Recommending the wrong business structure for a client can raise significant governance issues and management responsibilities, expose operators to personal liability, impact the ability to raise equity, and impose higher tax liabilities and compliance costs. Despite the long-term implications for business operations, there is a lack of Australian research on this topic.
In our study on choice of business structure, we found that advisors recommended a combination of structures to their clients operating small and medium enterprises (SMEs), with companies and discretionary trusts featuring prominently. The focus of this article is the underlying reasons for business structure advice provided by SME advisors, which is important to understand what advisors are trying to achieve.
Our analysis demonstrates that there are two core attributes that advisors seek to achieve for their clients – tax minimisation and asset protection.
Key findings
In this study, 48 professional advisors were provided with one of 12 SME business scenarios, with each business scenario having different circumstances such as industry, turnover, number of active owners, number of employees and family circumstances.
During interviews, they would provide their business structure recommendations for the scenarios described, followed by the reasons behind their recommendations. Thematic analysis of the interview data was used to determine if there were common reasons behind the recommended structures and unique reasons given the different factual circumstances behind the scenarios.
In the study, all but one advisor recommended a combination of business structures for each business scenario, namely companies and discretionary trusts. The main combinations were a trading company owned by a discretionary trust and a trading trust with a corporate trustee.
The reasons for recommending a discretionary trust within a combination of structures were for tax benefits (tax minimisation, income splitting/flexibility of income distribution, and access to capital gains tax concessions), asset protection, and succession planning or exiting the business. Implementing a company within a combination of structures related to the benefits of low corporate tax rate, asset protection, succession planning or exiting the business, limited liability, and the ability to retain profit.
The factors most frequently referred to by participants (75% –100% of participants) were tax minimisation/tax rate (94%), complexity and compliance costs (94%), asset protection (92%), separation of assets from business risk (87.5%), income splitting/flexibility in distribution (81%), requirement for working capital/ability to retain profits (81%), and small business concessions (79%).
The factors referred to with medium frequency (50% – 75%) were succession planning/exiting the business (73%), limited liability (69%), and industry (54%). Superannuation (25%) was the factor mentioned least frequently (less than 50%).
The focus on tax appears to be multifaceted, which includes benefits obtained from the lower corporate tax rate (compared to the highest marginal rate for individuals), the imputation credits on franked dividends, and the distribution of franked dividends through discretionary trusts.
Complexity and compliance costs factors were identified when the participants were asked about the disadvantages of their recommended structure. They indicated that adopting a combination of business structures for one enterprise could be complex and incur high compliance and administrative costs.
Recommendations for future tax policy
The disparity of tax rates and tax treatments amongst business structures appears to influence the choice of the business structure. The findings indicate that advisors’ recommended use of trusts in SME business structures is tax-driven and inconsistent with the tax neutrality principle. This situation raises the issue of whether measures should be implemented to move Australia closer to achieving tax neutrality.
One recommendation is to apply a uniform tax rate to all business structures, including companies, trusts, partnerships, and sole proprietorships. For instance, in Denmark, under the Business Tax Scheme, the business income of individuals who conduct their business through a sole proprietorship or partnership can be taxed at a rate equivalent to the corporate tax rate if it is retained for business purposes. However, if a business owner were to withdraw business income, the withdrawal amount would be subject to individual tax at the marginal tax rate, with a tax credit for the tax already paid.
Introducing such a tax system in Australia could be extended to cover sole proprietorships, partnerships, and trusts. Applying a 25% or 30% tax rate across all business structures on income that needs to be retained could achieve greater tax neutrality amongst different business structures. This measure could also encourage businesses to generate and retain capital to finance expansion and growth.
Overall, the goal of tax neutrality is an essential factor, as it is of concern that the non-neutrality in the current Australian tax system could incentivise taxpayers to implement suboptimal business structures to operate their businesses. Achieving neutrality requires SMEs to choose the business structure that is most appropriate to meet their commercial needs without being influenced by the biases in the business taxation system. Breaches of tax neutrality may result in economic costs for businesses and less efficient outcomes for the nation.
For these reasons, it is crucial to determine the underlying reasons for adopting business structures in Australia and the commercial implications of such adoptions, particularly whether discretionary trusts are effective business structures for business operations.
Journal article
Barbara Trad, John Minas, Brett Freudenberg and Craig Cameron, ‘Reasons Behind SME Advisor Business Structure Recommendations’ (2024) 39(1) Australian Tax Forum 93.
Neutrality requires income be taxed once and once only not in the hands of the entity which earns it but in the hands of the person who enjoys it.
Therefore income splitting corrects tax design distortions.
Running a business through a company is an obvious preference for limited liability reasons. But it is persecuted through full taxation on capital gains earned and distributed.
It is simplistic from capital raising and sale, but a purchaser takes on its historical baggage.
Of course, structures through which profits and gains can be shared by the family members is a focus of advisers – they would be negligent in not doing so. As we age, we are conscious of the transfer of assets on death. Better to have assists held in a family entity so that death does not disturb the continuity of the assets – and it better reflects the intention of building assets for the benefit of the family members rather than one person.
All of the tax reviews since 1985 have observed the inefficiency of the classical corporate tax system. The preference of all is for the profits and gains of an operating entity to be shared amongst the beneficiaries of the profits and gains. The best way is to tax intermediate entities as flow through (e.g. partnerships and trusts). In a corporate sense this is an integration model. Imputation was a half way house. But even though a limited reform, it has been astoundingly successful for the efficiency of capital markets. And in no small way operates as a reverse transfer pricing mechanism… Australian companies prefer to pay Australian tax rather than foreign tax.
Indeed, flow through is the correct approach and it should be applied to labour income as much as capital income. The idea that a wage is solely the income of a man who is sharing it with a wife and children is nonsense and vice versa.
Labour income is shared both within and without the nuclear family unit.
Tax systems which fail to recognise income sharing are fundamentally non-neutral and penalise workers raising families.
So Treasuries end up successfully taxing their flock of taxpayers out of existence.
Welcome to the re-run of the Later Roman Empire – demographic and fiscal implosion plus currency debasement.