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An Example Business Structure

An Example Business Structure

Clive and Carla

Clive is escaping the corporate world after 20 years as a marketing executive to become a freelance consultant. He is leaving the world of high cost marketing campaigns to help small business owners build brands on a budget.

Clive’s wife Carla is a qualified accountant and will help with the business admin and finances in whatever time she has left after looking after their two preschool kids.

Their only major asset is their home with a mortgage to service.

How should they structure their affairs?

Their Questions

Clive and Carla have three criteria:

  • Risk – They don’t want to lose their house if things go badly.
  • Tax – They want to ensure they can pay their tax, without paying too much.
  • Complexity and Cost – They want to keep things as simple as practical and their costs to a minimum.
    With some research and advice, they have come up with a plan.

Business Risk

They know that business is risky and insurance won’t cover them for everything that may go wrong.

To protect themselves from potential liability to the business risks, they decide to form a company. They incorporate Clive’s Consulting Limited to own and run the business.

Clive and Carla are both shareholders (owners) of the company. As it is a limited liability company, the most they stand to lose is a nominal amount of, say, $100 they will pay for their shares. The company takes the risks, not the shareholders.

The company needs at least one director who will have responsibilities to manage the company and comply with company law. As Clive is primarily running the business, doing deals with clients etc., he will be the sole director. Directors can be personally prosecuted if they do something reckless, so they don’t see any need to expose Carla to those risks.

Protecting Personal Assets

They’re happy that the company will reasonably contain the business risks, but their biggest fear is losing their house. What if Clive is help personally liable for failing in his director’s duties and sued for millions?

Owning their home in their personal names is always going to leave it vulnerable to their personal risks which may or may not be related to the business. Personal disputes with neighbours or causing a forest fire could leave them with a liability they cannot pay.

They decide to form a trust and transfer the house into that. Once the house is owned by the trust, it is no longer in their ownership and so is out of reach of their potential creditors.

Confident Clive has plans to grow his new company into a high value investment that he can sell in the future to fund a comfortable retirement. As they now have a trust to protect their assets, they decide to put the company in their too.

On the advice of their accountant they form their company with 100 shares. 98 shares will be owned by the trust and one share each by Clive and Carla. Holding a share in each of their personal names gives them the flexibility to pay themselves shareholder salaries from the company without deducting PAYE.

Tax

Clive is confident he can generate fees of around $130K with business expenses of $30K, leaving $100K profit in his first year of business. So how will that be taxed?

A company is a flexible vehicle for managing income tax, splitting the $100,000 profit between the company, Clive and Carla.

Clive and Carla need money to live on. As shareholders, they can take money out of the company during the year to live on. They won’t pay PAYE on this as they will take it as drawings which is effectively a loan from the company. They will be taxed on their “shareholder salaries” determined at the end of the year.

Let’s assume Clive’s confidence is justified and he does make $100K profit in year one. Once the year has finished and the profit is calculated, shareholder salaries are worked out.

Carla’s Tax

Carla has worked a few hours a week. They have worked out a fair market value for this work is $20K. This becomes her shareholder salary which is an expense in the company accounts and income to Carla. The company deducts the salary expense reducing its profit to $80K. Carla’s tax return is filed, and she pays tax on her $20K income. Her tax is calculated at her individual tax rates being 10.5% for the first $14,000 of annual income and 17.5% on her next $6,000. Her tax on her $20K salary comes to $2,520.

 

 

 

 

 

 

 

Clive’s Tax

Clive has generated most of the profit through his personal efforts. His shareholder salary must reflect that, so they allocate him $70K. Clive pays tax of $14,020 on this, calculated at his individual tax rates as follows:

 

 

 

 

 

 

 

Clive’s Consulting Ltd’s Tax

After paying the shareholder salaries, the company is left with a taxable profit of $10,000 ($100K – $20K – $70K).

The company will pay tax of $2,800 being $10K times the company tax rate of 28%.

Tax Efficiency

Overall, they will pay $19,340 tax, an average rate of 19.34% on the $100K taxable income. They could save tax by paying a higher salary to Carla and less to Clive. Carla would pay 17.5% tax on additional income up to $48,000, while Clive would save 30% tax by reducing his income. However, if the shareholder salaries do not reflect the actual market values of the services provided, IRD could see it as tax avoidance and disallow the income split.

If Clive was operating as a sole-trader rather than through a company, he would be personally taxed on the whole business profit. At $100K, his tax would come to $23,920, an average rate of 23.92%. This is because any additional income over $70K is taxed at the top personal tax rate of 33%. With the company setup, this additional income is split between Carla’s tax rates of 10.5% and 17.5%, and the company rate of 28%.

Sole-Trader Tax Calculation

As a sole-trader, the business could still pay Carla some income. However, Clive would have to register as an employer and get permission from IRD to pay a wage based on the value of Carla’s work. The business would have to deduct and pay PAYE monthly.

Compared to a sole-trader setup, the company provides more flexibility and lower overall tax.

