Business Structures
Choosing the right business structure(s) for your family business is a key business decision. Your business structure is one of the key foundations on which a family business is built. Any decision regarding structure will impact many aspects of your business, including risk management, capital funding and bank finance, taxation, distribution of profits, business management, complexity and cost.
The structures you choose may also have significant and, on occasion, unintended impacts on matters outside your business, at a family level, such as personal liability, estate planning, succession and government assistance for families. Structures can impact family relationships.
If the foundations for your business are poorly laid, poorly understood or not fit for purpose, then significant negative consequences can occur at both a business and a family level.
Further, changes in our society, in terms of law, taxation, financing etc., and changes in a family, whether that be new assets, new family members, family members passing on, or a change in purpose or intention, can impact the appropriateness of business structures. A review and confirmation of the purpose, benefits and disadvantages of your family business structure should be a regular event, preferably on the agenda of your annual general meeting.
It is also worth noting that any decisions relating to business structures should involve all your advisers, including your solicitor, business adviser, tax adviser, financial planner and even your bankers, as they all look at the structure from different and important perspectives.
You may wish to consider the following drivers to the appropriate business structure for your family business:
Purpose of the business
The purpose for which a business is formed and operated will be an important factor in determining which structure you choose for each purpose. Traditionally, companies are a preferred structure for a trading business to limit liability and, more recently, for achieving a lower tax cost on business profits. Trusts have historically been established for the holding of assets and flexibility of distributing income. It may be that you would like your business to have the effect of income splitting between yourself and members of your family.
You may have a need to divest assets to protect them from creditors. Or the business structure you choose may have an impact on your eligibility for subsidies, pensions and other forms of government assistance.
Succession
The majority of farm businesses in Australia are established as partnerships, as tax laws provide relief from the tax cost arising when adding and exiting family members to or from the business partnership (i.e. succession). However, those livestock and equipment partnerships expose the business (asset) owners to business risks and do not address asset transfers (e.g. land and water).
We consider that succession planning is a key input in the business structure decision. On occasion, we have found clients establishing structures to promote a lower annual income tax cost, to find that the capital gains tax cost on succession is prohibitive. Developing a structure that promotes the transfer of assets between family members and generations promotes succession certainty and a pathway for family members.
Income allocation
Various structures offer different alternatives and limitations to the allocation of income earned by the business to business owners and other family members, not only from a tax effectiveness measure but to provide returns to family members for their effort or a return for assets they own employed in the business.
Liability
Every business involves risk, and as an owner, it is in your interest to minimize your personal liability. That risk is not just for the business liabilities but also extends to regulatory matters such as Work Health and Safety, a matter becoming more prevalent for all businesses but particularly for our farm business clients.
Generally, sole traders incur the greatest personal risk as they are personally liable for all debts of the business. Partners are generally jointly and severally liable for certain acts of the partnership. There are many variations of the corporate structure, and of those, a feature of the limited liability company is that the shareholders’ liability for the debts of the business is limited by their share in the equity of the business. However, the downside of limiting risk is that suppliers and lenders may be less inclined to advance credit to your business.
When considering liabilities and asset protection, most businesses view any solution as protecting the family members from business risks. However, there are risks and potential liabilities at an individual level from which the business requires protection. Family law matters, the bankruptcy of an individual, owners’ health issues, etc., may all impact a business.
Management
As owners of a business, it is understandable that you will want to retain managerial and administrative control of the business. Some forms of structures are more appropriate for this than others. A sole trader will retain the greatest amount of control over a business, and at the other end of the scale is the public company, where the ‘owners’ may not have a majority shareholding. Management of a trading entity, as represented by who the directors of a company are, may conflict with the risk of being a director and exposure to liabilities.
Taxation
The method by which tax liability is calculated for various structures is different. Taxation rate considerations include income tax on profits, capital gains tax on the sale or transfer of assets, land tax, payroll tax, registration costs for motor vehicles and other forms of taxes and levies.
