How Discretionary Trusts Work With Profit First

How Discretionary Trusts Work With Profit First

In this weeks article I wanted to continue the business structuring discussions. To following on from the previous articles that focused on Profit First in Sole Trader and Company structures, this week I’m looking at my favourite business structure option of all…Discretionary Trusts.

While many Australian business owners are somewhat familiar with how a company works they are far less comfortable with Discretionary Trusts (often called Family Trusts). This results in many businesses being run inside companies purely because the business owner doesn’t understand the benefits the trust could offer.

What the heck is a Trust?

Trust law is complex and trust administration should always be left to professionals. Having said that, a very simple example of establishing and operating a Trust is below:

I give my wife (Jaine) $1,000 and ask her to look after it. To invest it in accordance with a list of rules i have written down and to ensure any profits generated go to our daughter (Melody).

We have just set up a very basic Trust. The members of my little family are playing the following roles:

  • Settlor – myself
  • Trustee – Jaine
  • Beneficiary – Melody
  • Trust Property/Asset – $1,000
  • The Trust Deed – My list of ‘rules’

If you currently have a trust you might find a $10 note stapled to the front of the Trust deed. That’s your original Trust asset. Don’t lose it!

Why do I love them so much?

One word…Flexibility! Trusts allow your accountant to get creative at tax time and look for ways to better manage taxable income across your family group. They help to prevent situations in which most of the business income is taxed in the hands of one person. There are limits to what the trust can do and the rules are complex, but your accountant will be across it all.

Profit First and Discretionary Trusts

If you are operating your Australian business through a Trust (or considering it) what should you consider when implementing Profit First?

Trusts and Owners Pay

Unlike a company structure the trust can ‘give’ it’s profits to the business owner(s) without the need to put the payments through the payroll system and treat them as a salary or wage. You can process the business owners as salary employees if you wish, but you don’t have to. Furthermore, people can be beneficiaries of the trust even if they don’t actively work in the business.

As I mentioned earlier this increased flexibility allows your accountant to get creative, but you need to work closely with them through-out the year to ensure the profits are flowing to people who qualify as beneficiaries and in appropriate quantities.

Trusts and Superannuation

The superannuation system is a great ‘forced saving’ mechanism. Funds accumulate in your superannuation fund because the law says that if you are an employee you must have contributions made.

A trust structure allows us to distribute profits without compulsory superannuation contributions. This can be great in cases where you want to pay off personal debt or build investment wealth outside of superannuation but it’s not right for everyone. I always recommend a financial planner is involved in those discussions.

If you’d like to make contributions from your dstributions you can, but you’ll need to set aside the appropriate amounts from your Owner’s pay account and transfer them to your superfund.

If you accumulate the funds outside of superannuation and hold them until the end of the financial year then you can make the choice when you are doing tax planning.

Trusts and the Profit Account

The same principles apply to your quarterly profit from the Profit Account. In a trust we don’t have to put this through as a wage and pay superannuation on it. However, you should consider this part of your total ‘drawings’ from the trust for the year when discussing the topic with your accountant.

In Summary

My message for all business owners who use a Discretionary Trust is this: In my opinion you have the best structure available for Profit First. While the system functions exactly as described in the book in any structure, the trust allows the maximum tax reduction potential for businesses that have outgrown the sole trader option. While they can be complex your accountant or Profit First Professional can guide you through every step.

Further Information

Read our comprehensive review of Profit First here

Join the Facebook group here

Using Profit First with Australian Company Structures

Using Profit First with Australian Company Structures

Following on from the previous article that focused on Profit First in Sole Trader businesses I thought I’d write something similar for those operating through a company structure.

An Australian Proprietary Limited Company is a considerably more complex business structure than a sole trader. As such, there are a few additional considerations that are unique to a company.

I usually like to keep my articles easy to read and, for the most part, free of references to specific tax laws. However, the issues you will run into with a company are founded in quite complex tax legislation, so this article is a bit heavier than usual!

Lets explore the points one by one:

1. Company Structures, Owner’s Pay and Division 7A

Anyone running their business through a company will have discussed Division 7A with their accountant at some point. However, for the benefit of those that are not familiar with this piece of tax legislation lets take a high level look at it.