Cost and Complexity

Clive and Carla have a small business and a house. It doesn’t justify or require a large complex structure. What is involved in this structure.

Forming the Company

Incorporating a company in New Zealand is quick and cost-effective. Clive and Carla should be able to get an accountant to setup their company, including the required IRD registrations and preparing the initial company minutes and registers, for around $500.

Forming the Trust

Setting up a trust is more complicated. A trust deed will be drafted detailing who will manage the trust (the trustees), who will benefit from the trust’s assets (the beneficiaries), and the rules for running the trust. Presuming they use a lawyer to draft this deed, it may cost them between $1,200 and $2,400. Moving the house into the trust will incur some additional conveyancing fees of, say, a few hundred dollars.

Ongoing Requirements

Clive, as director of the company, must ensure it meets its statutory obligations. This includes preparing:

  • Annual financial statements
  • Income tax returns
  • Shareholder and director minutes

Generally, these will all be completed by an accountant as part of an annual compliance job. The business would require financial statements in some format whether it was owned by a company or not.

The ongoing trust management should require minimal work. The trust will only need to file a tax return if it receives taxable income from any source. Just owning the house and company shares will not require a tax return.

An annual trustee meeting and recording of minutes will normally suffice.

 

Choosing a Business Structure

Choosing a Business Structure

There are four types of legal entity used to own most private businesses in New Zealand: sole-traders, partnerships, companies and trusts. Before choosing your business structure, consider the pros and cons of each below.

Sole Trader

If you start your own business without forming a separate entity, you are automatically a sole trader. Many contractors or self-employed people operate as sole traders due to its simplicity. However, being a sole-trader leaves you personally exposed to all the commercial risks of the business.

I generally would only recommend trading as a sole-trader if your business is very straight forward with very low risks. If your business fails for any reason and cannot pay its debts, you are personally liable. This can result in you losing your assets such as your house and/or being made bankrupt.

Sole Trader Advantages

No formation of a separate entity required
No additional legal administration obligations like a company or trust
If the business makes a tax loss it is automatically offset against your other income, reducing your tax bill

Sole Trader Disadvantages

You are personally liable for all debts and legal problems of the business as there is no legal separation between you and the business
All income is taxed at your personal tax rates which can exceed those of other entities
It is hard to split income with others such as a spouse
If you take on a business partner, you will have to form a new entity, creating potential tax issues when transferring the business and business assets

Partnership

If you start operating a business with one or more others, without forming a separate entity, you are operating as a partnership.

A partnership is like a sole-trader in that there is no legal separation between the partners and the business. If the business cannot pay its bills, the partners are personally liable.

While being a sole-trader carries risks, a partnership multiplies the risks as each partner is joint and severally liable for the results of actions of the other partners. Should your partner run up a large debt in the name of the partnership, the creditor can demand payment from you.

A partnership is a risky business structure. If you are going into business with someone else, I would strongly recommend considering a company structure as below.

Partnership Advantages

Simple to setup and administer
If the business makes a tax loss, it is automatically offset against the partners’ individual taxable income

Partnership Disadvantages

Unlimited legal exposure to the risks of the business and your partners’ business actions
All income taxed at the partners’ personal tax rates which maybe higher than necessary
If one partner leaves the business, the partnership is effectively ceased, and a new entity must take over the business, creating administrative and potential tax

Company

The company has been the business structure of choice for commercial ventures for centuries. A company, or corporate structure, is a separate legal entity that can act as a (non-natural) person forming contracts and owning and operating assets and businesses.

By trading through a company, you are building a wall of protection between yourself and the business. The company owns and operates the business. You, as an owner of the company, have a limited liability investment.

“Limited” at the end of the company name indicates limited liability. The limited applies to the shareholder(s), limiting their liability to the amount of capital they have paid for their shares and they cannot be forced to contribute any more if the company cannot pay its debts. If you form your company with 100 shares paying $1 for each, your loss is limited to $100.

In practice this limited liability is often compromised. Shareholders of small companies often personally guarantee the company’s loans and debts. If the company is formed to run your business, you will also be a director. A company needs at least one personal director who takes on legal duties to manage the company properly and can face liability if they breach these duties. Directors also often give personal guarantees for the company’s debts to suppliers as part of their trade agreements.

Despite the disadvantages, forming a company is often the most effective risk management move when going into business.

Company Advantages

Limits your personal exposure to commercial risks
Allows you to raise funds from investors in exchange for a share in the business
Enables tax-efficient splitting of taxable income

Company Disadvantages

Requires some additional cost and compliance
Brings legal responsibilities to directors

Trust

The final business structure option discussed here is a trust. Trusts are very common in New Zealand for their ability to protect assets.

A trust is not strictly a separate legal entity. A trust is an arrangement whereby one or more people (the trustees) legally own assets for the benefit of one or more other people (the beneficiaries). By forming a trust and transferring your assets into it, those assets are no longer in your ownership. If you go bankrupt, the assets are safe.

