What structure should I use to operate my business?

Scenario
I wish to set up a start-up business with a person who is not a family member.


Background information
Me
* Not married
* Nowhere near retirement age.
* No capital contribution into the business
* Future revenue or income generation is unknown but the agreed split will be 50/50 with my business partner
* Option to be director but haven’t decided, either way I will have voting rights which are equal to that of the director
* Will perform the majority of income producing work


Business Partner
* Will supply premises and office facilities, capital contributions
* Wants to be a director

Concerns
* Asset protection - I want to protect my personal assets and investments which are held in my own name against creditors should I be sued as I’m in a high risk profession
* Need to consider the possibility that a partner may want to leave the business
* Need to consider the possibility that the business will not generate the income levels we are happy with, and hence will have to end or change the business structure
* Costs


What’s an appropriate structure to use for my proposed business (sole trader, company, partnership, discretionary trust, unit trust, combination of structures, etc)?

Provide reasons for your recommendation in terms of advantages, disadvantages, costs, asset protection, CGT implications, and other considerations, etc.

It would be much appreciated if I could get your comments, views and opinions. Thanks.

 

The correct structure is probably one of the most commonly asked questions by people looking to commence a new business.

Chances are that unfortunately you are not going to get the absolute perfect structure that achieves everything you want to do cheaply.

We can easily eliminate the following operating structures because of poor or non-existent asset protection and/or the fact there are two unrelated parties entering the venture:

- Sole trader (not really possible as there will be two separate owners looking to share the income)
- Partnership (possible, but legally you will be liable for any debts the other partner incurs - so not good for asset protection)
- Discretionary trust (typically only good when ownership by one person or one family)
- Unit trust (OK in terms of joint ownership but definite issues with capital gains on sale of a business)

That leaves the good old company structure.

A company is probably going to give the best in terms of basic asset protection - it is legally separate from the owners - so the owners only put at risk their capital contribution to the business.

Shareholding could be 50/50 owned directly by the two owners (shares issued in personal names) or alternatively owned by a couple of family trusts. Having the shares owned by family / discretionary trusts would give a bit more flexibility in terms of distribution of income / capital gains.

Obviously if you have 50/50 ownership and 50/50 voting rights there is the possibility of a deadlock. This can be overcome or addressed by a shareholders agreement which can determine a process if there is a deadlock and also what needs to happen if one of the owners wants to sell out of the business (i.e. they have to sell to the remaining owner before 3rd parties).

Also with having two unrelated owners you should look at having a buy-sell agreement (maybe not initially crucial but if the business is successful and builds up in value). Such an agreement when coupled with insurance will enable each owner to buy the other out in the event of the untimely death or disablement of the other.

The owner who is contributing the capital maybe should look at putting in place loan agreements (with a charge registered against the company) or lease agreements rather than transferring the ownership of assets and capital to the trading entity. Typically this separation is good (although not perfect) means of asset protection in the case the trading entity is sued or creditors are chasing.

In terms of asset protection for the assets in your personal name, you maybe need to look at transferring them into a trust or super (CGT implications).
If you get married in the future have as much of your families asset as possible in your partners name (assuming your partner is at a lower risk of being sued!).

Also, with the business if one person is doing the majority of the work ensure you have a written agreement in place in terms of remuneration.

Costs of setting up a company are not too bad. Sure - it only costs $400 to register a company with ASIC, but if that company is being used as the trading entity to run a business you will need a GOOD QUALITY constitution that has been drafted by knowledgeable and experienced commercial lawyers. Give yourself a budget of $1000 for this (including the ASIC fee).

Taxation is relatively flexible with a company. You can pay directors fees or wages (+ super) as remuneration. Any profits after paying the remuneration will be taxed at the company tax rate of 30%. The tax paid will sit there as franking credits and can be paid out to the shareholders via franked dividends (hence the idea of having the shares held by 2 x discretionary trusts).

When it comes to selling the business in the future, there will be no general CGT 50% discount - but the company should be entitled to all the other small business concessions. And anything left will be taxed at a flat rate of 30%

A major disadvantage of the company structure is the inability for you (more you than your business partner) is unable to take a loan from the company with out running into tax issues with Div7A (debt loans to shareholders). This can be managed and worked around though.

So, in summary a flexible structure that ticks most of the boxes is a company, with the shares owned by respective discretionary trusts if possible.

You will need a good accountant - get paid advice if you serious about getting it right. The above is simply based on the information provided and does not take into account any other factors that you have not mentioned.

SM

 

What Structure

Hi Utopia, yes a company would appear to be the better option given the information. See a good solicitor so that you and your future partner fully understand your responsibilities. Be aware that there are instances where a director is personally liable for debts incurred by the company. Have your solicitor explain these to you. Also a bit of light reading try the Corporations Act.

 

The most common circumstances is where the company is trading while insolvent (i.e. has no ability to pay its debts) and also in regards to PAYG Withholding tax on employee wages.

It is very rare for the corporate 'viel' to be pierced - so it is unlikely to impact many directors of a small business unless they are putting up personal gaurantees for company debts (i.e. for a bank loan etc).

But yes - have a chat to a lawyer and get a good constitution.

SM

 

Don’t underestimate the powers of a superhero. Thanks for your response Superman.


To ensure I’ve completely understood what you’ve written, I have tried summarising the main points and have provided some additional questions.