What is Division 7A

A company is a separate legal entity under Australian law. It earns income, pays expenses and ultimately generates a profit in its own right. The company then pays tax on this profit at a rate specific to companies. Currently, most small companies are paying tax at a rate of 27.5%. This tax rate is usually lower than the owner(s) of the business would pay if all the profit was being taxed in their hands.

Now, back in the 1990’s (and prior) wealthy business owners used to abuse this company tax rate. Their businesses, which were earning 100’s of millions of dollars, would be operated through a private company. By paying tax at the company rate they would save themselves millions of dollars in tax every year.

The company would then use these profits to:

  • Buy houses, luxury cars, large boats and other items. All of which were used by the owner’s of the business/company personally, for free; and
  • Lend millions of dollars to the business owner(s) directly, interest free!

It was an incredible tax loophole while it lasted. However, in the late 90’s Division 7A was introduced to stop company structures being abused for tax savings. Now, if you owe money to your private company or you use company owned assets you must compensate the company for this (eg pay interest) or pay tax on the amounts personally.

Division 7A and Profit First

Why is all of that relevant to Profit First? Due to Division 7A accountants need to work with their clients to plan the movement of cash and profit in and out of private companies.

Businesses using Profit First set aside Owner’s Pay and a portion of their Profit Account specifically for the owner(s) of the business. However, if you just take all this cash out of the company and spend it you may inadvertently spend far more income than your accountant wants to put in your tax return for the year.

This results in a tax problem that we only really has two viable methods to resolve:

  1. Put all the income in your tax return and take the tax hit from the higher margin rates; or
  2. Enter into a loan agreement and pay the money back to the company, with interest.

If you are operating through a company and your business is highly profitable (as all Profit First businesses aim to be!) reach out to your accountant. Ask them what your maximum, after tax salary from the business should be to avoid creating a tax headache at year end. This is something they should be able to work through with you quite easily based on your goals and their plans for your business’ tax work each year.

2. What do we do with capital raised through a share issue

As a company grows there may come a point in time at which a large injection of capital is required to take it to the next level. You could borrow the funds from a bank but that requires security and interest payments.

An alternative is to sell shares to investors, this is called a ‘Share Issue’. The investors purchase partial ownership of the company and, in return, inject working capital into the business.

Share Issues and Profit First

The funds received from the investors are not ordinary income to be split between your normal Profit First accounts. Profit First companies that are planning a Share Issue must open another account specifically for this purpose. The account should be held at Bank 2 and all amounts received from the investors must be transferred to this account directly

In Summary

My message for all business owners who use a company is this: Don’t let the above information freak you out! The Profit First system will work exactly as described in the book. The items discussed here are merely Australian specific issues to keep in mind. Your accountant or Profit First Professional can guide you through all of this. In particular, Division 7A is something your accountant should have already been proactively managing. Even if its in the background without your knowledge.

Further Information

Read our comprehensive review of Profit First here

Join the Facebook group here

Want some professional help getting Profit First running in your Australian business?..We can help

Profit First Australia – FAQ’s – Sole Traders

Profit First Australia – FAQ’s – Sole Traders

I’m often asked about modifying the Profit First system specifically for different types of business structures. It is true that each business structure type, and how the structure is used, will present unique challenges. However, the fundamentals of the Profit First system remain the same.

Here are some common questions I am asked in regard to running Profit First in Australian Sole Trader businesses.

A sole trader is ‘the business’. Do I need an Owner’s Pay account?

For me, the answer is absolutely ‘yes’. While I understand that all of the business’ profits are automatically taxed in your hands anyway, using a Profit First Owner’s Pay account can still be incredibly useful.

The Owner’s Pay account accumulates funds based on your Profit First Percentages. The business owner (you) draws a fixed salary from that account each week, fortnight or month. Assuming the salary level has been set at a level the business can sustain this will mean that in good months the account will accumulate a cash buffer. In your slower months this buffer will pay your salary. This can really help business owners who are constantly stressed about the variable nature of business income. Essentially, we have created a regular, steady personal income for you from a business that may not have regular income itself. For many business owners this is a source of great comfort.

