Quite often this is one of the first questions we get asked, and the answer isn’t always straightforward. It depends on so many circumstances and is very specific to each client’s situation. However, we will provide some generalized information in an attempt to answer the question as best we can without knowing your individual circumstances.
There are four main tax structures that we will go into; sole trader, partnership, company and trust. That is also the order of complexity of each structure, the least complex being sole trader and the most complex being a trust. The more complex the structure, generally the more expensive the accounting fees. What business structure you choose affects how your business operates in the law, and what it is protected against if something goes wrong.
Sole Trader
The sole trader structure is where you operate under your personal name, so all income and expenses are taxed in your personal name. Individuals are taxed at marginal tax rates starting at 10.5% for income earned up to $14,000 and increase to 39% for income earned over $180,000. We often find people think they need to set up a company to go into business, however that is not the case. As a sole trader you can employ staff, be GST registered and operate any type of business you like.
Advantages:
Easy to set up and administer (lower accounting fees)
Disadvantages:
Assets owned in your personal name are subject to claims if you are unable to pay business debts
Subject to higher tax rates if earning over a certain threshold
Partnership
A partnership is where two or more people go into business together. This may be set out in a partnership agreement, which details how the profits and debts will be split, and the day-to-day running of the business. However, in most farming partnerships involving a husband and wife (or partners) this isn’t the case. A partnership involves a high degree of trust as all partners must operate in good faith.
Advantages:
Less compliance cost (lower accounting fees)
Business profit split between all partners to utilize lower individual tax rates
Profit can be split in proportion to the amount of work done, eg. If a partner works outside the business they could get a lower split to maximise tax efficiency
Disadvantages:
Required to apply for an IRD number for the partnership and register for tax types (eg. GST)
Assets owned in your personal name are subject to claims if you are unable to pay business debts
Each partner is joint and severally liable for the results of actions of the other partners so your partner runs up a large debt in the name of the partnership, the creditor can demand payment from you
Profits taxed in partners individual names so can create tax inefficiencies if partnership earns a decent profit
There can be tax consequences if there is a change in partners, for example if the partnership owns depreciable property or livestock
Company
A company is a separate legal entity from the people that own it (shareholders) and run it (directors). It tends to be the structure of choice for most businesses.
Advantages:
Limited liability – if the company owes a debt the directors and shareholders personal assets are protected (however it is becoming more common for directors to be liable for company actions as they are the ones operating the company)
Company tax rate is a flat 28% so offers tax advantages compared with individuals who are taxed at 30% or higher on income earned over $48,000
Disadvantages:
Company set up fees
Extra compliance involved with annual returns, minutes and resolutions, and the maintenance of an Imputation Credit Account
Tax complications that catch people out such as having to charge FBT on company owned vehicles, overdraft shareholder current accounts being subject to interest, and having to pay rent on farm house
Farm Ownership and Trusts
Trusts are usually only set up to own assets - it is not common or recommended to set up a trading trust. If you are buying a significant asset such as a house, commercial property or farm, this is when you might consider settling a trust and the trust buying the asset. This enables asset protection and allows assets to be passed from one generation to another. In the case of a commerial property or farm, the trust would lease the asset to the operating entity. The trust may own shares in the company, which enables dividends to be paid to the trust, which can then be distributed to the beneficiaries. Trust legislation is becoming more onerous and costly so careful thought needs to be given when settling a trust. Trusts are also expensive to set up, maintain and wind up.
What structure should I select?
If you are already in business, it may be easier and cheaper to stay with that business structure and discuss changing the structure with your accountant when changing business type. For example, if you are already operating as a sole trader or partnership when contract milking you may consider changing to a company when you go sharemilking. Assets can be sold across to the company when the company is set up. This does incur additional accounting fees so may not be the most cost-efficient option if done while you are still contract milking.
For a business earning up to $100,000 a sole trader is still a good option if you are single or have a partner who earns a decent off farm income. If your partner doesn’t have an off-farm job, a partnership is still a good option as you can split the profit and utilize the lower individual tax rates.
The point at which we start recommending a company is around $150,000+ profit if both partners are working in the business. Up until this point in a partnership, each partner is earning up to $75,000 each and at anything more than this, the tax saving is usually greater than the additional compliance cost of a company. If one partner earns a decent income outside of the business (over $70,000) the threshold for recommending a company may be lower. However, this depends on factors as stated below.
If you are new to business, thought should be given now as to which structure is best from the start. Factors that influence the decision include what your long-term plans are, whether you own personal assets such as a house, and whether you have a partner and what they do for work.
There can be tax consequences when assets are transferred between associated parties (ie. from a sole trader to company), particularly if there is livestock valued on National Standard Cost.
Sharemilkers can earn in excess of $200-300,000 during high milk price years so it is beneficial to have a structure that allows more tax planning (ie. a company). Sharemilkers also tend to take on more debt so limited liability is advantageous (however the banks will often make you sign a personal guarantee anyway).
As you can see, there are many factors to consider and the answer isn’t straightforward. Your best option is to discuss with an accountant the best option for you, and this is especially important when first going into business so that you get the right structure from the start.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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