You are suggesting I use a company as the vehicle to carry on my business. The company will issue different classes of shares to us in our personal names or individual discretionary trusts (; partnership of discretionary trust structure), each with equal voting rights so we can continue to jointly control the company and any other conditions we may have (e.g division of income, capital gains, and deadlock rules, etc.)

We should set out in the constitution the objectives of the company, how it’s run, the rights of each shareholder, responsibilities of each director, deadlock, and succession planning rules, etc. In addition, we should draw up a buy/sell agreement.

As the shareholders’ liability for the debts of the company is limited to the amount they have subscribed to the company, you are suggesting we both can be directors as I will not be personally sued or exposed to a potential liability should the company run into financial difficulties in the future (provided we both do not breach director’s duties).

If my partner rents a premises rather than transferring assets to the trading entity, they should be protection from asset protection.

The different classes of shares will assist each director in stream different franked dividends to their individual names or individual trusts.

Regarding asset protection for the assets in my personal name, are you suggesting I transfer them to the discretionary trust I already set up to hold my shareholding or create another discretionary trust (that’s separate from the business)? Another option would be transferring my family’s assets into my partner’s name if they have a low risk of being sued.

What are the major differences between a discretionary trust and family trust? Once I get married, I will need to accommodate for the distribution of income to my family members, so will I need to create or reset a trust then or will my trust deed cover the addition of new beneficiaries or other circumstances?

For CGT purposes, when the business is sold, the capital gain will be divided directly by the individual discretionary trusts. Each trust can use the CGT small business concessions to reduce any taxable capital gain from the sale, minus the 50% CGT discount.

I will definitely seek accounting and legal assistance.

Let me know if I've understood you correctly.

 

Thanks for your response Intellikev.

 

Dear Superman,

I am just an university student currently studying company law and superannuation at this semester.

I am wonder, if the company is suit the category as small proprietary companythen is that mean all gain from selling the business put into a superfund can aviod CGT? Is that possible?

Since the writer is has no experience of operating the business so the liquidity risk is higher & close to retirement so if he went into liquidation and being taxed at the CGT concession then if he put most of his gain from selling the business into his super as shareholder he'll be able to withdraw the money out of his super soon and avoid his personal tax asses on his gain from selling the business.

Is that possible for him to avoid the individual CGT tax? or it will be counted as personal assessable income?


Regards,
Irene

 

Irene,

The small business CGT concessions are awesome.

Many small businesses owners say that their business is their super (i.e. they invest in their own business rather than put money in super) - and the small business CGT concessions enable them to put money into super upon sale of the business and avoid CGT (up to a certain level).

In the case of a company (which is not eligible for the 50% general discount) the sale of a business would typically qualify as the sale of an active asset - so get a 50% discount.

For example if a business owner sold their business (that was started from scratch - meaning $0 cost base) for $1 million, they could apply the 50% active asset discount the capital gain down to $500k and then put that amount in super and not pay any CGT.

The above is a very simplistic example, and obviously a lot of conditions must be met.

There is a $500k cap on the Small Business Retirement Exemption (per person).

As I said - it is a complex area but if used correctly should have major benefits for any small business owners.

You can find more information from the ATO on the application of these concessions here.

Have fun!

SM

 

Discretionary Trust??

The other option would be a discretionary trust. SUperman is right to say it gets a little harder when the two people are not related, trust issues etc etc. Companies however can be difficult to deal with - Div 7a issues, can only take money out through wages and dividends, FBT and new issues with FBT and personal use assets. You might also like to use a discretionary trust with a corporate trustee, and have some sort of contract/agreement between you and the other owner as to what happens in certain situations, i.e. break down of relationship etc etc. Just a thought because companies are getting more difficult to use as tax structures in my opinion. Also companies do not get the 50% CGT discount, but hopefully Small business concessions and super could be used.

 

I think set it up as a PTY LTD has its benefits.



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Hi Superman,

Thanks for the link to the small business CGT concessions. I must confess they make my head spin.

I can understand the goal, which seems aimed at the guy running the local newsagency. But I really can't penetrate how it might apply in a more complex situation.

For example, we have a family company which holds various investment assets (cash, shares), and which also holds a one third interest in a much larger company with about 50 employees. I am a director of the family company and also the larger company. I also founded the larger company. Clearly, my holdings in the larger company are something I've been working on my whole life, and a key retirement asset.

If the family company sells its one third stake in the larger company, does the family company see any CGT relief?

Thanks

-- Wally

 

Hi Waimate

The CGT small concessions trace through to a significant individual - i.e. someone that owns at least 20% of the entity which is sold.

If someone holds 100% of the shares in a company, and that company owns 33% in another entity, then the individual can trace their control through.

If you want more specific advice in regards to your personal situation I can recommend someone if you like.

SM

 

Hi SM,

Yes please, a recommendation would be great.

Thanks

 

A company has lots of problems for a small business operator.

A much better solution would be a partnership of discretioary trusts with a common corporate trustee.

 

Superman has given good advice, but I should add one thought.

The small business CGT concessions when you sell the business are great, but the rules are complicated. To use them, the company or trust must have a significant individual, being a person with at least 20% “business participation percentage”. To be a significant individual, the individual must have at least 20% of the voting power, dividend entitlements or capital distribution entitlements. If there are different percentages for these three factors, the business participation percentage will be the lowest of the three.

The bottom line is, go with Superman's advice, but, if you come to sell the business, get an expert to have a good look at the structure well before you sell, to advise on any changes to your business structure before you sell, and to advise on how to structure the sale.

 

Thanks both for the advice - really helpful.

-- Wally