In regard to superannuation, using the owners pay account also allows for owner’s payments to be clearly tracked. Should the sole trader wish to make super contributions they can put aside a percentage of each wage payment.

Please note: as a sole trader you are not legally obligated to make super contributions for yourself. I always recommend you seek professional advice around this. Depending on your age and total income superannuation is not allows the most tax effective way to invest your money.

As a sole trader can my Profit and Owner’s Pay accounts merge into one account?

The Profit and Owner’s Pay accounts play very different roles in the Profit First system. As such my recommendation is always to have two accounts.

  • The owners pay account is responsible for providing you with your regular personal income. Your wage for services provided to the business;
  • The Profit Account accumulates funds which are allocated quarterly to either debt reduction, emergency savings or business owner rewards.

For the system to work properly those funds should be kept separate!

My car is also the business car – which account should pay the expenses?

While this question comes up with all business structures it is far more common with sole traders. It’s an important question to answer because it highlights a point at which business owners can manipulate the numbers to allow Parkinson’s law to continue eating up the business’ cash. If something really should be a business expense but we allocate it to personal just to get our total numbers closer to our Target Allocation Percentages then we are cheating ourselves.

My rule of thumb when it comes to expenses that are shared between the business and yourself personally is to use the ‘predominant use test’. If the expense is predominantly (more than 50%) personal, then you pay for it from the owners pay account. If the expense is predominantly business, then your Operating Expenses account should pay for it.

The Predominant Use Test and Tax

It’s important to note that all we are discussing here is where the cash comes from to pay the bill(s). It has no impact at all on whether your accountant can claim some of the amount as a tax deduction or not. Keep clear records of all expenses which you feel are partially business and partially personal. Give these records to your accountant at the end of the year. In the case of a motor vehicle these records should include your logbook.

In Summary

My message for all Sole Traders is this – treat your business the way you would any other business structure when it comes to Profit First. Set the accounts up the same way everyone else does. Treat the business and yourself as two separate ‘entities’ when it comes to managing cashflow.

If you stick to that approach I guarantee you’ll avoid any of the pitfalls that come with treating your business income account as a personal ATM!

Further Information

Read our comprehensive review of Profit First here

Join the Facebook group here

Business Structuring 101: Part 5 – Trusts

Business Structuring 101: Part 5 – Trusts

A trust is a business structure unlike any other. Everyone has heard of them, in particular ‘Family Trusts’ but very few business owners understand how they work. As a result, they tend to avoid them and stick to sole trader or company options. It’s such a shame because a trust can provide your tax advisor with some great tax planning opportunities, most of which are unavailable to any other structure.

The Trustee carries on the operations of the Trust on behalf of the Beneficiaries. The rights and obligations of all parties involved are contained in the Trust Deed, which is why your accountant will always ask for a copy of it!

If a corporate trustee is used the trust offers all the same asset protection benefits as using a company structure along with the additional benefits of using a trust. A trust that has individuals acting as trustees exposes the trustees to same levels of business risk as a sole trader.

Broadly speaking there are two common trust forms that you will encounter when making your business structuring decision, Fixed Trusts and Discretionary Trusts.

 

Discretionary Trusts

A discretionary trust is the most flexible form of business structure for a family trust. No single beneficiary has a fixed interest in the trust property or the trust income. The trustee has complete discretion in the distribution of funds to each beneficiary. This makes the discretionary trust (with a corporate trustee) a strong and flexible option for a family business. The family members are protected from business risk and the trustee has the discretion to distribute the income in the most effective way possible.

It is important to remember that all of the benefits offered by a discretionary trust for a family business make it a poor choice for a business where more than one family or group is involved as neither group of beneficiaries retains a fixed right to property or income.

