LEGAL INFORMATION FOR THE SOLE BUSINESS OWNER IN MELBOURNE
Australian Business Corporate Structures
BUSINESS CORPORATE STRUCTURES
One can build complex structures or simple structures as modules (designed for personal requirements) to isolate property and assets from the high-risk areas of business and personal activity. The basis of the modules builds on the type of structure available such as:
Sole Business Owner or Partnership
Discretionary Trust and Unit Trust
SIZE AND COMPLEXITY OF THE BUSINESS
If one wishes to operate a mowing round franchise, one does not establish a complex business structure. A sole trader structure for such a person is suitable. However, if the business is of significant substance, then the larger expenditure is justified.
There are various options in a situation where one has a larger budget, for example, a company, in which the various parties own, a shareholders agreement can regulate shares and the relationship.
Whilst it is important to make the most appropriate business structure available, it is common for clients to expand too much energy and effort on the establishment of a business itself before it commences to trade or return a profit.
COMPLEXITY AND VARIETY OF THE ASSETS FOR THE BUSINESS SUCH AS PHYSICAL ASSETS AND INTANGIBLE ASSETS
A simple business may require little physical assets and with technology, clients can run a business from any location. Technology and outsourcing allows clients to operate with lower capital costs. However, if there are significant physical assets or intangible assets employed or used in the business, it is appropriate to hold the assets in separate structures.
Physical assets such as plant, machinery, and equipment, which the proprietor can receive depreciation allowances can remain in the business entity until their book value is negligible. If the assets still have significant value, (for example specialised machine tools) it may be appropriate to transfer them from the business entity for zero consideration (or written down value if modest) to holding entity at a later point in time.
Private individuals can hold and license to the business entity, computer programs, trademarks, and similar assets, which have a capacity to appreciate.
If they remain in the individual’s name and have capital appreciation, they take full advantage of the capital gains tax concessions presently available to assets, held in individual’s name. The assets remain isolated from the business and if the business takes on further participants; the original ownership of the intellectual property associated with those items is not in dispute at any time. Consider each asset on its merits and endeavour to place it within the business structure where it is most advantageous to the structure at that time.
AGE, PERSONALITY, AND EDUCATION OF THE PERSONS INVOLVED IN THE BUSINESS
The age of the participants in a business structure is important. Persons who are in their middle years are more inclined to look at issues such as succession for their business structure. They may favour a business structure, which would enable a younger participant to become a part of the business and allow an exit from the business in an orderly fashion. In this context, one favours a small private company with a reasonably substantial shareholding. The more flexible and substantial the shareholding, the more one can allow equity participation from other persons before reaching a 50% threshold, which would freshen up any assets in the business. This helps to minimise the impact of capital gains tax when the original participant or founder of the business leaves the business.
The personality and educational qualifications of individuals are extremely important in terms of considering business structures. Many lack personal skills and find it difficult to deal with other people. They are often better to stay in their own individual business structure, and go into arrangements with other people for individual projects. A person with higher levels of literacy and numeracy enables a person to handle a more complex business structure. People should understand precisely the legal implications of any business structure in which they are going to participate. There is no point giving someone a business structure that he does not comprehend.
What capital is presently available?
What capital will be required?
Should the financing be by equity, or by borrowing?
What are the implications?
A separation of a business into separate legal entity is always a good starting point in considering structuring issues. If a business requires little capital, or there is adequate capital available for the business financing without external borrowing, a company is the most efficient and economical answer to operate such a business.
However, if there are a number of participants who are putting in equity into the business, then one must consider the needs of those individuals. Some prefer to purchase shares in a company, whilst others prefer to keep their participation confidential and prefer buying units in a private unit trust.
It is important, when having more than one client contributing equity to a business, to make certain they understand their obligations to one another and have appropriate “exit provisions”, whether in the form of a shareholders’ agreement or unit holders agreement agreed in advance.
Sole traders have everything at risk, as do partners. In terms of external borrowing, the banks and other leading institutions prefer to lend money to companies as against trusts. Documentation is more straightforward and the capacity of the bank to take a direct security over the company by way of a debenture is preferred.
Other persons involved in the business may advance funds to the business enterprise by way of loans. This has the advantage of placing the business entrepreneur (or an associated related entity) in a position of being a secured creditor by the granting of a debenture charge over the company or other form of equitable mortgage or security over the assets of the enterprise. If borrowings are made by the participants in the business to the business itself, then clear guidelines should exist as to the repayment of those loan funds and what form of priority, interest etc.
What are the responsibilities for short-term, medium-term, and long-term growth?
Most start out with the expectation that their business will grow. It is important to discuss at the outset what the realistic expectations are for short term, medium term, and long-term potential growth for the business. If the prospects in the growth of the business are very low, then a less complex structure is useful. If a person only intends to be effectively self-employed in business, then it may be appropriate for that person to maintain a small business structure and a sole business trader arrangement.
