Business structuring – types of entities

When starting a new business people are faced with a myriad of choices as to the type of entity which can be chosen.

You can trade as a sole trader if you are a single person or you can use an entity. The use of an entity by a sole trader is subject to some taxation tests in the personal services income regime under taxation legislation but this article does not examine this complex area of the law.

This brief article examines the main choices:

1. A company

The benefit of using a company is that most people understand what it is and how it works. It is a simple form of structure. A company has its own legal personality and can sue and be sued.

Most companies incorporated in Australia are incorporated with a constitution – although it is not necessary to have one. A constitution is a contract between the company and its shareholders which governs the relationship between the shareholders and the company and as between the shareholders themselves.

If a company does not have a constitution, then replaceable rules apply under the terms of the Corporations Act 2001. These are a series of rules which apply to how the company is to be governed.

As a company has its own legal personality, it pays tax the way an individual does and must lodge its own return. It may retain profits or distribute them. If it distributes profits it may do so in a fully franked, partially franked or unfranked manner. This means the dividends if declares to shareholders may come with full, partial or no tax credits.

Losses with companies are carried forward to be offset against future years profits. There are some tests to be passed to enable this to occur.

A company does have some disadvantages. A company cannot access the general 50% capital gains tax discount available under Division 115 Income Tax Assessment Act 1997.

A company is also not the most suitable entity to hold capital appreciating assets as generally any tax preferences tend to be clawed back on a declaration of dividends.

If a company is to be used there are also decisions to be made as to the appropriate way to fund it – that is – the debt/equity mix – which depends on a mixture of taxation and practical commercial considerations.

2. A trading trust

A trading trust may itself take many forms. A trust used by a family will normally take the form of a discretionary trust or a hybrid trust – in this context, a discretionary trust but with some ability on the part of the trustee to fix interests in the trust assets by issuing units which may confer rights to income generated by the trust or to the assets of the trust.

A trust used by unrelated persons entering into business together will normally take the form of a unit trust – this is a trust where the investors into the trust subscribe for units in the trust which may confer income, preferred income, capital or voting rights or a combination of all of these.

A trust is simply a series of obligations which are expressed in a deed for the benefit of persons who are called beneficiaries. There must be trust “property” for a trust to be properly constituted which trust property is owned by the “trustee”.

The “trustee” must look after and administer the trust in accordance with the terms of the trust deed. The trust deed will spell out the trustees powers, duties and responsibilities.

Provided there are beneficiaries who are entitled to the trust income under the terms of the deed, the trustee does not pay tax – the beneficiaries do. The trustee, nevertheless, does lodge a tax return each year which details which beneficiaries are entitled to the net income of the trust.

With discretionary trusts, this is determined normally by resolutions made by the trustee. With unit trusts the entitlement to income is normally automatically determined by the terms of the deed – usually the income will fall to those unit holders who are entitled to receive the income under the terms of the deed.

Trusts do have some capital gains tax advantages over companies – they are entitled to the general 50% discount on capital gains made under Division 115 Income Tax Assessment Act 1997 – companies cannot access this.

Discretionary trusts can be effective asset protection vehicles provided the trust is drafted with wide, open classes of beneficiaries and there is an ability on the part of the trustee to accumulate income, rather then being obligated to distribute it under the terms of the trust.

Unit trusts are less effective for asset protection purposes but some degree of asset protection and taxation flexibility can be achieved if units in a unit trust are owned by discretionary trusts with appropriately drafted trust deeds.

3. A Partnership

A partnership is also a simple means of one person or more entering into business together. Alternatively, there can be partnerships of companies, or of trusts, or a combination of companies and trusts.

Partners in a partnership will normally document their relationship in a partnership agreement of deed, although there is no compulsion or need to do so before a partnership will be constituted for common law or taxation purposes.

The main advantage of a partnership is its relative simplicity and the flow through nature of income and losses – that is, income is attributed to partners and losses flow through to the partners to be offset against any other income the partners may have.

If the partners are trusts or individuals they can access any general capital gains tax discounts available under Division 115 Income Tax Assessment Act 1997

The choice

There are many taxation, commercial, personal and professional factors which can influence the choice of an appropriate entity in any given circumstance. It is important that the right choice of entity is made from the outset. Changing entities or structures can involve significant capital gains tax and stamp duty imposts.

It is important that professional advice be sought from the outset.

If you are contemplating starting a new business and need assistance, please contact me to discuss your needs and requirements.

Peter Gell

Peter was admitted as a solicitor in 1981 and holds qualifications in law and a Masters degree in taxation conferred by the University of NSW. Peter practises in taxation advisory, estate planning and wills, probate and commercial law.