LEC 2: Business Structures

LEC 2: Business Structures

Issues to consider:

You should advise on:

(a)the characteristics of the various entities:

(i)the structure of each entity and any limitations on the number of owners;

(ii)the liability of the owner(s);

(iii)the simplicity/complexity and cost of setting it up;

(iv)the simplicity/complexity and cost of operating it;

(v)the nature and extent of control and management;

(vi)the ability to raise and secure finance;

(vii)the difficulty of admitting new investors;

(viii)the taxation implications (particularly income splitting, offsetting lossesagainst other income and CGT);

(ix)the cost and simplicity/complexity of terminating it; and

(x)the ability to sell the business.

(b)the advantages of the various entities (for example, incorporation provides the corporate veil as an advantage);

(c)the disadvantages of the various entities (for example, incorporation requires various reporting mechanisms such as the filing of returns with the Australian Securities and Investment Commission ('ASIC') - which may be a disadvantage in terms of the expense incurred;

(d)how any particular structure will achieve the objectives and short or long term goals of your client (for example, the client may wish ultimately to include members of her/his future family, and so in the long term a trust may be appropriate when the time arises to include the family members).

(e)An example of a list of issues to consider when advising as to appropriate structures is set out in the College of Law Practice Paper Business Structures.

When giving legal advice on business entities, you must always consider the following elements:

(a)the client's existing assets, income and taxation position and other business structures;

(b)the potential for failure of the business;

(c)the nature and size of the business;

(d)when there are two or more parties to the business, whether the same structure will work for each of them (that is not always so, for example, in a partnership, one partner may benefit from a being a company, whilst the other partner may not);

(e)whether taxation implications will justify the use of complex and expensive structures (for example, when a sole trader's average tax rate exceeds the company tax rate, it may be more beneficial to consider a corporate structure with a lower tax rate) – it is not always the case that tax issues should be the deciding factor, but they must not be disregarded;

(f)there are considerable advantages in having a simple structure and not overly sophisticated – the characteristics (eg experience and sophistication) of the client could well be taken into account in this context;

(g)there are advantages in having a flexible structure to allow for future growth or contraction of the business and changes to taxation laws;

(h)there are often advantages in using multiple structures for a business, eg when the participants are existing corporations, a partnership or trust structure might well be considered.

Sole Trader

•Def: single person conducting person on own account

•May purchase business as ST – only put name in contract (no doc/reg needed)

•If ST under own name  no need to register business name with OFT

•If ST under reg business name Business Names Act 2002 (NSW)

•May open bank account in own name or reg business name

•May enter contracts & engage employees to work in the business

•May have to obtain business licence – Business License Information Service on OFT web

•Personally liability – may be protected by insurance:

Public risk insurance, WC, income protection insurance, prof indemnity insurance etc.

Advantages

Management:

•Simple, inexpensive to establish/control/discontinue

•Proprietor has full control/ownership

•Proprietor entitled to all profits

•Very little statutory regulation – except prof negligence and compliance

•Proprietor may withdraw funds at any time

Tax (individual):

•Tax losses can be offset against other income

•50% CGT discount for individuals – tax is only on 50% of the capital GAIN (if held prop for min 12 mths)

•ST is not an employee – so no need for compulsory super payments, no payroll tax or WC liabilities

•Can “split” income by employing fam members – but see below!

Disadvantages

No SLE:

•Unlimited personal liability for all debts/neg of business

•Personal assets of ST are at risk

Management:

•Success dependent on health/ability of proprietor

•Business ceases on death/retirement

•Skills confined to proprietor & employees

•Possible difficulty in raising capital to expand/operate business

Secure loans using personal credit rating and asset base
Personal guarantees

•Unsuitable if others want to contribute capital & management

•Limitation on estate planning

Tax:

•Limited ability to split income between family members (salary paid to fam is limited by ITAA s26-35)

•Cannot vary income between fam members year-to-year (limited tax planning)

•Must substantiate business deductions for “fringe benefits” – difficult and onerous to get documentation

•Little tax deduction for super contributions.

