What structures are available to builders that can balance tax efficiencies, flexibility for businesses, and ease of compliance? There are 4 main structures that are available: Sole Trader, Partnerships, Companies, and Trading Trusts. Each structure has benefits and negatives, and it is the balancing of those competing factors that works out what the best structure should be. Members who have their LBP have the additional complication that the structure is “looked” through to the individual license holder. These members may need to discuss with their advisor’s way of undertaking additional asset protection structures with trusts and spouses.
A sole trader is the simplest structure. It is easy to set up being a sole trader because as soon as you are born you are given an IRD number and that is all that you need. From a compliance point of view, all income after expenses are deducted are treated as being taxed in the sole traders’ hands, but that does not always give you the most tax efficient outcome. You are not able to, for example, employ your spouse without IRD approval and the deductibility of some expenses is also limited. On the counter side, it is very easy to wind a sole trader up as you make an election with IRD to cease operating.
The business risk of the sole trader is that they are all liable for all business debts as there is no separation between the individual and the business. Therefore, all personal assets that the sole trader could be exposed to creditor risk.
If 2 friends get together and decide that they want to work together then they can form a partnership. The partnership is separate from the 2 individual partners, and so the nature of expenditure in a partnership is directly related to the business and any personal expense is “charged” to the partners current accounts. The partnership has an additional level of complexity for compliance in that the partnership requires to have tax returns completed, and then profits (or losses) are attributed to the individual partners. If partners enter and exit the partnership, then this is seen as a restructure and the partnership continues (although there can be some adjustments for the exiting and entering partners) and so there are no negative tax consequences to the remaining partners. The partnership can be dissolved with all partners agreeing, and it is a similar process to the wind up of a sole trader.
Partnerships can be risky as all partners are joint and severally liable for the other partners. It is almost like a business marriage, so when entering into a partnership it is important to have trust in your business partners, or at a minimum documented accountability. While you may have confidence in your abilities, you need to also have the same faith in the confidence of your business partners.
Due to the liability issues of the partnership, a Company is the preferred structure for business partners. A company has limited liability (which is what the LTD represents at the end of the company name) and that means that the shareholders of the company are seen as being separate from the company itself. This also increases the compliance costs as the company needs to account for the inflows and outflows of the resources of the company.
The separation of the ownership (shareholders) and management of the company (directors) this means that expenditure to assist the running of the business, including payments to working shareholders, is treated as deductible expenses to the company and not as private expenses to the shareholders. The company pays tax in its own name which is separate to the tax paid by individual shareholders. Surplus profits are distributed by way of dividends to the shareholders, and this is where the Imputation Credits are used but in effect reduces double taxation on the distribution of surplus profits.
Winding a company up can be difficult because of the separation between the shareholders and the company itself. The company needs to go through a formal removal process from the companies register and needs to show that the shareholders have agreed to cease trading. Companies are often removed through “liquidations” which has a negative connotation on the basis that the business was insolvent, but even solvent companies can be liquidated. It is more common to have the company struck off for not filing an annual return, but the proper process is a liquidation process.
The fourth option, which has diminished in popularity over recent years, is the trading trust concept. Trusts will be well known to many members as part of asset protection for the family home, or other investments that are held in trusts. These are more passive in nature, as they are not taking on business risk by trading. Trading trusts have the same level of compliance as companies, as there is an accountability to the beneficiaries on the use of the resources of the trust by the Trustees; but trading trusts have the flexibility on the distribution of the profits as these can be taxed in the trusts hands (33%) or in the hands of the beneficiaries (marginal tax rate). Trading trusts are still governed by the trust deed, so it is important that trustees are still familiar with the terms of the Deed.
The Trustees of the trading trust will usually take on the risk of the business, and if trading insolvent can be held personally liable. It is common, therefore, to have a company as the corporate trustee of the trading trust. To wind a trust up is easier than a company, as it only requires a deed to bring forward the vesting date, vest the assets, and then wind up the trust as it no longer holds any assets. Often the Trustee company will be wound up which means the trust can “fail” as it no longer has a trustee.
The table below summarizes the benefits and weaknesses of the four options:
|Structure||Ease of Compliance||Tax Efficiency||Personal Risk|
Each business is going to have different needs and it is also expected that business will evolve over time. Pick the best structure that meets your needs and monitor the evolution of the business and adapt as your needs change.