Deciding on an Operating Entity
In too many cases the operating entity of a farming business is treated as a “set and forget”. It may have served its purpose for the last 20 years or longer and everyone has got used to the status quo. This approach can have serious detrimental effects. Many aspects of the business may have changed and the external environment, from a legal and tax perspective, will certainly have altered over time.
If you ask your accountant “what is the right operating entity for my business?”, they may well focus on the tax implications in determining the right structure. If you ask your solicitor, they are more likely to be concerned about protection against unforeseen liabilities. If you ask your business partners or family, they may want it to be simple and inexpensive. All may be right from their own particular perspective.
The following is a brief overview of a few of the advantages and disadvantages of some common structures.
Sole Trading and Partnerships
These are extremely common and are simple structures that are inexpensive to maintain. They serve many farming families well.
One of the important advantages of a partnership is the ability to utilise losses. If a taxable loss is incurred by a partnership, then that loss can be distributed to the partners who can then utilise their share of the loss to offset against other income received that year. This can be important if a partner is earning income in a personal capacity outside of the farm.
They do however, have a number of important limitations.
• They do not protect personal assets and landholdings
from business risks. Farming is a risky commercial business. If the partnership assets and insurance cover are insufficient to cover a claim against the business (or a claim is not successful), each partners’ personal assets, e.g. houses, landholdings etc., can be liable to satisfy these claims.
• With partnerships, each partner is seen to personally own a fractional interest in the partnership and, as such, their share of their assets can become embroiled in their personal dispute. This can be exceptionally disturbing to the other members of the partnership. Further to this, all partners are jointly and severally liable to the activities and actions of the other partners in the partnership.
• They are not conducive to future succession needs and other changes. Although there are a number of restructuring concessions available, in general, when people exit partnerships, by death or retirement, or enter partnerships by the addition of new partners, the old partnership dissolves and a new partnership is created. This event can create both income tax and stamp duty liabilities.
• With a fixed structure like a partnership, there is little opportunity for each partner to share the income and capital of the business with their spouse, children or other entities e.g. companies, etc. As a result, partnerships are very inflexible when it comes to the management of income tax.
Family Discretionary Trusts
Another common vehicle used as the operating entity on a farm is a Family Discretionary Trust. In a trust structure the assets of the family are held by the trustee on behalf of the trust beneficiaries. The trustee is responsible for the day to day activities of the trust. Again, the trustee does this on behalf of the trust beneficiaries.
By using a Company to act as trustee for both trading and landholding trusts, the beneficiaries can protect personal assets from business risks. The beneficiaries are protected if the deed is correctly worded as they usually have no value in their potential interest in the trust. The trustee can be personally liable for the debts of the business but is usually indemnified out of trust assets to the extent they are available.
If the trustee is a company, a Discretionary Trust offers greater protection against business risks. Potential beneficiaries are not entitled to any assets or income of the trust estate until the trustee exercises their discretion. This provides considerable flexibility in relation to trust income and asset protection.
Discretionary trusts are also useful vehicles for succession purposes. They allow for a gradual change in ownership without relinquishing total control. For instance, Mum and Dad can hand over the trustee powers to their children and still remain as the trust’s appointors. The appointor has the power to dismiss and appoint the trustee. At a later time, they can resign their positions.
This methodology can be useful in the event of a marriage break down. By spreading the control of assets there is less likelihood that the trust assets will be included in a marriage settlement.
One of the matters that needs to be taken into account is the potential for the governing deed to come into conflict with the rules and procedures that individuals wish to apply to the business. The trustee is the operator of the business and is answerable first and foremost to the terms and conditions of the Trust Deed.
It is important that any directions do not fetter the powers of the trustee. A solution is the establishment of a ‘Business Management Agreement’ to give the trustee a set of guidelines and a framework to work within. For example, the agreement could contain a decision-making policy that determines how decisions are made (e.g. what decisions by majority, unanimous etc.) it should not, however, dictate to the trustees what those decisions must be.
Partnership of Trusts
One of the conditions of obtaining vital Small Business CGT Concessions is the $6 million net asset value test. The test applies to the relevant taxpayer. If the net value of the business exceeds $6 million, a company or trust structure will not be eligible for the concessions on an asset sale.
The same result does not apply to a partnership of Discretionary Trusts where you have a partner with a less than 40% interest. In this case, the relevant taxpayer is each partner. This means where the partner has a less than 40% interest, you only take into account the value of the partner’s share in the business. If for example, you had four equal partners of the business (25% each) and they did not own any other assets required to be taken into account, the net value of the business could be up to $24 million and still be under the maximum net asset value test.
Companies are useful structures if you wish to cap your tax rate at 27.5%.
• They can’t use FMDs
• They are ineligible for primary production averaging
• They cannot obtain the general 50% CGT concession
• There are tax issues on eventual wind up
This article is simply a brief overview of operating structures and there are advantages and disadvantages with each. Your professional advisor is best equipped to guide you through the maze. Keep in mind, however, that business structures do not manage farms, people do. The structure should suit the needs, aspirations and goals of the stakeholders and not be driven from only one perspective.