Posts

Choosing a Business Structure

/in /by

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.

Registering Your New Business with IRD

/in /by

Registering your New Business with IRD

If you have decided to start a business, your first question may be whether you must register the business with IRD.

Let’s first clarify what a business is. A business is an activity carried on to make money. Your business will be owned and operated by a legal entity such as an individual (you) or a company. It is the legal entity operating the business that must be registered with IRD. The business activity itself cannot be separately registered as it is not a legal entity and therefore cannot form contracts in its own name.

If you start a business under your personal ownership, rather than using a separate entity, you are a sole-trader. You are the legal entity running the business and, so long as you have an IRD number, you are already registered with IRD.

If you form a new legal entity to run your business, such as a company, partnership or trust, that entity will need to register with IRD and get an IRD number.

If the legal entity is not already GST registered, and the new business is expected to sell more than $60,000 of goods or services per year, it will generally have to register for Goods and Services Tax (GST).

Contact Robb with any questions.

Should you be a GST Registered Consultant

/in /by

Should You be a GST Registered Consultant?

If you are starting out as a consultant, you may or may not have to be GST registered. If it is not required, it may or may not be to your advantage to register voluntarily. This article explains why.

How does GST work?

Goods and Services Tax (GST) is collected by GST registered consultants (and other businesses), from their clients, and passed onto IRD. GST registered consultants also claim back, from IRD, the GST content of their expenses. When a consultant’s GST collected on fees exceeds GST paid on expenses, the excess is paid to IRD. If GST paid exceeds GST collected, the shortfall is refunded by IRD.

Who can be GST registered

A business, or consultant, can generally be GST registered providing they sell taxable supplies. Taxable supplies are the sale of goods or services. If you are a consultant, you almost certainly are providing taxable supplies to your clients.

GST charged on consulting fees

GST registered consultants add GST to their fees charged to clients. With a couple of exceptions mentioned below, GST is charged at the standard rate of 15%. So, if a GST registered consultant charges $100 for their service, they generally add $15 GST and charge their client $115 including GST.

Zero-rated supplies

Certain taxable supplies are zero-rated, meaning GST is charged at 0% instead of 15%. Zero-rated supplies include:

  • exported goods or services
  • sales of a whole business as a going concern
  • sales of land from one GST registered person to another.

A GST registered consultant generally charges GST at 0% on services provided to overseas clients (exported), unless the services relate to property in New Zealand.

Exempt supplies

Certain types of supplies are exempt from GST. If you are in the business of providing these, you cannot be registered for or charge GST. Exempt supplies include:

  • salary or wages
  • residential rent
  • interest (whether paying it or receiving it)
  • most other financial services
  • sales of fine metals.

Should a new consultant register for GST?

If a consultant’s fees exceed $60,000 per year, they must register for GST. Even if their fees are likely to exceed $60,000 over the following 12 months, they must register.

If a consultant’s fees are less than $60,000, the consultant has the option of becoming GST registered or not. Voluntary registration may be worthwhile depending on the consultant’s circumstances.

Advantages of GST registration for consultants

The major advantage to a GST registered consultant is claiming back GST on business expenses. A non-GST registered consultant must wear the cost of GST of all GST inclusive expenses including:

  • Vehicle running costs
  • Computer equipment
  • Books and training costs
  • Office rental (offices are commercial rents so not exempt from GST like residential rents)
  • Big items like motor vehicles or even office buildings

Note however that once an asset such as a vehicle has been purchased by a GST registered consultant and the GST claimed, GST must be charged on a subsequent sale of the asset.

Disadvantages of GST registration for consultants

There are two potentially significant disadvantages to being GST registered: GST registered consultants must charge their clients GST and they have GST compliance requirements.

Charging GST to clients

Charging GST to clients may or may not be a problem depending on the type of client the consultant has.

For a consultant selling business to business (B2B) services, GST registration may not be a problem. The B2B consultant’s clients will generally be GST registered businesses themselves and can therefore claim back the GST. Paying a non-GST registered consultant $100 with no GST to claim back equates to paying $115 to a GST registered consultant and claiming back the $15 GST.

For a consultant selling business to consumer (B2C) services, GST registration is a problem. The non-business clients will generally be unable to claim back the GST content, so it does not matter to them whether the consultant is GST registered or not. If the maximum they will pay for a service is $100, the consultant will have to suck it up and return the GST content out of the $100. The GST registered consultant is wearing the GST cost.

