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| Information - Business Operating Structures |
Business Operating Structures
A business revolves around one person. No other parties have an interest in the business. The sole trader is personally liable for all debts. All income earnt in the business becomes part of the sole trader's assessable income. Advantages and disadvantages of operating as a sole trader When it comes to choosing a business structure, income tax should be only one of many considerations. Most businesses go through several stages. This is more apparent when they are started from scratch, but it can also apply when a business is bought as a going concern. Because of this, the owners of a business have different requirements depending on the stage the business is at. From an income tax point of view, nothing stops business owners operating through one structure, such as a sole trader, then later changing the structure to one that better meets their needs. The Australian Tax Office will not be able to attack this change as long as the prime reason for changing was not to obtain a tax benefit. Under income tax law, the ATO can attack anything it can prove was done for predominantly income tax reasons. When it comes to choosing a business structure, income tax should be only one of many considerations. By considering these other factors, the chance of the ATO successfully attacking any change is greatly reduced. In addition to income tax and capital gains tax, the other important factors that should be considered are protection of personal assets, the set-up cost of the tax structure, legal liability, superannuation and WorkCover. Operating as a sole trader is the most common structure used when starting a business. When the business is being started part-time, while the owner continues in full-time employment, operating as a sole trader allows the owner to reduce tax payable on the employment income if losses are made. This tax reduction is subject to the business satisfying non-commercial business loss provisions. This income tax advantage becomes a disadvantage when the business starts to make profits, as the business income will be added to the owner's employment income. This could mean that tax is paid at the higher tax rate of 40 per cent when the combined income exceeds $75,000 or at 45 per cent if it exceeds $150,000. Compared with the other business structures, operating as a sole trader is the cheapest option to set up and the easiest to administer. There can be no set-up costs unless a business name is required. In addition, the only administration system required is an accounting or bookkeeping system that produces a statement showing business revenue and expenses, and the profit or loss. Legal liability and protection of personal assets are two areas where operating as a sole trader is a major disadvantage. In the event of a legal claim against the business, where insurance does not cover the full extent of any damages awarded, the owner's personal assets can be attacked to pay the damages. This should only be regarded as a major consideration where the business has a high level of operational risk. An example would be a tree-felling business. In the event of a tree falling the wrong way and destroying a house, the cost of rebuilding the house could force the owner of the tree-felling business to sell his home to meet the liability. Another risk can arise where a business incurs large debts to suppliers and then fails. Operating as a sole trader means suppliers can attack the owner's personal assets to meet any shortfall the business owes. One way a sole trader can protect against this, if he or she is married, is to have all assets owned by the spouse. As people cannot employ themselves, a sole trader is not required to pay WorkCover on earnings from the business. However, this also means that if an accident occurs the sole trader will not receive WorkCover benefits. To protect himself or herself, anyone operating as a sole trader should take out sickness and accident insurance. The final consideration of capital gains tax is not a major issue for a sole trader. Due to the general 50 per cent capital gains tax exemption available to individual taxpayers, and after applying the 50 per cent active assets exemption available to qualifying small business owners, only 25 per cent of a capital gain on the sale of a business is assessable. Partnerships An association of two or more legal persons carrying on business in common with a view to profit.
A company is a separate legal entity distinct from its members formed under the provisions of The Corporations Act
A trust arises when the settlor (the creator of the trust) gives property to the trustee to hold or invest on behalf of the beneficiaries.
