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Business trading structures: What’s best for your business?

When you have plans for starting a new business, one of the central decisions is which business trading structure will work best for your venture.

The general problem however can be that there are both pros and cons with the main options available, so considerations need to be given with regard to the overall situation as well as the specific conditions presented with any business venture. To explain the options, we can look at one example that has typical conditions found in many businesses.

Take for example the case of Paul and Jenny, who want to purchase an existing food catering business together. They are considering the best business structure that should result in the best conditions for success.

Paul is a nutritionist and has expertise creating customised nutritionally balanced meals for a variety of customer needs. He is also a qualified chef and has management experience having worked as an executive chef in a major hotel chain in Singapore. However, he does not have any experience in Australia. Even though he has the right skills set to operate a catering company, he’ll need help from someone who is familiar with the local food industry to help him build his business.

Jenny, on the other hand, has more than 20 years’ experience in the Australian food industry, having worked in and managed various sized retail food outlets and also at a central kitchen facility for a franchisor. She has the relevant contacts to enable the business to grow after
its acquisition. She intends to continue with her current consulting role for her private company.

PURPOSE OF THE ACQUISITION

Both Paul and Jenny want to expand on the business that they are acquiring, which currently only has a very small commercial kitchen preparing pre-packaged (nutrition/ calorie controlled) meals for fitness centres. The business is mainly wholesale but they are planning to cater for retail customers as well and eventually have a retail store selling not just pre-packaged meals but fresh, healthy food and beverages on site. They will need funding for the proposed expansion very soon after the acquisition of the business.

THE TRADING VEHICLE

The crucial issues for them both to consider include:

  • the nature of the business
  • their intentions for the business
  • funding requirements
  • exposure of personal assets to creditors of the business
  • ease of admittance of new business partners and the departure of existing ones
  • taxing of profits
  • considerations for specific structures that may avail them of tax concessions.

The main options that could be considered include a partnership, a company, and a unit trust.

A PARTNERSHIP

Paul and Jenny essentially come together as two individuals, working together to pursue a joint venture. Points to consider here are:

Joint and several unlimited liability: The partnership is not a separate entity and both Paul and Jenny will be entering into contracts with third parties in their personal capacities. This means
that each will be liable for the other’s actions in the conduct of the business and their liabilities to third parties are joint and several (meaning that third parties can pursue each of them for the full amount owed even though Paul and Jenny may be 50-50 partners in the venture).

Cannot draw a salary: They cannot be employees of the partnership and they can only be remunerated in the form of profits distributed to them. If Paul intends to be the chief operator and brain behind the creation and delivery of the meals, and Jenny only works part time to bring in leads, then this structure will create problems for them. However, this problem could be rectified by allowing Paul to draw a salary as a first cut of profits, which would not be a deductible expense for the business, before the 50-50 split of profits. Paul and Jenny would also need to have this arrangement clearly specified in their partnership agreement.

Funding obstacles: Paul and Jenny will need to resort to personal assets as security for any debt funding required for the business. Equity funding is possible with the admission of new partners, but issues will arise on the taxation front because this will involve a disposal of the partnership assets to the new partner, with the attending tax consequences. The 50% CGT discount however is available to Paul and Jenny if the disposal occurs after 12 months of the business acquisition.

Profits distributed from the partnership will be taxed in the hands of Paul and Jenny: As Jenny is continuing with her existing consulting role, she may be subject to a higher marginal tax rate than if profits are taxed at company rates.

A COMPANY

Limited liability: Paul and Jenny’s liabilities will be limited to any unpaid amount on shares issued to them.

Remuneration: Paul and Jenny can be paid a salary commensurate with the time and efforts they devote to the business.

Continuity: The company is a perpetual entity and will not be affected when either Paul or Jenny leaves the business or when new principals are admitted.

Reinvestment of profits: It is a cost effective way to reinvest earnings into the business to meet growth and operational needs, as companies can retain earnings.

Security for funding: Funding can be accommodated by issue of new shares (without requiring a disposal of existing partners’ interests as is the case with a partnership) or debt financing where the company’s assets can be used as security. In practice, however, financiers will still require the directors to put up their personal assets as security.

Tax rate: Company tax rate is fixed at 27.5% (presently) for the proposed business (as this is a base rate entity).

CGT 50% discount: Not available to companies when they sell their assets. In the current scenario, it is unlikely that the company will accumulate significant assets that will be sold later for significant capital profits. Therefore, in reality, the benefit that may flow from this concession to Paul and Jenny is very limited. However they will need to form a view about whether they consider the goodwill may increase significantly in value over time and this may influence their choice of structure.

Small business CGT concessions could be considered at the time of sale.

A UNIT TRUST

Limited liability is possible: A unit trust with a corporate trustee will give Paul and Jenny limited liability as in the case if using a company structure.

Reinvestment of profits not as cost efficient: All profits of the unit trust will need to be distributed (to avoid being taxed at the highest rate) to the unitholders and taxed in the unitholders’ hands first. Post tax profits can then be loaned back to the business.

CGT 50% discount: Available to unitholders, but the nature of Paul’s and Jenny’s business means that they will not derive much benefit from this concession.

ADMINISTRATION AND MAINTENANCE COST DIFFERENCES

Partnership: Usually requires a partnership agreement (which can be verbal, but to avoid future disputes between the partners it is advisable to have a partnership agreement prepared). The partnership will need to file a tax return even though it does not pay any tax itself.

Company: Involves registration and set up costs,
costs of annual reporting and preparation of tax
returns. Administrative work is also required to keep the company register and ASIC data up to date. To better document the rights and obligations of the shareholders to avoid future disputes, a shareholders agreement is recommended.

Unit trust: Established by a unit trust deed and, where a corporate trustee is appointed, the costs of setting up a company will need to be included. The relationship document between the various unit holders will be a unit holders agreement.

KEY TAKEAWAYS

When exploring the various business structures, the following will need to be taken into account:

  • the new business’s objectives
  • revenue and duty implications
  • how funding can be achieved under each structure, and what are the different forms of financial or security arrangements
  • the possible need for the advice of other professionals, such as lawyers, financial planners, mortgage brokers or insurance brokers.

Please consult with this office should you need further guidance or help.

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Welcome to the InterActive Tax Consultants’ news – part of our personal and easy to understand approach to taxation. We are committed to working with you to achieve the best results for your business. If you have any question or would like more information on any of the articles please contact us.