Business mentor: Structure makes real difference

Q.What are the pros and cons of forming a limited company, partnership and other alternatives? Under what circumstances can the owner be paid a wage with tax deducted?

Peter Taylor* of BDS Chartered Accountants replies:

A. There are many considerations and it is normal for your adviser to discuss such things as your reasons for going into business, your goals and ambitions, your attitude towards saving for tax as opposed to paying as you go and your personal situation, all of which will have a bearing on the right decision for you.

Moving into the correct structure can involve considerable time and frustration. But the wrong decision can result in paying more tax than necessary.



It is useful to ensure all those affected by the decision, such as partners and spouses, are with you when you discuss this with your adviser, to give their input and gain their agreement.

Any recommendation about the best structure will usually cover assumptions about distributions and income for these parties.

Partnership

A partnership is by definition an association of persons. It is relatively inflexible: the partnership does not pay tax on its income and a tax-paid salary can be paid to a partner only where there is a contract of service.

At the end of each year the net profit is shared in accordance with the pre-determined split - for example, one-third to one owner and two-thirds to the other.

The IRD can reallocate the payment of salary, wages, share of profits or other distributions if it considers they do not fairly reflect the nature and extent of the services provided.

I recommend a partnership agreement that includes reference to the services provided.

Two serious shortcomings of partnerships are that the partners can be sued personally and are liable in full for acts of all the other partners. As a consequence borrowing can only be in the joint names of the partners, as each partner is personally liable to the lender. For example, any secured borrowings can result in the partners losing their family homes if the business becomes insolvent.

In addition, and most importantly, any unresolved disagreement between the partners can and often does lead to dissolution of the partnership.

There are some advantages: being a relatively informal structure, any understanding can be altered by the mutual agreement of all partners, and it is relatively quick and inexpensive to set up.

Company

Companies have significant advantages over a partnership. A company is a separate legal entity under the Companies Act.

Registered documents will usually include a constitution and consents for those agreeing to act as directors and shareholders.

The company has an unlimited life and if capital is fully paid up the shareholders are not normally liable for debts of the company.

However, this is subject to any breaches of the Companies Act, that is, trading recklessly or knowingly trading while insolvent. It is also subject to any personal guarantees given to your bank.

The company can take legal action in its own name and can borrow in its own name.

Transferring ownership can be as simple as selling all or some of the shares. Where there is a disagreement among the shareholders all or part of the shares can be sold at fair market value and the continuity of the business and the goodwill maintained. If shares are sold to a third party the business can continue to trade without disruption.

The company must pay tax at 33 per cent on any profits it retains. However, the shareholders can distribute the profits in three ways.

The shareholder can take drawings throughout the year and at the end of the year a shareholder salary can be approved. The shareholder will have to pay income tax on this.

Shareholders can be paid a salary with PAYE deducted in the normal way. These salaries are deductible for the business as an expense and reduce the tax payable by the company. An added benefit is that the amount of provisional and terminal tax the shareholder must pay is reduced.

The company can pay dividends to shareholders (after tax has been paid on company profits).

Other structures that you may consider are a Loss Attributing Qualifying Company (LAQC) or a trading trust. However, these should be used with care.

Setting up in business is fraught with difficulties. Getting this decision wrong could cost a lot more than a visit to your professional adviser.

* Peter Taylor is managing director of BDS Chartered Accountants, a firm specialising in business development for small to medium-sized businesses. You can contact Peter at 0800 829-627 or at petert@taxmaster.co.nz

* Send Mentor questions to: ellen_read@nzherald.co.nz

Answers will be provided by Business in the Community's Business Mentor Programme.