The Basics A family trust:
Trust Deed The terms and conditions under which a family trust is established and maintained are set out in its deed. The trust is established by the trust's settlor and trustee (or trustees) signing the trust deed and the settlor giving the trust property (the "settled sum") to the trustee. The Settlor The settlor's function is to give the assets to the trustee to hold for the benefit of the trust's beneficiaries on the terms and conditions set out in the trust deed. The settlor executes the trust deed and then, generally, has no further involvement in the trust. The Trustee The trustee is responsible for the trust and its assets. The trustee has broad powers to conduct the trust, and manage its assets. In a family trust, the trustees are usually Mum and Dad (or a company of which Mum and Dad are the shareholders and directors). Their children and any other dependants are usually listed as beneficiaries. Family Trust Income One of the key benefits of a family trust is that the trustee can distribute income earned by the trust [from the trust property] in any way they see fit, provided distributions are made to people who qualify as beneficiaries. They do not have to make trust distributions in any particular proportion or in the same proportions as they did in previous years. A trust does not have to pay income tax on income that is distributed to the beneficiaries, but does have to pay tax on undistributed income. The trustee is free to distribute trust income to as many beneficiaries as possible, and in proportions that take best advantage of those beneficiaries' personal marginal tax rates. The beneficiaries then pay the tax on distributions made to them. For example, if an adult beneficiary of the trust only receives income from a trust and has the benefit of the tax-free threshold (currently $6,000) for the year, the trustee could distribute part of the family trust's income to this person. The result is that the beneficiary will receive some income but may not have to pay tax if that amount is less than $6,000. If the distribution to the beneficiary exceeds his or her tax-free threshold, the excess amount will be taxed at the beneficiary's personal marginal tax rate. Distributions received from a trust are not a special form of income, but instead forms part of a beneficiary's assessable income. If the beneficiary receives income from other sources in addition to distributions from the trust, all of the income will be taxed together. Even if the beneficiary's income does exceed the tax-free threshold for a particular year, the rate of tax applied to the amount of the excess income over the tax-free threshold may be lower than for other beneficiaries because of the total income that these other beneficiaries already receive. Undistributed income is taxed in the hands of the trustee at the top marginal tax rate of 45% for the 2006/2007 year, giving a strong incentive to family trusts to fully distribute the trust's income before the end of each financial year. The trustee should also take care in relation to which beneficiaries are chosen to receive distributions, as penalty tax rates can apply to distributions made to minors. Unit - The trustee is given the power to distribute trust income and capital among a nominated class of beneficiaries. The income and capital is distributed in a proportional method relative to the number of units held by each beneficiary. A Unit Trust is similar to a Family Trust but is used for businesses rather than a family. The Unit Trust is simply the extension of a Family Trust into the field of commerce. One or two people, usually a husband and wife, control a Family Trust. The husband and wife have complete discretion how they distribute income each financial year. Such "trust" is not usually shared out side a family! Hence the need for a Unit Trust. At the end of each year, income is distributed to the Unit Holders in proportion to the units that beneficiary holds. The Trustee has no discretion. Units may be held by Family Trusts, companies or by individuals. A Unit Trust serves a different purpose to a discretionary Family Trust. A Unit Trust has: a) Negotiability (you can buy and sell units) b) Fixed annual entitlements to income and capital A Unit Trust can have discretionary units. However the discretion is restricted to income (not capital). A Unit Trust should generally not be used as a substitute for a Family Trust. Rather it may be prudent to have your Family Trust owning the units in the Unit Trust. Unfortunately unit holders can be liable to pay any shortfall of assets on the Unit Trust going broke. This is the case especially if the trust is not properly drafted and maintained by your professional advisers. The ownership of the trust funds is divided into a number of equal units. The units are recorded on a register and are transferable like shares in company. Well constructed Unit Trusts include mechanisms for cashing in (redemption) and transferring the units. Of particular importance is the procedure for determining the price at which units are to be redeemed. Units in the Unit Trust can be readily traded and people holding them can participate in the profits of the business on a set percentage. Unit Trust vs. the Company On the face of it, owning units in a Unit Trust is similar to owning shares in a company. The High Court of Australia has, however, stated that a unit in a Unit Trust is fundamentally different to a share in a company. A shareholder has no interest in the assets of the company. A Unit Holder has a proprietary interest in all the trust property. A unit holder can therefore lodge a caveat over land held in the Unit Trust. A shareholder in a company has no such right. Other differences are:
The Trustee can issue additional units that have different "terms of issue". This facility is a major attribute of the "hybrid trust" as it enables the client to transfer assets from "risk" entities into a safer protected vehicle. Trustees
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