Getting Your Business Structure Right
This article appeared in Issue 3#1 (November/December 2008) of Business Franchise Australia & New Zealand
Plenty has been written by me and other contributors, regarding the processes and matters that a prospective franchisee should consider, when assessing an opportunity to acquire a franchise business.
Once that decision has been made, or shortly before it is made, a prospective franchisee needs to consider the structure in which he or she will conduct the franchise business.
There are many different types of structures that suit many differing circumstances and the purpose of this article is to outline the different types of structures commonly used in franchising, the advantages and disadvantages of those structures and the reasons why it is important to get a business structure correct from the outset.
1. Sources of Advice
The best sources for advice as to business structuring are accountants and/or solicitors, preferably those with solid experience in franchising, taxation and asset protection. This article contains, on the whole, general propositions and should not be relied upon for any given circumstance. I am sure all readers’ circumstances vary; hence the need to obtain advice specific to your individual circumstances.
2. Why is business structuring important?
(a) Asset Protection
It is prudent for any person embarking on a business enterprise (which is in itself a substantial risk) to take steps to minimise the impact of insolvency that might arise from business failure. This generally involves separating the person or entity owning assets desired to be protected, from the personal entity taking the business risk. This may be particularly important depending on the type of business.
For example, if you invest your available cash resources into a business and the business fails, desirably you would not want to risk the loss of your family home as a result.
Some of the business structures below provide no asset protection and others provide substantial (but rarely fool proof) asset protection.
(b) Legitimate Minimisation of Taxation Liability
Many types of taxes will become payable by franchisees. In the context of this article I am specifically referring to income tax and capital gains tax. Differing business structures result in different taxation treatments and any prospective franchisee needs to consider their current and projected circumstances for taxation purposes when considering a business structure.
3. Types of Business Structure
The most common types of business structures used by franchisees are as follows:
(a) Sole Trader;
(d) Trust (discretionary, unit or hybrid).
Each of these types of structures will be described below, but before doing so, I would like to outline the reasons why a particular type of business structure may or may not suit a particular franchisee.
(a) Sole Trader
Here I am referring to a business owned by an individual person. That person would register an appropriate business name under State business name legislation, but he or she would remain the proprietor of the business.
The main advantage of this structure is that it is simple and involves virtually no cost to set up.
The disadvantage is that if the business proprietor has other assets (for example, a house, investment property or shares) those assets are at risk if a judgment is entered against the business proprietor or the business proprietor becomes bankrupt.
Upon bankruptcy, all divisible assets of the bankrupt vest in a Trustee in Bankruptcy, who is then required to liquidate those assets and make distribution to employees and creditors in accordance with the priorities contained in the Bankruptcy Act.
Therefore, if the sole trader owned a house and became bankrupt, he or she would lose the house.
Further, if the sole trader was sued for a debt and a judgment was obtained in favour of the creditor, that creditor could ultimately seek to enforce that judgment by selling the sole trader’s house or other major assets.
Income tax payable by the sole trader would be assessed in accordance with the normal rates of taxation for an individual currently:
(i) Up to $6,000 – nil;
(ii) $6,001 to $34,000 – 15 cents for each dollar over $6,000;
(iii) $34,001 to $80,000 – $4,200 plus 30 cents for each dollar over $34,000;
(iv) $80,001 to $180,000 – $18000 plus 40 cents for each dollar over $80,000;
(v) $180,001 and over – $58,000 plus 45 cents for each dollar over $180,000.
If the business is very successful (earning a little over $130,000) it may well be that the average rate of tax paid by the business proprietor will be higher than the rate of tax payable by a company (30 cents in the dollar).
A Partnership involves two or more people conducting a common business enterprise. The relationship between partners should be governed by a formal partnership agreement – this is highly recommended to minimise uncertainties and disputes, but it is not essential.
It is relatively inexpensive to set up a partnership. As I have said, it is desirable to have a partnership agreement and it will be necessary to obtain an ABN for the partnership and in due course it will be necessary for a partnership taxation return to be prepared and lodged.
The terms of the partnership will deal with the proportions in which the partners own the capital of the partnership and the proportions in which profits are to be shared.
Tax is paid by the individual partners at their normal marginal rates on their share of the profit (as determined by the partnership agreement). Therefore, for taxation purposes the same amount of tax is paid by a partner on his or her share of profit as would be paid if that partner was a sole trader.
Likewise, partnerships do not provide any real asset protection because the partners are each jointly and severally liable to creditors for debts incurred by the partnership.
For example, if the partnership had two equal partners and it incurred a debt of $50,000, each of the partners would be potentially liable to repay the creditor $50,000, not $25,000 each. Therefore, if one partner has substantial assets at risk and the other partner has no assets at risk, the latter partner may simply throw his or her hands up in the air and refuse to pay the debt leaving the “at risk” partner fully exposed. The “at risk” partner would have the right to seek contribution from the other partner but if the other partner has no assets, those rights might be worthless.
A partnership is also rather inflexible in that the partnership agreement determines the share of profits and ownership of assets. Any change in those proportions or the introduction of a new partner will necessarily give rise to a disposition of part of the business for capital gains tax purposes. This may result in the continuing partners suddenly having to pay capital gains tax that would not otherwise be payable.