For a GST registered B2C consultant, the costs of paying GST out of their sales will exceed the benefit of claiming GST on expenses unless their expenses exceed their sales and they are losing money. For B2C consultants, I suggest not registering for GST until you have to.

GST compliance requirements

The other disadvantage to GST registration is the compliance obligations. A GST registered consultant must prepare and file GST returns, make payments to IRD, prepare tax invoices for sales and collect tax invoices for purchases. These records must be kept for seven years. Of course, accountants or bookkeepers can do most of this for you and modern accounting software makes it a whole lot easier.

If a GST registered consultant breaches any of their obligations, they are exposed to IRD’s penalties regime which can be very costly.

Summary

If you provide taxable supplies exceeding $60,000 per year, you must register for GST. If your supplies are below $60,000 per year, you have a choice.

For B2B consultants, I would generally recommend registering voluntarily as the GST charges should not hurt your sales and you can claim GST on expenses. I would only suggest staying non-registered if the GST on your expenses are not worth the GST compliance hassles.

For B2C consultants providing services to non-GST registered people and organisations, I recommend remaining non-registered until you must register. It may be tempting to register if you intend claiming GST on a large business asset such as a vehicle, but ultimately, if you are successful, your sales will exceed your costs and the loss of 15% of those sales will exceed the 15% reclaimed on costs.

Avoid the New Business Tax Trap

/in /by

Avoid the New Business Tax Trap

Whether we like it or not, a lot of our money goes on tax. With up to 33% of our profits going to income tax alone, tax has a major impact on our business’s cash flow. But when we start a new business, it can be up to two years before we need pay a cent, making it too easy to put our head in the sand.

It does catch up with us. Facing two years of tax, payable within a month, can be enough to knock a fledgling business over. This is one bill that a new business owner must have a plan for.

The start-up

Take Sally, an Interior Design Consultant. She starts some private work in April 2016 hoping it might lead to a fulltime business. After a couple of successful projects, referrals start coming in from a busy boutique architectural firm. By January 2017 she is flat out. Money is coming in but also pouring out.

The busier she gets, the more she spends to save time – a house cleaner, child-care and eating out several times a week.

Sally also worries that her personal image isn’t compatible with her profession. Rolling up to a new prospective client’s home in her trusty 14-year-old station wagon wearing an old sweatshirt isn’t inspiring confidence in her as a style expert. So, she starts regularly upgrading her wardrobe. She also trades the station wagon for a respectable four-year-old SUV.

Sally’s second year in business gets even busier. She knows something must give and plans to hire some administration help, if only she had time to advertise and interview. Other than visiting an accountant when she first started up, who tried to explain her tax requirements and registered her for GST, she has done everything herself.

By February 2019, Sally knows she needs to sort her accounts out. She puts aside a day, collates her financial records and visits the accountant who helped her at the start. It is a relief to finally hand a job over, but she isn’t prepared for what is coming.

On the 20th March, her accountant emails her financial statements and a tax return showing a $75,000 profit in the tax year ended 31 March 2017. She finds it hard to believe as there sure isn’t $75,000 in her bank.

He also tells Sally she has $15,670 income tax payable for that year, due in 18 days. Right now, Sally isn’t feeling too good. She knew she should have been putting money aside for tax, but always needed things for the business.

To top it off, the “Provisional Tax” that the accountant had warned Sally about at that initial meeting has also reared its ugly head. Sally has $16,454 of provisional tax, for the year to 31 March 2018, due by 7 May.

That is over $32,000 of tax due in the next seven weeks.

How did it get to this stage?

By 7 May 2019, when the $16,454 provisional tax is due, Sally has been working for just over two years. Her tax payments on 7 April and 7 May 2018 are the tax liabilities on two years’ profits.

When starting a business, it is easy to ignore a bill that you won’t see for up to two years, especially when there are more pressing, and more interesting, things to focus on. But as soon as you are making money your debt to IRD is accumulating.

How to plan for tax payments

Every business should have a financial plan, including a cash flow forecast, to plan for major financial commitments including purchasing equipment and paying tax. The plan will show you what percentage of your income received needs to be put aside for commitments such as income tax, GST and ACC levies. Once you have these commitments clearly scheduled into your plan, it is easy to find the discipline to put the money aside. Not so when they are a big unknown on the horizon.

It is well worth a modest investment at the start of your business journey to get professional help with your financial plan and take control of your business commitments before they take control of you.

Contact us with your business questions.