable for these amounts under the director penalty regime. These are very real risks of running a business that you should be aware of.
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So when looking at asset protection the golden rule is to separate, as much as possible, the assets from the risks (liabilities).
When doing this we look at what the assets are, or will be, (such as Cash, Goodwill, Plant & Equipment, Patents, Trademarks etc) and what the risk of getting sued is (e.g from employees, customers, suppliers, the ATO etc) for matters not covered or outside of your insurance policies, or if you’ve done (or not done something like notifying them in the required time) that will invalidated your insurance claim.
We also look at what exposure the owners/directors will have and ways we can minimise the risks to them if it all goes pear shaped.
This consideration covers not only what happens if you die, but what about if you want to bring on a business partner, or reward/remunerate some employees with some of the business value? Or sell the business in 5, 10, 20 years time? Having a structure flexible enough that also minimises not only income tax, but transfer duty, is a key consideration and one that is easy to overlook when you’re just starting out by yourself in your garage.
Common Business Structure
So we've covered the 4 areas to consider when structuring, but how does this practically play out in the real world?
Sue wants to manufacture & sell widgets. Her husband, Steve, is primary carer for their young kids.
We establish a company to operate the business. Sue is the sole director, Steve is the trustee of the “Widget’s make us wealthy discretionary trust”. Steve is not involved in the business at all.
Why This Structure?
This 2 layer structure provides you with high levels of asset protection, and tax minimisation benefits, whilst also being flexible to accommodate changes in the future as the business grows. It is also fairly cost effective to set up and administer from an accounting and tax perspective.
Want to bring in new equity? No problem,
Want to buy the warehouse? No problem,
Want to distribute some of the profits to the non-working spouse? No problem.
Now this structure won't suit all cases, so its important that consideration is given to you and your circumstances and the business you are trying to create. But hopefully all that has given you an insight to the considerations that go into designing a group structure for you in our business accounting and tax services.