Regrettably, I see too many disputes between partners. The absence of a properly drawn partnership agreement makes it harder to determine a partner’s legal position and resolve disputes.
Like you and I, a company is a “legal person”. It is a separate legal entity capable of entering into contracts; it becomes liable for its acts or omissions; and suing and being sued. The operation and management of companies is, to a large extent, governed by the Corporations Act 2001 (Cth).
Costs associated with establishing a company range from $700 to $1,600.
The underlying owners of a company are called “shareholders”.
Those who are charged with the obligation to run the company are called “directors”.
It is desirable that a shareholders agreement exist governing the rights as between shareholders. As is the case with partnerships, the Courts are littered with cases involving disputes between shareholders who have fallen out. The risk of litigation of this type can be minimised if a shareholders agreement exists, that foreshadows the possibility of future falling out and spells out an agreed solution.
As a company is a separate legal entity, it is only the company that is liable for debts incurred by it or its liabilities. The assets of the directors or shareholders are not at risk unless they have personally guaranteed payment of the debt to the creditor. Directors may also be exposed for the debts of a company if the company has incurred the debt at a time when the company was insolvent (thereby attracting provisions of the Corporations Act which render directors liable for debts incurred whilst a company is insolvent). There are a number of statutory duties and obligations imposed on company directors and if these duties are not met, a director may become liable to prosecution by ASIC (Australian Securities & Investments Commission).
So as a general rule, a company provides fairly sound asset protection.
But asset protection is not as simple as this. Almost always, bankers and other lenders, landlords, franchisors and some major suppliers will require directors and/or shareholders of a franchisee company to provide a personal guarantee.
This means that if the company fails to pay a debt or honour an obligation owed to such a creditor, that creditor will be free to take action against those who have provided personal guarantees.
However, in relation to most other creditors, they will be content to deal just with the company meaning, that if a debt is not paid, recourse can only be had against the company and not the directors or shareholders of their company (or their personal assets).
The taxation of companies is also treated differently to the taxation of individuals. Companies pay tax on profits earned at the rate of 30 cents in the dollar. Unlike individuals, there are no tax free thresholds, nor are there varying marginal rates – it is a flat rate of 30 cents in the dollar for every dollar of profit.
Therefore, a prospective franchisee who is considering whether or not to incorporate, operate as a partnership, or as a sole trader, needs to consider the likely taxes that would be payable under either of those structures, having regard to the additional costs associated with incorporating a company and filing annual statutory returns.
A Trust is a creature of the law and it comes into existence where the person who has the ultimate benefit of an asset is not the legal owner of the asset. The legal owner of the asset is called a “Trustee” and the person who is entitled to the benefit of the asset is called a “Beneficiary”. The Trustee can be an individual or a company.
A trust is not a separate legal person (like a company), but it is regarded as an entity for taxation purposes.
In most instances, the trust is governed by a Trust Deed and the two most common types of trusts are unit trusts and discretionary trusts.
With unit trusts, a certain number of units are issued with individual proportions being given to individual unitholders (beneficiaries). For example, the unit trust could have 100 units and there may be five beneficiaries each owning 20 units.
The income earned by the unit trust must be distributed in accordance with the unit holding. In the above example, one fifth of the income would be distributed to each of the unitholders.
The proportion of units owned by unitholders may be easily varied by either issuing new units (say for example a sixth beneficiary was introduced, 20 additional units may be issued to that sixth unitholder) or by existing unitholders selling units to new unitholders.
No income tax is paid by the trust if it distributes all of its income to the unitholders. Tax is payable by the unitholders in accordance with their normal marginal rates of tax. Unitholders may be individuals, companies or other trusts.
Discretionary trusts are often common in family situations. A discretionary trust is one where the income earned by the Trust can be distributed to a wide range of beneficiaries in such proportions as the Trustee of the Trust deems appropriate on a year by year basis.
This enables income to be distributed for taxation purposes in a manner that will minimise the amount of tax payable by the beneficiaries as a whole.
If the Trust has a company as its Trustee, it has the same asset protection benefits as a company (as outlined above).
If the Trust has an individual or individuals as the Trustee, the Trustee’s personal assets could be at risk in respect of liabilities incurred by the Trustee on behalf of the trust because, from the creditor’s viewpoint, it is dealing with the Trustee. The Trustee will have the right to be indemnified by the trust, but the value of this right of indemnity is dependent on the value of the assets of the trust.
Persons setting up trust structures for their own benefit or the benefit of their family must ensure that they retain the ultimate control of the trust.
Some drawbacks of trusts are that they are of limited life (they must “vest” or be wound up within 80 years). Further, if a trust incurs a loss, that loss cannot be distributed to beneficiaries (in the same way as income is distributed). The trust has to wait until, in a given tax year, it earns income against which past losses can be offset.
As a general rule, it is better to spend some time and money at the outset to determine the most appropriate business structure for you. Although tax is a factor that needs to be considered, it should never be the main factor determining a business structure. In my view, asset protection is far more important.
Head of Dispute Resolution & Litigation Division
Accredited Specialist in Commercial Litigation
MASON SIER TURNBULL LAWYERS
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