However, if there is a likelihood of significant growth in the business and the prospects of requiring either substantial external capital whether it is borrowings or equity, then one should look an incorporated structure.
If there is likelihood for a requirement of participation from a large number of other participants or the necessity to assemble complex skills to undertake the particular business enterprise, then one might be more inclined to look to a private unit trust. The advantage of a private unit trust is that one can structure the unit holdings within the trust in any conceivable form (subject to the agreement of the parties and the imagination if the draftsman). This can allow a large participation of different people at different levels within a significant business or a significant growth path.
If the nature of the growth is a financial growth path requiring either the issue of additional shares or the borrowing of external funds, then the company is the preferred structure with the prospect of some limited liability and isolating the risk of failure to a specific corporate entity.
If one is involved in a situation of an entrepreneurial product or something in the nature where the parties believe they can float the company into the stock exchange, then, one can incorporate an unlisted public company for this purpose.
What is the risk profile of the business activity?
Is insurance readily available?
Can the risk be isolated?
One should explore insuring the risks associated with the business, such as product liability, professional indemnity, directors insurance or such like. One must offer this option to the client and to make certain what risks the insurance covers.
Where the level of insurance is impossible to match the risk, the favoured business structure may be essentially one of the two:
An individual conducting the professional practice or the high risk activity; or
An incorporated entity conducting the high-risk activity
If the individual is selected to take the risk, then assets should be in other structures whether they be trusts or in the name of spouses or partners. If the risk can be isolated in an incorporated entity, then this would be the preferred option.
Is the business operating in an existing business structure that one can acquire?
What other existing structures does the client have now?
BUYING AN EXISTING STRUCTURE
When acquiring a business, one should use a fresh structure, which has no previous history risk, attached to it to acquire the business. However, there are exceptions, an existing business structure can have either licences (for example an export licence) a registration (example – real estate and building) which could have significant value. One should therefore consider carefully the vendor structure in this context.
CLIENT'S EXISTING STRUCTURES
The other aspect of “existing structures” is to examine the existing structures that a client already has. A client may have an existing structure, previously used by the client, which can be profitably recycled to the benefit of the client. Alternatively, the client may have substantial and complex structures, which do require any addition. I have always favoured the simplicity approach in terms of keeping business structures and their development under control. Loan accounts in particular are extremely “dangerous” in terms of isolating risk and creating tax issues. There is no point confining a risk to an individual or a structure if that income-producing structure has money owing to it by various asset-holding structures.
Clients may want to retain confidentiality about their business activities and so there is significant advantage in using trusts, particularly unit trusts. There is no requirement to register the unit holdings in a unit trust nor to register or disclose the beneficiaries under a general definition of beneficiaries in the discretionary trust. However, Unit Trusts are favoured as the business entity particularly where there are more than one group of participants in the business entity. With a company, the shareholding is subject to search at ASIC and is public record.
Are there differing roles, contributions, skills, or equity participation from the various participants in the business?
One can create a private unit trust, which has different classes of units with different priorities in terms of ownership of specific assets, participation in terms of return from the business, and returns of equity especially where the parties are keen not to have the complex nature of their arrangements made public.
This cannot be achieved by different classes of shares in a company, however, the constitution of the company discloses the nature of those classes of shares or alternatively the special resolutions required to create those classes of shares or alternatively the special resolutions required to create those classes of shares would have been subject to public registration at the ASIC.
Goods & Services Tax;
Income Tax; and
Capital Gains Tax
One must take into account the various tax considerations of any given structure. Clearly, with a sole trader, tax is payable at penalty rates once the sole trader becomes profitable. Partnerships can split income but in set or predetermined proportions. Partnerships can have flexibility about the manner and method in which to divide profits amongst partners however there is little or no flexibility with tax treatment.
Discretionary Trusts have the advantage of income splitting. Provided a Discretionary Trust has a company as one of its beneficiaries, and then in those circumstances, the liability to pay tax in the discretionary family is capable of being limited to the corporate rate of 30%.
Unit trusts do not pay tax as the taxes are by the various unit holders in accordance with their individual structures. A unit trust can have individuals’ partnerships, discretionary trusts, or companies or other trusts holding individual units or groups of units. The flexibility in a unit trust has great advantage. The tax advantage with the company is the fixed maximum corporate rate of 30%, and franking credits. The tax implications of the GST in internal business structures have been relieved to some extent with the reasonably liberal approach taken by the ATO in terms of its grouping provisions. There was considerable anxiety that creating separate corporate structures within the same, beneficial ownership may lead to the incurring of additional GST but this does not appear to be a major danger.
In terms of capital gains, the concessions given to capital appreciating assets held in the names of individuals are an advantage. Assets such as intangible assets can be held easily by an individual in a business context should be left with individuals if possible (that is, if the individual is not subject to other risk profiles).
Are there industry specific rules, which require particular structures?
There are certain industries that require the participation or the majority of equity or board membership to be of a certain group of people. For example in real estate you will find that there is a requirement for 50% of the board of directors of a corporate real estate licence to be licensed real estate agents.