Trusts are probably the best vehicle for protecting assets. Commonly, New Zealanders put their house into a trust, especially when they are personally involved in business or other risky ventures. Trusts can also help you to control what happens to your assets and who will ultimately benefit from them.

A trust, subject to the rules contained in the trust’s deed, can run a business. A trust that runs a business is called a trading trust. Trading trusts are not as common as family trusts that own personal assets such as a home and investments. It is more common for a trust to own the shares in a trading company that runs your business. This provides limited liability protection from the business activities and asset protection of the value of the investment in the company.

Trust Advantages

Protects assets from personal risks
Helps control who ultimately benefits from your assets and investments
Allows for tax-efficient distributions of income to people with different tax rates

Trust Disadvantages

Adds complexity to managing your affairs
Means you no longer own the trust property
Can be a complicated method of managing a business if the trust itself runs the business
If trusts are not managed properly, they can be deemed to be a sham and set aside by a court

Business Structure Conclusion

Sole-traders and partnerships are the simplest ways to run a business as they don’t require setting up and managing a separate entity. However, the benefits provided by a trading company will usually outweigh the moderate cost and compliance requirements. A company is generally the preferred vehicle for managing even small businesses.

A trust is probably the best vehicle for protecting assets but is less commonly used to own and operate a business. Trusts are great for protecting personal assets such as homes and investments including shares in trading companies.

Go to the first post in this business basics series

Contact Robb with any questions.

Business Structure Sole Trader or Company

Your Business Structure: Sole Trader or Company?

Business is risky. Risk is the price we pay for the rewards we hope to get from owning a business. Risk is the reason we expect a higher return from a share investment than a bank deposit.

If investing in a portfolio of businesses via the share market is risky, it is nothing compared to investing in one small business. While we may be very happy with a 10% return on our share portfolio, a venture capitalist may look for a 30% return on his investment in small, growing companies, knowing a good portion of them will fail.

It would be foolish to go into business ignoring the fact that things can go wrong: consultants get sued by client for advice gone wrong; businesses lose key customers and can’t pay their bills; professional firms are attacked by ransomware and cannot operate. Your best defence is your business structure.

Sole trader

A sole trader is the simplest business structure. Just start doing business on your own account and you are one by default. But as a sole trader, you are the business and the business is you. You have no legal separation from the business with all its hazards.

When your business cannot pay its debts, your personal assets are fair game for your creditors. When your business fails, it is not just the value of your investment at risk, but your house, your cash and everything else you own.

When it all goes wrong, you need to be legally separated from your business and the most common method of separation is using a company to run your business.

How a Company Protects You

A company is a separate legal person able to run commercial activities in its own name. You own your company and your company owns your business.

Company ownership is divided into shares. A small company may have 100 shares for which a sole-owner pays $1 each, investing $100 into the company. While the company itself carries unlimited exposure to business risks, the company’s owner’s risk is limited the $100 invested.

In practice, however, the limited liability can be compromised.

Examples of losing your limited liability

If you neglect to include your company name on agreements and correspondence, you can inadvertently form legally binding contracts in your own name. Always make it clear it is the company doing the business.

As an owner-operator of your company, you will also be a director. The Companies Act puts legal responsibilities on directors such as requiring them to act honestly, in the best interests of the company, and to not trade recklessly. Directors must also ensure their company prepares financial statements, files tax returns and complies with other legal requirements. Breaching these responsibilities can result in personal liability or prosecution.

Banks and other lenders to the company usually require personal guarantees from the company so if the loan cannot be paid, the directors must cover it.

When a company cannot pay its creditors, including IRD, those creditors can try to break through the corporate structure and go after the directors personally. You can protect yourself from this “lifting of the corporate veil” by making sure your legal duties are complied with.

Other Advantages of a Company

Tax Advantages

A company can save you tax. A sole trader pays tax on all profits at personal tax rates, up to 33%. A company pays tax at 28%, providing a potential 5% savings on profits retained by the company.

A company makes it easier to split income with others such as a spouse. With individual tax rates starting from 10.5%, even a modest share to a spouse with little other income can save thousands in tax annually.

Raising Funds

The division of the company’s ownership into shares helps capital raising. Others can invest in exchange for shares, entitling them to a share of future profits and gains. You can’t split the ownership of a sole trader business.

Cost and Complexity

No one likes adding costs and compliance requirements, but we are lucky that New Zealand is ranked one of the easiest countries to start a company. A company can be setup within a few hours at minimal cost.

Companies do require some additional compliance such as filing returns, preparing annual resolutions and maintaining legal registers. Neglecting these puts the director at risk. The good news is that, for a small privately-owned company, these things are not difficult. Your accounting firm can take care of the routine requirements as part of their annual accounting service.

Get it Right at the Start

The risks of business are real, even for one-person operations, so why stand in the firing line. Just make sure you get some advice on how to structure it before incorporating your company. It is much easier to set it up properly than try and fix it when things go wrong.

Contact us with your business questions.