Dear Ms Barbara Wantana
I refer to your enquiry about advising the most appropriate entity structure for your business for tax planning purpose. In your case, operating private education centres is considered as a business and income from the business would be assessable under section 995-1 ITAA97. Depending on the business entity structure, you would be subject to being taxed under different tax rate.
You have the following options for structuring the business:
• Sole trader
• Partnership
• Company
• Trust
Option 1: Sole Trader
A sole trader business structure is the simplest form and an individual trading on their own legal responsible for overall aspects of the business.
• Advantages of Sole Trader
– Relatively easy to establish with a nominal amount of paper works and less costly
– As not a separate legal entity, the income of the business is the owner’s individual income. Therefore, the business loss would be offset against your other taxable income if your business passed tests under Division 35 ITAA97.
– 50% capital gain discount for individuals is applicable to sole trader. When you dispose property for your business which derives capital gains, you would get 50% capital gain discount.
– As an owner, you are not considered an employee or a self-employed. Therefore, you do not need to pay compulsory superannuation contribution, PAYG and workers compensation for yourself.
– Regarding Chapter 2 Part 42 ITAA97, sole trader can claim business deductions if it derives Personal Service Income.
• Disadvantages of Sole Trader
– For tax planning purpose, sole trader business structure cannot split business profits with family members from year to year.
– As mentioned above, sole trader cannot be an employee of the business that you are limited to claim for your superannuation contribution to concessional cap ($25,000 in 2018).
– Sole trader is required to prove deductions for Fringe Benefits.
– As not a separate legal entity, owner of sole trader business has unlimited liability. All assets include your private assets of the business are at risk.
Sole trader business structure is considered as a default position. If the tax law does not allow establishment of partnership, company, or trust for you, it would be the most appropriate business entity structure. As a sole trader, your business income would be taxed at your marginal individual tax rate and your income cannot be split to your family members.
Option 2: Partnership
A partnership business structure involves a number of people (up to 20) to carrying on a business in common with a view to profit under legal agreement.
• Advantages of Partnership
– Relatively easy to establish and less costly
– Income splitting between partners in the business would be possible as there is obvious significant contribution by both partners
– As not a separate legal entity, each partner pays tax on shared partnership income. Accordingly, shared net partnership profits or losses impacts an individual partner’s tax payable or return.
– Like sole traders, 50% capital gain discount for individuals is applicable to partners. When you dispose property for your business which derives capital gains, you would get 50% capital gain discount.
• Disadvantages of Partnership
– The split income must be controlled income which means that every partner must input significant contributions which meet tests under Part IVA ITAA36 and Personal Service Income Regime to split partnership business income. If the income is uncontrolled income, it is taxed at 47% under section 94 ITAA36.
– Partnership is not a separate legal entity, so partners cannot be employees which means there is no Fringe Benefit, PAYG, superannuation contribution, etc. available for tax deduction.
– There is limited liability and partners have joint and severable liability.
To split income, both partners must satisfy two tests under Part IVA ITAA36 before implication of PSI Regime.
• Firstly, you must pass business test. According to your case, the size, profitability, effort, and existence of the business is considerable so the ‘Newstart Education’ will be considered as business.
• Secondly, you and your spouse Brian must put a significant contribution in either control or time. In your case, you and Brian can devote certain hours per week in the business. The hours you will devote 50 hours a week can be considered a significant input in the business. But the number of hours Brian will devote 8 hours a week would not be a considerable amount of time as a significant input and his bookwork is not qualified as significant duties under FCT discretion. According to this, you can prove your significant contribution on business, but Brian cannot prove it. He can be a partner of your business input significant amount of capital on the business such as transfer property from you to him, but you must beware of stamp duty, capital gain tax implication etc.
Therefore, if you operate your education business under partnership structure with your spouse and split income to him as a partner, the income would be taxed at 47% under section 94 ITAA36 as uncontrolled income.
Option 3: Company
A company business structure is a separate legal entity which means that the company has the same right as a natural person. You need to register a company the Australian Securities and Investments Commission when you establish, and directors must comply with the legal obligations under the Corporations Act 2001 (Australian Government).
• Advantages of Company
– Company is a separate legal entity.