There are similar rules for architectural practices, legal practices and medical practices and various other professional structures. These rules are relevant when advising people from individual industry groups for their structures.
How can one successfully isolate & protect non-business assets from business (risk) entity?
The general proposition to start with in considering the protection of non-business assets and business risk is to communicate to the client the fact that all businesses carry with them risks. There are obvious risks, for example, in running a trucking business is the high risk of accident on the road. This obvious risk, which is apparent to anyone, varies to down to the more obscure risk for example a drainage contractor who is sinking a trench to put in the drain severs a major power supply risking killing all of his employees and cutting off the power supply to a major industrial subdivision.
These are risks associated with the business, which go outside the actual risk of not running a profitable business. Therefore, establish the nature and the extent of the potential risk in the business enterprise that the client is to engage in.
One must understand the nature of the risks before one can look to balance the cost of the protection and the tax implications, which can sometimes flow from the introduction of new or different structures into the client’s life.
Clients should use companies whether as ordinary trading entities or alternatively as trustees of various trust structures.
Non-business assets should keep a distance from the business. The major non-business asset owned by most people in Australia is the matrimonial home. The spouse of the business proprietor should be the registered proprietor of that home, and the operator of the business should not be on title.
It is very difficult for most people to raise the starting capital for a business without putting the home at risk but one should always review the exposure of that home whenever financial reviews take place.
Whilst there is a risk associated with putting a major asset such as the home in the name of one party (divorce, debt and unfriendly Wills) the isolation of a major asset away from the business is usually a preferred position. There are no hard and fast rules in considering risk management and it is a question of what the parties themselves believe is reasonable.
Having isolated the risk, the most important question then becomes how one move profits from the profitable business entity out of the risk entity and into other assets. As much there has been an attack on the discretionary family trust, clients should still look to discretionary family trust (particularly in a family business context) as the holding structure for non-core business assets (other than the matrimonial home).
A family trust can hold all the shares in a company and be isolated from any risk associated with the business so long as it only ever remains a shareholder. Given the corporate tax rate at 30% one should pay fully frank dividends into the trust.
The business operator can take minimum salary and can salary sacrifice in favour of superannuation and with a correctly managed (self-managed) superannuation fund, the profits of the business can be safely repatriated away from the business entity itself. Even with bankruptcy of the business proprietor, substantial proportions of superannuation is protected under the Bankruptcy Act, assets in the family trust is not available if the matrimonial home is in the same name of the partner or spouse, then in those circumstances, that asset is protected.
It is important that one puts the appropriate structure in place at the commencement of the business and well before the business ever strikes difficulty. It is too late to isolate or save assets “once clients are in trouble”. Sensible protection at the outset is the most appropriate defence. If one puts a business structure in place for proper commercial reasons, it is very difficult for subsequent attacks to succeed.
The most important thing that helps isolate and protect non-business assets is the proper regulation of loan accounts. There is no point having large loans owed to a successful business if enterprise from asset owning structures. If the business or profit generating structure gets into difficulty and falls into the hands of a liquidator, then the liquidator will look to recover loan accounts. This is a constant problem in trying to assist clients in financial difficulty in the business context.
The other issue is the constant requirement of Banks to over secure their loans. The difficulty that most people have with Banks is that they start out in a situation where a Bank will have a Personal Guarantee from a spouse in order to have a security over a house or the matrimonial home. It is very difficult to subsequently unwind that relationship. Banks will often promise to discharge securities or surrender guarantees but never actually do it. The most successful process is to actually get the client to change banks. Whist this can at times be expensive, it is a very effective way of curtaining and cleaning up any old guarantees or previous risk.
Discretionary trusts have the advantages of:
Asset protection; and
Significant internal flexibility as to ownership and distribution
One must assess the state of each individual trust before endeavouring to assess the impact of the proposed tax charges. The proposed introduction of the entity tax application to trusts provides legal practitioners with an opportunity of opening discussion with their clients about current structuring of their trust situations.
If the primary purpose of establishing the trust is asset protection and the holding of long-term capital appreciating assets, then there is little purpose in significant alterations to the trust. The most pressing issue for each trust is to examine the loan accounts. The introduction of the profits first rule would make the repayment of any loan account (after the introduction of entity taxation) subject to tax based on profits first rule. Appropriate steps need to be in place to repay the loan account.
Similarly, trusts should repay commercial loans wherever possible. These repayments are capital items. Where the cash resources are not available, the benefit of the loan accounts is assignable to the parties controlling the trust. Most deed trusts should allow the trustee to accumulate within the trust. This can be done by adding to the general powers of the trustee or alternatively modify the accounts and financial statements aspects of the trust. If further assets move into the trust, it is better to do it by way of gift than by way of loan.
NEED MORE INFORMATION
Behan Legal assists and advises on these important issues. For an appointment, call 03 9646 0344