Partnership

•Def: “ Business in common with a view of profit.” s1- Partnership Act 1892 (NSW) (PA)

Distinct from joint venture: is business carried on together by participants (agent for each other and joint/several liability) and for mutual interest in sharing in profits?
If indicia of PA  treated as PA, even if stated as not a PA
Effect: joint and several liability
Effect: fid duty to one another – extends after PA ends (eg. restraint of trade) and maybe before PA begins
Cannot benefit afterwards from PA opps: Chan v Zacharia (1984) 154 CLR 178
Cannot get personal benefit before PA from potential PA opps: United Dominions Corp Ltd v Brian Pty Ltd (1985) 157 CLR 1
Can trade under partners’ names – or reg business name

•Partnership agreement:

May be oral or in writing
Governed by Partnership Act 1892 (NSW) (PA)
Does not prove existence of partnership.

•Max no of partners:

20: Corp Act 2001 (Cth)
50: actuaries, med practitioners, sharebrokers, stock brokers, patent attorneys, trademark attorneys and certain collab sci research partnerships.
100: architects, pharmaceutical chemists, vet surgeons
400: legal prac
1000: accountatns

•NOT a SLE:

All assets jointly owned by partners
Any docs must be executed by all partners (unless partnership agt allows for 1 auth rep)

•All assets and obligations should be in name of ALL partners.

•Must maintain good financial accounts – income/exp of PA and capital contributions/withdrawals by partners

•Needs own ABN

•Cost:

PA agt – depend on complexity ($1000-$2000)
Accting costs in prep PA tax return

Partnership Act

•Div 1-2 of Pt 2: applies to all PA irrespective of any private arrangement

Identification of PA + rel between PA and 3rd parties

•Div 3: relationship between partners

Apply unless excluded/varied by PA agt

•Div 4: dissolution of PA – some prov can be varied, some can’t.

•S2: indicia of PA:

Written PA agt
PA bank account
Reg business name for PA under Business Names Act 2002 (NSW)
Office station in name of PA stating address, tel, fax, names of all partners
Evidence that each partner has real/effective control/disposal of that partner’s share in net profits
Proper books of account
Lease/ownership of prem in name of PA
Evidence of drawings by partners against their share of PA profits
Conduct of business (eg. contribute capital, working, time, sharing profit/loss)
Prov in any written agt – partners have authority to bind PA

•S5: every partner is agent of PA and other partners (joint/several liability)

•S24 (subject to agt):

All partners entitled to share equally in capital/profits and contribute equally to losses: (1)
Every partner may take part in managing business: (5)
Maj of partners may make decisions in ordinary course of business – but no change to nature of PA without consent of all partners (unless agt states otherwise): (8)

•S29: duty to render full accounts of profit

•S30: partner cannot compete with business and all profits made by partner must go to PA.

Advantages

Same as ST – individuals.

Management:

Allows sharing of workload & responsibilities
May contribute diverse skills to business
Relatively simple & inexpensive to set up, administer & dissolve
No ASIC returns
Formation cheaper than incorp of comp
No stat req to keep register
Legal rights easier to understand than comp
Cheap dissolution
Flexible – vary profit/loss between partners on annual basis
Flexible – reduce or increase capital (with agt of partners)

Tax:

Simpler: PA must file PA tax return (just discloses net income/loss and allocation to each partner) – to determine income of each partner. Then taxed at personal rate (part of personal income tax return)
Losses can “offset” partner’s other income
50% CGT discount for individuals apply
Tax preferred amounts (tax incentives, tax free capital gains) – passed to individuals
Cf: comp/trust – tax applied at shareholder/ben level still.

