The legal structure of a business should not be stagnant. It generally changes over time as the business grows.
For example, an operating discretionary trust is useful when the business is operated within the family. However, when an employee/investor wishes to come on board, as an equity owner, it is almost impossible to have such employee/investor become an equity owner of an operating discretionary trust.
Which legal structure is best?
Sole trader vs. operating discretionary trust vs. operating company
In terms of a partnership, it may be a partnership of any of the above e.g. partnership of individuals, partnership of operating discretionary trusts. Therefore, a partnership is not a legal structure which we consider to be distinct from the above three (3) structures.
A unit trust is a combination of the benefits of a trust and a company where equity is fixed through units (akin to shareholders in a company) but the legal structure is a trust. A unit trust is not considered in this article.
Sole Trader
There are only very limited circumstances where a sole trader structure is recommended. These are:
the net profit generated from the business is equal to what an employee performing the same role would be paid as salary/wage
there is low risk that, if the business is sued, the amount would substantially exceed the business value. For example, a plumber’s risk of a poorly connected water connection would be water damage and, although the damage could be in tens of thousands, that alone would not bankrupt the business
It is acknowledged the sole trader structure is the most cost effective in that the business information is simply added to the individual tax return, However, from a tax planning and asset protection perspective, a sole trader structure is the least effective.
Further, a company solely owned by an individual shareholder is not recommended from the tax planning and asset protection perspective because it is the least effective.
Incurring more costs in establishing a structure other than a sole trader will save your client significantly more in the longer term, especially as all business owners have aspirations to grow their business which leads to tax planning requirements and greater risks attached to the business.
Operating discretionary trust
An operating discretionary trust is, by far, the legal structure that suits the vast majority of clients.
It allows for tax planning and has great asset protection benefits.
We understand trusts are under attack and are not as useful as they were previously. However, trusts remain a very good legal structure.
In our experience, the business life-cycle starts with an operating discretionary trust and evolves to a company owned by the discretionary trust where the trust stops being an operating trust and becomes a passive trust.
The key factors of this evolution are:
the need for third party investment
implementation of employee share plans
a need to retain profits for business growth
Generally, we find that a business that has net profit reaching $500k start thinking about moving towards a company structure as Mum & Dad are both receiving $180k with $140k distributed to the corporate beneficiary and profits above that are generally put back into the business so that a company structure, with the ability to retains profits, is advantageous.
However, it is important to note that there is, informally, a threshold amount where a purchaser will buy shares in company as opposed to buying the assets out of the company. This amount is around the $2M value. Further insight on this will be provided in an upcoming tax tip.
Finally, a trust structure combined with a company structure (as a corporate beneficiary) is the ideal combination. Further insight on how to structure the corporate beneficiary will be provided in an upcoming tax tip.
Company
Unless a company structure is required immediately upon business commencement, then a trust is recommended with evolution to a company structure in the future.
There are certain situations where a company structure is needed at the outset:
for R&D claims
to hold intellectual property as, for example, transferring a patent is difficult and holding the patent in a company allows an easy future sale where the shares are transferred.
The key disadvantage of a company, over a trust, is its inability to access the CGT 50% discount. This can be overcome by accessing the CGT 50% discount at the shareholder level however, as detailed above, the informal threshold of a $2M value for there to be share sale means any business under $2M ought to be in a trust structure.
It is our view that a company structure combined with a trust structure (as the shareholder) is the ideal combination.
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