Advantages of a Discretionary Trust:

  • Flexibility with income and capital distribution;
  • Tax planning possibilities;
  • Access to Small business CGT concessions;
  • 50% 12 month CGT discount;
  • Asset protection (if a corpoate trustee is used)
  • Can pay salaries and wages as well as superannuation;
  • Less regulations than a company

Disadvantages of a Discretionary Trust:

  • Distributions must be in accordance with the Trust Deed;
  • Risk of resettlement if changes are made to trust members or trust property without giving consideration to the rules outlined in the trust deed;
  • Losses cannot be distributed
  • Costly to establish and maintain when compared to Sole traders or partnerships;
  • Trustees can be personally liable for some debts of the trust (if individual trustees are used);

 

Fixed (Unit) Trusts

Fixed (Unit) trusts are recommended when more than one family or group is involved in the business operation. The interest in the trust is divided into units, similar to shares in a company. The Trustee distributes income to the beneficiaries in accordance with their respective unitholding in the trust. This is the key point of difference between the fixed and discretionary trusts. The units removed the Trustees discretion around the distribute income.

Advantages of a Fixed Trust:

  • Fixed Interests provide protection where more than one family or group in involved in the business;
  • Asset protection (where a corporate trustee is used);
  • Access to small business CGT concessions;
  • Access to 50% 12 month CGT discount;
  • Can pay salaries and wages as well as superannuation;
  • Less regulations than a company.

Disadvantages of a Fixed Trust:

  • Sale of units can be a CGT event and attract stamp duty;
  • Not as flexibility as a discretionary trusts;
  • Trustees can be personally liable for some debts of the trust (if an individual trustee is used;

 

Where to from here?

Business owners looking to establish their business operation inside a trust structure can experience a number of benefits. However, there are also a number of potential issues that must be carefully managed. I would never recommend any small business owner work through this process without seeking some sort of professional advice. Panic Atax works closely with every client we have that operate through a trust to ensure all the risks are managed and any potential issues are identified early enough to correct them.

I would encourage you to read the rest of the articles in this series. Each article explores a different structuring option and its important to understand all of them to make an informed decision. In particular, you may want to read our article on private companies.

Business Structuring 101: Part 4 – Companies

Business Structuring 101: Part 4 – Companies

In the second installment of this series we looked at Sole Traders, where the individual is the business. Now its time to explore the other end of the spectrum. A company is a completely separate legal entity from those who own and operate the business. A company has directors who run the business and are responsible for the day-to-day administration of the company. The ownership of the company sits with the shareholders. Anyone who has ever purchased a share on the ASX would be familiar with this concept.

When small business owners start to consider restructuring their operations the most commonly visited option is a company. They’re familiar and most business owners are aware that they offer significantly improved asset protection for business owners over the sole trader option. While asset protection is certainly on the checklist of things to think about when choosing your business structure, it is not the only consideration.The Pros and Cons of using a company are briefly outlined below.

 

Advantages & Disadvantages

Advantages

  • A company can be owned and run by one person;
  • Shareholders are not responsible for company debts unless they sign a personal guarantee;
  • Easier to attract capital because of limited liability;
  • Companies can operate globally and own properties;
  • Companies pay a flat 30% tax on every dollar of profit regardless of home much money is earned. This rate falls to 28% for small businesses;

Disadvantages

  • Relatively expensive to establish and register;
  • Record keeping requirements and compliance costs are generally higher;
  • Shareholders may have difficulties in recovering their investment because of limitations on who can buy shares;
  • Funds taken out of the company by the owners that are treated as wages attract the usual PAYG withholding and superannuation obligations imposed on any employee;
  • Companies that hold Capital Gains Tax assets do not receive the 50% tax discount for holding the asset for more than 12 months that an individual would be entitled to.

 

Division 7A

Business owners who are considering operating through a company structure must consideration Division 7A. Division 7A essentially seeks to prevent directors and shareholders of private companies from taking the company’s profits for personal use. Individuals who take ‘Drawings’ from a private company have until the lodgment date of the company’s income tax return to either repay the funds in full or enter into a loan agreement with the company. If you fail to do so you will have to pay tax on the full amount taken in the current financial year in your own name. This could mean paying in excess of 40% tax on income that the company may have already paid up to 30% on. As you can imagine if the sum taken from the company is significant this can result is a substantial tax bill.

 

Where to from here?

Business owners looking to shift their business operation from a sole trader into a private company can experience a number of benefits. However, there are also a number of key differences and potential issues that must be carefully managed. I’d never recommend any small business owners work through this process without seeking some sort of professional advice. Panic Atax works closely with every client we have that operate through a private company to ensure all the risks are managed and any potential issues are identified early enough to correct them.