Disadvantages

Partners jointly & severally liable for debts & torts: Div 2 of PA

Management:

Stat limit on no. of partners
Business decisions must be made by majority– disputes/breakdown of rel (dependent on consensus)
Consider character/financial standing of partners
Lack of continuity if membership changes (change in membership = dissolution = new PA)
Consent of all partners needed for admission of a new partner, subject to agreement
Less control – each member entitled to manage

Tax

Admission/retirement of new partner – CGT and stamp duty liabilities
Each new partner = new capital = CGT

Limited PA:

1 gen partner and 1 lim partner
Gen partner: liability unlimited
Lim partner: liability limited, but cannot manage business or bind PA
Formed by reg at Register of Limited Partnerships.
Letterheads must state Ltd PA

Advantage:

Silent partners
Can add limited partners and gen partners without consent of others
Not dissolved by death/retirement of partner

Disadvantage:

Ltd partner cannot manage
Ltd partner req consent of gen partner to transfer their interests
ATO treats ltd PA as company for tax purposes.

Company

Def: SLE - apart from its shareholders, and has:
Perpetual succession
The right to own property
The ability to sue and be sued in its own name
Most small incorporated businesses are carried on as pty. limited companies
May be single director & secretary (single person comp)
Must lodge company tax returns
Corporations Act 2001 (C’th)

Advantages

SLE - limited liability for Sh
BUT common practise that lenders (banks) will want personal guarantees from Dirs and Shs anyway.

Management:

Losses can be transferred to wholly owned sub company
Continuity – perpetual succession.
Large no. of Shs.
Flexibility – diff classes of shares, dividends etc:
Vary rights of Shs
Estate planning
Transfer interests (shares) without transferring assets
Flexibility – ownership
Can change Con
Appoint/remove Dirs
Separated from control/management (Dir) whereas ownership (Sh)
Easy to raise capital (Mg over prop, equitable charge over income/assets)
Raise equity capital without CGT penalty

Tax:

Company tax rate much lower than highest individual tax rate (45%)
Imputation system (no double tax) – if comp paid tax, then Sh can claim credit
But if not franked – pay tax on dividends
Super contributions to employees – tax deductible
Retirement payments to employed fam members – tax deductible
Comp can employ YOU – get FBT without having to substantiate (ST)
Can split income among fam – employ fam members or issue diff classes of Sh
Can vary – year to year
Can defer CGT (rollover) – eg. where assets sold to comp, wholly owned by individual
Can transfer ownership (via shares) with minimal duty (as opposed to assets)

Disadvantages

More complex & expensive to set up & dissolve (liquidation)
More complex & expensive to administer:
Annual filing fees , accounting fees, annual review fee to ASIC
Formal meetings must take place and certain docs filed with ASIC
Shareholders’ details are on public record
Dirs may be personally liable under common law and Corp Act: (onerous duty)
to act in good faith (general law requirement and see s.181 (1), CA);
to avoid using the director’s position for personal gain (s 182, CA);
to avoid using the company’s information for personal gain (s183, CA);
to exercise care and diligence (s180(1) CA – note that it is qualified by the “business judgment” rule in s.180(2)); and
to prevent insolvent trading (s588G C A – and see also ss.588J, 588M and 1317H).

 FAIL above may have fines, imprisonment, compensate comp for losses.

 responsibilities may extend after comp dissolved eg. use comp info for personal gain

Control can suffer depending on who shareholders are – minority interest may have no say
If principal becomes min Sh
Principals become employees – less control, exposed to payroll tax and compulsory super

Tax:

Tax preferred amounts (eg. Tax free capital gain and tax incentives) ARE taxed when they reach Sh (cf ST – no tax at all)
Losses cannot be offset against Sh’s income (trapped in comp)
Cannot claim 50% CGT discount.