Capital/equity raising
A necessary aspect of running any business is the injection of capital from time to time. Generally, it is more difficult for sole traders and partnerships to raise capital from external sources; and in relation to discretionary trusts, no equity can be provided to incoming investors, as discretionary trusts are not “owned”. These business owners will often have to provide the funds themselves or from debt financing.
Costs of business structure
The costs involved in establishing a business structure and also the ongoing costs of maintaining it are relevant factors to take into account. Generally, corporate structures are more expensive to set up and run than a sole trader or a partnership. A trust structure is more expensive again, and usually, to achieve family goals, we may recommend a range of structures for different purposes. Note also that the cost to unwind or change structures is often more than the cost of establishing them in the first place.
Generally speaking, the characteristics of a good business structure and each entity within a structure are:
Consistent with the family goals and objectives, including succession arrangements (“purpose”).
Flexibility so that the structure will be able to accommodate changing circumstances with minimum consequences
Provision of adequate asset protection for the owners of the business
Minimization of costs, including tax
Facilitates efficient distribution of profits
Let’s now look at each structure’s advantages and disadvantages.
Sole Trader
Being a Sole Trader is the simplest and least expensive option. Designed for business owners who are the sole proprietors of their companies, this structure doesn’t give you much protection if things go wrong. Your personal assets are unprotected from any claims arising from your business.
Pros:
The owner is solely in control and, therefore, fully independent (i.e. decision making);
The simplest and cheapest entity to establish;
The owner takes all profits and has access to all taxable losses;
Speed and flexibility of change(s);
Takes advantage of low marginal rates on the first $37K taxable income
For primary producers, access to Farm management Deposits and Primary Production Averaging
50% discount for capital gains on the sale of assets; and Privacy
Cons:
Unlimited liability on the sole owner and all assets exposed;
Doesn’t enable other partners to own a portion of the business and share the risk/reward;
Subject to high marginal rates (32.5% to 45%) on taxable income greater than $37K;
Limited finance access (fundraising etc.); and
A business is subject to the life and health of the owner
Partnership
Creating a Partnership allows you to go into business with multiple people and share income. Partnerships are easier and less expensive than Companies to set up. However, all partners together are personally responsible for business debts and actions against the Partnership. And each partner is individually liable for debts incurred by the other partners. This means you have unlimited liability, unlike a Company structure. A partnership should be established with a legal Partnership Agreement prepared by your solicitor.
Pros:
Minimal cost in set-up where partnership of individuals. Note that you can have a partnership comprised of any legal entities, including individuals, companies, or trustees of trusts (more expensive);
Partners have fixed entitlement to partnership interest;
Shared responsibility and obligations;
Contribution of different assets (i.e. skills, resources to the business);
Relatively easy to operate and account for any on an ongoing basis;
A written partnership agreement can clarify operations, partners’ remuneration and exit expectations;
Control, flexibility and privacy may be positive aspects of partnerships;
Partnerships do not pay tax. They distribute taxable income to the partners, who are assessed on their share. Where partners are individuals, takes advantage of low marginal rates on first $37K taxable income for each partner, assuming no other income);
For primary producers, partners who are individuals (or individuals receiving partnership distributions via a trust) can access Farm Management Deposits and Primary Production Averaging;
Partners who are individuals are entitled to a 50% discount for capital gains on the sale of assets; and
Tax losses are accessible to the partners directly (they are not quarantined like trusts or companies).
Cons:
Unlimited liability (including joint and several liabilities, where a liability caused by one partner shall cause all other partners to be liable);
Transfer and termination of partners and/or partnerships may have some complications and need to be properly accounted for;
Potential for decision-making conflict and stalemates;
Partners who are individuals subject to high marginal rates (32.5% to 45%) on taxable income greater than $37K;
No permanence, i.e. on termination or dissolution; and
Can be limits on the number of partners (state jurisdictions apply), so expansion may be limited.