Successive perpetuity – no CGT implication unless the asset is disposed.
There is unlimited liability.
Principals can be employees and they can claim tax deductions such as PAYG deduction and salary sacrificing.
– Flexibility in income splitting to family members
– Dividend imputation
– Fixed tax rate at 30% (if the company’s turnover is less than 10 million, taxed at 27.5%). Company tax rate is lower than maximum individual tax rate (47%= marginal tax rate 45%+ full Medicare levy 2%).
• Disadvantages of Company
– More paperwork and more costly than sole trader and partnership structure.
– Principals can be employees which means the owner employees of the company must pay superannuation guarantee, workers compensation on their own wages, subject to FBT on benefits, etc.
– No 50% capital gain discount for company in relation to gains after 21/9/1999. If you dispose the properties for your business worth which generate capital gain, you would not be allowed capital gain discount.
– Section 47(1A) ITAA36 ignores the effect of indexation and capital loss offsets when assessing liquidators’ distribution from capital profit reserves.
– As your children are minors, there will be lack of flexibility of distribution and obvious problems of Div. 6AA.
The greatest advantage of company business structure for tax planning is high flexibility in income splitting to your family members. It is possible to split income by shares with different rights simply setting up different classes of shares, however you should beware of all your children minors. All your children are prescribed persons (while Berry-17 years old-is unemployed currently and other children are full-time students) and their unearned income exceed $416 will be caught as unearned income taxed at penalty rate in accordance with Div. 6AA.
Other than income splitting, there are possibilities of tax deduction for tax planning purpose. As a separate legal entity, principals can be employees. You can claim tax deductions for FBT salary sacrificing, PAYG etc. by employing yourself and other family members such as Brian or Berry. But at the same time this can be disadvantage that you must pay superannuation guarantee, workers compensation and subjected fringe benefit tax on them.
Option 4: Trust
A trust is an obligation delegated on a person to hold property or income-generating business for the benefit of beneficiaries of the trust.
• Advantages of Trust
– Trust has several similarities to company in that:
Separate from trust holders
Settlor (principal) can be employed by the trust
Successive perpetuity
– Profits of trust cannot be directly taxed by ATO because it is not separate legal entity. The trust profits will be taxed when it is distributed to beneficiaries under beneficiaries’ individual income tax rate.
– Trust income can be differently distributed to beneficiaries. You can set distribute income to beneficiaries under 18 less than $416 tax free threshold for minors (Div. 6AA).
– Beneficiaries do not need to contribute significant input in the business.
– (Minors will also have ultimate ownership rights to business assets transferred to the trust and can claim any trust distributions made in their name.)
– 50% capital gain discount is available.
• Disadvantages of Trust
– Costly and complex to establish and administrate
– Trust loss cannot be distributed to beneficiaries.
– Trust is not separate legal entity so there is no limited liability.
– Split income to minors is problematic (Div. 6AA ITAA36).
– Entire profits must be distributed to beneficiaries as there are taxed at the highest marginal rate. Retained trust profits will be taxed at flat 47% s99A ITAA36.
Trust allows income splitting to family members even children under 18 can be distributed as beneficiaries, however it is difficult to split income to minors because of Div. 6AA ITAA36 penalty tax exceed $416 unearned taxable income. Discretionary trust can be set the amount distributed annually to the beneficiaries, so trustee should set a different amount of trust income to minors among your family members keep distributions less than $416 tax free threshold for minors.
I would like to recommend a combination of company business structure and trust for your business. Trust does not provide limited legal liability and this nature of trust could be an obvious disadvantage of ownership rights of trust property and protection from dispute problems. However, it can be limited liability if the trustee is company. Within the combination of both business structures, legal liability would be limited to protect the rights of trust property and to prevent dispute problems of beneficiaries but the flexibility of income distribution to the children, who are minors, would be still retained. Therefore, a business run by a discretionary trust with a corporate trustee would overcome deficiencies of trust and company business structure.
I would like to inform you that the business structure I recommend in this letter is not absolutely the best form but as shown above, each business entity structure has its advantages and disadvantages depending on your own circumstances. I am pleased to help you to choose your business structure. If you have any further enquiries, please feel free to contact me.