I would encourage you to read the rest of the articles in this series. Each article explores a different structuring option and its important to understand all of them to make an informed decision.

Business Structures 101: Part 3 – Partnerships

Business Structures 101: Part 3 – Partnerships

A partnership is a common and relatively inexpensive way to set up a business in which more than one person has control and ownerships. It involves two or more owners (the partners) operating a business together with the intention of making (and sharing) a profit. While a Partnership can be a great way to bring additional capital and knowledge to the business issues can quickly develop where the parties are each moving in different directions and don’t effectively communicate with each. You need to work as a team rather than multiple, independent business owners.

 

Why is the intention to make a profit important when looking at Partnerships?

The focus on making profit is the key difference between a Partnership and a Joint Venture (JV). Partners in a Partnership operate a business and share in the profits generated whereas parties in a Joint Venture share in the knowledge or products produced by the JV and generate profits independently. A common example of a JV we see in Australia is when two or more mining companies enter a JV to develop a new coal mine. The JV pools resources from the mining companies and operates the mine. However, the companies don’t share in ‘profits’ from the mine. They each receive an amount of coal from the site, sell this to their own customers and keep all of the profit achieved from those sales.

 

Should there be a Partnership agreement?

While it is not compulsory to have a formal agreement when establishing a business under a partnership structure, a formalised partnership agreement spelling out the rights, responsibilities and obligations of each partner can be a great communication and planning tool. Setting expectations up front saves unnecessary arguments later on. Maybe we need formal marriage agreements as well? I’ll leave that up to you to decide!

A partnership can exist with no formal agreement between the parties at all. In the absence of a partnership agreement The Partnership Act of 1891 sets out the various rules that govern the conduct of partners in a partnership. The act places joint liability on all partners for debts and obligations incurred by the business during their involvement in the partnership. Partners are obligated to keep their co-owners properly informed.

 

Who Pays the Tax?

While a partnership is a separate business operation to the partners involved, having its own Australian Business Number (ABN) and Tax File Number (TFN), all the business profits are taxed in the hands of the partners at their respective marginal tax rates.

 

Pro’s and Con’s of Partnerships as a Business Structure

Advantages of a Partnership:

• Easy and inexpensive to establish and maintain;
• Fewer reporting requirements;
• Any losses incurred by the business may be offset against other income earned (such as investment income or wages) by each partner subject to satisfying certain conditions;
• Partners are not considered an employee of their own business – no payroll related expenses need to be paid on their profit share (Superannuation, Workcover Insurance etc).
• Relatively easy to change your legal structure if the business grows, or if you wish to wind things up.

Disadvantages of a Partnership:

• Unlimited liability which means all personal assets are at risk if the business operation gets into trouble;
• Some of your control over the business assets and decisions needs to be relinquished;
• Business debts and losses cannot be shared with anyone except the partners;
• Requirements to pay preliminary tax on business income which may not have been earned;
• Limited access to additional capital;

The main item to watch out for with partnerships is shared liability, particularly where the partnership is between multiple individuals (rather than multiple companies or trusts). Unless your business partner steps well outside what would be consider acceptable conduct under the partnership agreement or the Partnerships Act you are mutually liable for everything they do and all debts the business accumulates. This can place your own personal assets at considerable risk.

 

What do we think of Partnerships?

We recommend business owners avoid operating partnerships where the partners are individuals and carefully consider whether or not a partnership is necessarily the way to go even if the agreement is between companies or trusts. If you are currently considering a partnership as a business structuring option we recommend you read our later articles in this series that look at companies and trusts, or contact us for assistance if needed.

 

Where Do You Go from Here?

This article is the third in a series. To learn more about a particular structure option I would recommend reading further in series as each article is published.
For some professional advice on Business Structuring Contact Us.

 

Working with Panic Atax

Panic Atax is a Brisbane based Accounting and Business Advisory firm specialising in building strong relationships with clients and removing the stress many small business owners experience around Financial Reporting, Tax and Cash Flow. If you’re looking for an accountant to build a great, long term working relationship with we’d love to hear from you.