CHAPTER 2
Getting started: establishing the correct business structure
More mistakes are made at the beginning of a business than at any time in its life. As a result of either not getting advice or receiving the wrong advice, many people end up operating their business through a structure that means they pay too much tax, or that their personal assets are at risk when things go wrong.
When you operate a business, you have the choice of using any of the five main structures available. This chapter looks at what you have to do to prove you are, in fact, running a business, and reviews these five structures.
When a business is not a business
It is important to stress that a choice of business structures is only available when a business is being operated. Where someone is earning ‘personal exertion income’ — in other words, is really earning employment income — the structures, and thus the tax benefits available, are severely restricted.
There have been many legislative changes over the years to try and curtail the use of tax-effective entities by those earning employment income. Initially, the tax office had to prove that a master/servant relationship existed in order to prove that employment income was being earned — a difficult task. In some early cases the ATO was only successful because the attempt at diverting employment income was so blatant.
A lot of these attempts were labelled ‘Friday/Monday schemes’. They involved a person quitting on a Friday as an employee and then turning up for work as a contractor on Monday. Their duties did not change, they still reported to the same person and they still occupied the same office. It will be no surprise that these not-so-cunning schemes (usually attempted so that the person could split income with a non-working spouse) did not succeed.
The next major attempt at attacking tax-effective structures came in the form of part IVA of the tax act. Under this section, the Commissioner of Taxation was given the power to disallow a deduction or arrangement when it could be proven that its prime reason was to reduce tax. Thankfully this section has not been as effective as the commissioner would have liked.
There was a possibility that part IVA would be used to attack a person who changed from a sole trader to a company structure. As it turned out, however, the tax benefits of operating through a company were often minor compared to some of the other benefits — such as the limitation on the owners’ legal liability, and the ability to maximise contributions to a super fund. Given these other major benefits, it was almost impossible to apply part IVA.
Recognising that existing measures were not effective, the federal government introduced the ‘alienation of personal services income’ legislation in 2000. If changes had not been made to this, some couples who were operating a business and taking business risks could have been blocked from receiving tax benefits from any of the legitimate tax structures available.
In its original form, the legislation meant that an entity earning more than 80 per cent of its income from one source could not split that income with anyone in all had to be regarded as income of the person doing the work. Even if less than 80 per cent was earned from one source, other tests had to be satisfied to avoid the imposition of the tax maximising measures of the legislation.
The original wording of the legislation also meant that many people forced to operate a business through a company would have paid a lot more tax. The prime example of this were courier drivers, who had to supply their own vehicles but inevitably were only contracted to one company that found them work. A sufficiently strong case was made on this point that a change was made to protect this group.
The situation now
To prove that you are running a business, and not trying to avoid tax by splitting employment income, there’s now a new test that can be used before the 80 per cent test. Under it, a business that earns at least 75 per cent of its income from one source must meet three criteria. The business:
- must be paid to achieve a specified result or outcome, such as cleaning a house, delivering a parcel or installing a kitchen
- must supply plant and equipment or the tools of trade needed to produce the result
- must be required to fix any mistakes or problems that arise from it having carried out the work.
So for example, a husband and wife operating a carpentry contracting business, who supply their own tools and have to fix any defects in the work performed, would pass the test.
If the 80 per cent test is to be applied, after passing it a business must also pass at least one of another three tests. They are:
- that the income was earned from two or more unrelated clients and that the business had offered its services to the general public or a specific section of the public, such as by advertising
- that it operated from business premises that were physically separated from the owners’ home or the premises of a client
- that it employed other people or contracted with other entities that earned at least 20 per cent of the business income. In this case, the individuals or entities cannot be associated with the business owner.
In certain circumstances, if a business fails the 80 per cent test, it can apply to have the test waived. The business needs to show it has taken on one long-term contract this year, but had two or more unrelated clients in preceding years. It will also need to show that it’s reasonable to expect it will have more than two unrelated clients in the future. Where the business has just started, it will need to show that it reasonably expects to have two or more unrelated clients in the future.
What if you don’t pass any of the tests?
If none of the business tests can be satisfied, the trust, company or partnership owning the business does not have to be wound up. The tax deductions allowable will, however, be limited to those that an employed person could get. No deductions will be allowed for rent, mortgage interest, home to work travel or wages paid to an associated person or relative who does not earn the income. The only time home to work travel will be deductible is where the vehicle is used to transport bulky equipment.
A business that fails the tests can however claim deductions for expenses that strictly relate to the income earned. These include advertising for work, income protection and public liability insurance, workers compensation insurance, contracting with an independent person or entity, superannuation for the person actually earning the income, registration and company fees, and cars used for business purposes. The rules also allow for one private car to be claimed using the fringe benefits tax system by a business that failed the test.
When the business is a business, but making a loss
Once it’s been established that a business is being operated, one of the benefits is to be able to offset business losses against other income. But before this can be done the business must be able to pass one of the following non-commercial business loss tests:
- generate income of at least $20 000 in a full year, or
- use real property, such as real estate valued at no less than $500 000, or
- use other assets such as plant and equipment, stock and leased assets valued at least $100 000, or
- have produced a profit in at least three of the previous five years.
If none of the tests can be passed (and the last test is impossible for start-up businesses to pass), an application can be made to the ATO for the non-commercial business loss provisions to be waived. To be successful in this, a business plan should be prepared that includes profit and cash-flow projections that predict how long it will take for the business to become profitable.
Choosing a business structure
Once it’s been established that a business is being operated, or going to be operated, a person can choose any of the different business structures available. These are:
- sole trader
- partnership
- discretionary family trust
- unit trust
- company
- partnership of discretionary trusts.
As mentioned earlier, the type of tax structure you operate a business through can have far-reaching ramifications if you get it wrong. The consequences can include paying too much income tax, putting your personal assets at risk, paying too much capital gains tax or missing out on generous tax concessions on the sale of goodwill.
Most businesses go through several stages of development. This is more apparent when they’re started from scratch, but it can also apply when a business is purchased as a going concern. Depending on the stage that your business is at, you may have different requirements. Fortunately, from an income tax point of view there’s nothing to stop you operating a business initially through one structure, such as a sole trader, then at a later stage changing to a structure that meets your needs better. The ATO will not be able to challenge this change in business structure, as long as the prime reason for changing was not to obtain a tax benefit. When it comes to choosing a business structure, however, income tax should only be one of many considerations taken into account. And if you consider these other factors, the chance of the ATO successfully attacking any change in structure is greatly reduced.
Sole trader
The sole trader structure is the most common one used by those starting...