Company Incorporation
(i.e. forming a Proprietary Limited Company) effectively makes your business a separate legal entity from you. This structure involves quite a bit of paperwork and can be expensive to maintain. But may offer your personal assets protection from liability and only your company assets are at risk in the event of any legal actions and company debts (subject to the liability of directors and personal guarantees). We recommend that shareholders have their solicitor prepare a shareholders’ agreement, even between family members, to clarify the rules for disputes, exiting the company etc.
Pros:
Limited liability afforded to shareholders;
Unlimited life;
Generally fixed entitlement to income and capital;
Finance raising (recognized structure for both debt and equity funding);
Flexible business expansion prospects;
Written shareholder agreement clarifies exit and governance and dispute processes;
Separate legal personality;
Asset protection by a corporate veil (separation of operation and ownership);
Transfer of ownership by share transfer, allowing for flexibility in introducing partners to the business; and
Company tax rates (27.5% to 30%), applicable to all taxable income, are generally lower with a downward trend.
Cons:
Cost of set-up (though the basic cost has reduced in recent times for simple company structure establishment);
Higher ongoing costs than a sole trader and partnership structure (reporting and accounting), including a layer of regulation by ASIC and Corporations Act 2001.
Increased complexity re understanding of company concepts, governance, and operations.
How to get money out of the company – Division 7A.
Loss of control (i.e. to a management board, board of directors, etc.);
Limited tax concessions, i.e. no entitlement to 50% capital gains discount;
Director (office holder) obligations and liabilities, including severe personal penalties; and
Insolvent trading risks to directors personally.
For primary producers, the company cannot access Farm Management Deposits or Primary production Averaging.
Discretionary or Family Trust
A Trust isn’t an organisation at all, but instead a legal structure to hold assets. For example, you might set up a Trust to hold your business assets and then appoint a Trustee to manage them. Commonly, the Trustee is a Company, and the Trust provides asset protection and limits liability from operating the business. Trusts are very flexible for tax purposes. However, a Trust is a complex legal structure and establishing a Trust cost significantly more than a Sole Trader or Partnership.
Pros:
The trustee can distribute income at their discretion.
The trust model provides more privacy than a company.
The beneficiaries don’t own the trust assets, so there is scope for protection from a beneficiary’s third-party creditors. However, in a unit trust, if a person becomes bankrupt, their units will be treated in the same way as any other asset and can be available to a creditor or trustee in bankruptcy.
Limited liability is possible if a corporate trustee is appointed
Trustees and trusts are usually separate legal personalities.
Income can be distributed at the trustee’s discretion to beneficiaries with the lowest marginal tax rates to minimise the aggregate tax beneficiaries pay. The trust’s beneficiaries pay tax on income they receive at their own marginal rate.
Beneficiaries can access a 50% discount on capital gains distributed from a trust.
For primary producers, individuals receiving a distribution of primary production income from a trust can access Farm Management Deposits or Primary production Averaging.
Cons:
Typically, a trust structure is more expensive to establish and maintain than a company structure and the most complex of structures.
Beneficiaries may not have any fixed entitlement to trust assets.
Problems may arise when trying to dissolve or alter an established trust. Varying the trust’s terms or objects could amount to resettlement and liability for capital gains tax and stamp duty arising.
It may be difficult to borrow funds based on the intricacies of loan structures.
The trust deed limits a trustee’s powers.
With a trust structure, losses cannot be distributed (only profits can) and offset against other income.
A trust must distribute profit/income to beneficiaries each financial year. Otherwise, the trustee must pay tax on any undistributed (i.e. accumulated) income at the highest marginal rate (45%). If the business requires any working capital, then a company structure is more appropriate as undistributed company profits are only taxed at the company rate.
After a trust is established, it continues for a period set out in the trust deed and up to a maximum term as prescribed by law. In New South Wales, a trust’s life is limited to 80 years.
Trustees can be personally liable for the trust’s debts (subject to the trust deed providing that the
Trust’s assets indemnify the Trustee). However, if the trustee is a company, its liability will be limited.
In advising on structures, we recognise that families are unique and that each family business is different. There is generally no perfect structure that covers all wish-list items, so we always try to achieve a structure of ‘best fit’ and review its purpose regularly.