Trusts

Def: Trustee control/deal with prop for benefit of Ben: Trustee Act 1925 (NSW)
Creation: settler creates T deed, appoints Tee, appoints appointer, identifies T prop and Bens.
Trustee:
Personally liable to Creds/contracts – but can be indemnified, unless breached trust
Has right to reimbursement out of trust assets for expenses related to trust
Must act prudently and diligently within powers (fid duty) – in manner that an ordinary prudent man of business would manage own affairs
Must keep proper accts and provide info to Bens as required
Cost: deed ($800-1500 DT, $800 UT), deed has stamp duty, accounting costs (tax return)

Gen Adv:

Relatively simple to establish
Beneficiaries are kept confidential
Success – death of Ben doesn’t affect T.
Appointor retains ultimate power (estate planning) – can appoint/remove Tee

Gen Disadv:

Trustee personally liable to creditors & beneficiaries - personally liable on all contracts
Trustee subject to onerous duties under law
Beneficiaries cannot use trust losses to offset their own income tax
Reluctance of lenders to lend to trusts
Expensive to administer
Winding up can be expensive

Unit Trust:

Unit trust: unit holders hold units, which have prop interest in all prop of trust estate
More suitable for prop/share investment than trading activities.

Advantages

Tax: individual
Unit trust does not pay tax
Unit holders pay tax – offset against their losses (tax planning)
Tax free capital gains and tax incentives – passed to unit holders
50% CGT discount – can claim at both Tee and Ben level
Flexible – split income to diff unit holders (diff class of units)

Disadvantages

Tax losses cannot be distributed to unit holders
Cannot defer CGT (cf comp)

Discretionary Trust:

Tee has discretion as to which Ben to apply income/capital to.Ben only has right to be considered by Tee.
More suitable for trading – flexible distribution of income.

Advantages

Limited liability – if Tee does not own assets in own right (best to use comp as Tee)
Flexible – income varied year to year (amount, type), who gets ben.
Taxpayer can transfer his income producing prop to T – then distribute to other people (avoiding lumped income)

Disadvantages

Tax losses cannot be distributed to unit holders
Not well understood by lenders – reluctant to lend funds to T
Changes to T deed (eg change Ben) – likely to trigger stamp duty + CGT
Not entitled to tax exempt threshold for land tax purposes.
Costs/complexity same or more than comp.

Franchises

Def: where 1 party (For) authorizes 2nd party (Fee) to carry on business, market product, use system owend by For.
Not a business entity - but rather a type of business operation.
Regulated by Trade Practices Act 1974 (C’th)
Ie: form of licence – 1 party (for consideration0 gives rights to 2nd party on certain terms/conditions (eg. name, equipment, IP etc)
Agt usually in writing – but can be oral/implied.
Subject to mandatory Franchising Code of Conduct (monitored/enforced by ACCC)
For must provide Disclosure Statement prior to sale: details of
For – business exp, any litigation, annual turnover
Existing Fees, F territory, who is in For management, recently terminated/cease Fees
IP, sites
Supply of goods/services to Fee and by Fee
For and Fee’s obligations
Marketing and other coop funds
Payments to For and establishment costs
Earnings/finances, financing
ADR options

Advantages

•Good for ppl without must capital to get into business

•Instant market penetration – instant access to goodwill

•Reduced start up costs possible – depends on For (lease, fixtures, fittings etc)

•Economies of scale – bulk buying of products

•Sharing of costs, e.g. advertising

•Goodwill protected – via territorial arrangements

•Franchisor handles industrial/staff problems

•Thorough screening of Fees – strengthens F group

•Distribution network (for product/service) in place – referral network

•Proven systems (admin, financial, training etc)

Disadvantages

•Cannot own goodwill

•Less control:

Fee depend on For for suppliers, advertising promotions
Success depends on success of For
Must comply with For’s rules

•Performance criteria: if Fee doesn’t meet – then ejected from F

•Royalties/franchise fee – loss of % of profit

•Geographical area may be too small – increasing profit is limited

•There may be unreasonable restrictions on resale of the business