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ARE YOU CONSIDERING COMMENCING A BUSINESS

By Jeff Daniels,2014-07-09 19:40
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ARE YOU CONSIDERING COMMENCING A BUSINESS ...

Considering Commencing a Business? ?

    (What the best business structure will do for you)

Before commencing your business, whether a trading business, or a business

    consisting of investments such as property, or shares, you should carefully consider

    the range of structures available. You should also seek the best professional advice.

The Benefits of an Appropriate Business Structure

Many international writers on business, including Robert Kyosaki in his “Rich

    Dad Poor Dad” as well as his subsequent books, and John Burley in his book,

    stress the importance of establishing the best business structures, before

    commencing. The best structure will provide all, or at least some of the

    following benefits:

    1) Asset Security.

    (1) Business Risk The litigious society we now live in, results in

    businesses and people being sued, because of a claim that

    dealings between parties, has caused one of those parties to

    suffer real or imagined losses. Often those who would claim they

    have not directly caused any loss are caught in the „loop‟ and

    can be made

    accountable. Even if

    they have not caused

    any loss, it can cost very

    large sums to merely

    defend a claim. Because

    of this risk, people

    operating a business in

    particular face a higher degree of risk of losing their hard earned

    assets. The company or (corporation) in business, faces risk.

    Not only from legal claims, but just by engaging in business. An

    example is the trading and business risks and problems

    encountered by construction companies. Even a profitable

    business can be a casualty, through inadequate cash flow. The

    limited liability provided by registering a company will

    theoretically protect the company at this first level of risk. This

    means that the total value of the capital chosen by the

    shareholders and funded by them is the amount the

    shareholders are prepared to risk. However in practice, they will

    often lose more. This can be caused by shareholders‟ or family

    members‟ loans, which have not been secured adequately.

    (contact Company Solutions if you would like specific advice on

    how to solve this problem). Also personal guarantees by

    directors and/or shareholders to Banks, finance companies and

    suppliers for credit provided, will extend the personal risk, way

    beyond the limited liability of the company.

    (2) Directors Risk Clients trading through companies often

    consider that all their risks are handled because of the

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    (3) company‟s limited liability. This is not so. Directors also face

    personal director‟s risk. This can eventuate, if a customer takes

    legal action against the directors on the basis that they suffered

    loss, which was caused by a director(s) who traded recklessly,

    or without due care as a director, or traded while the company

    was insolvent. The measurement of duty

    of care required to be performed by a

    director, is of course very subjective. The

    individual directors would be unlikely to

    consider they had failed the standard, but

    more importantly, the lawyers acting on

    behalf of the injured customer and the Court may well take the opposing view.

The two effective protection measures to have in place at the

    beginning of directors appointment are: firstly directors liability

    insurance. This insurance cover will protect the director up to a

    nominated sum (normally $1 million as a minimum). This insured

    sum has to high enough to meet any expected risk, as any

    liability above the insured amount is the personal liability of the

    director. The premiums are a tax deductible expense by the

    company. Company Solutions Limited can assist with additional

    advice and referrals to competent professional insurance

    brokers for quotations.

The second protective measure is to have almost all the shares

    (say 98%) owned by the directors family trust. Should the

    director be found to be personally responsible for a claim, then

    he or she will need to have the value of this 98% of the shares

    safely gifted two years prior to the claim, and the shares and the

    value they represent will be safe. In this example, only the

    remaining 2% of the shares will be vulnerable. They would be

    held personally to enable the director to be classed for taxation

    as a „shareholder/employee‟. This classification provides the

    director the ability to receive part, or all, of their remuneration by

    way of provisional income, on which they would pay provisional

    income tax. (see taxation section for full details)

    (4) Relationship Risk. Marriage, as well as relationships which after a period of 3 years, permanently break down has been

    calculated to represent almost 13% per annum, of all marriages,

    and potentially more for relationships . In the absence of a

    binding agreement between the partners, generally the Courts

    will split the total assets owned personally by both of the

    partners 50% for each partner. In many cases where the

    contributions to the relationship have been unequal, this type of

    arbitrary split can in many situations may not be equitable. Also

    those people without any effective structure, who have suffered

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    a broken relationship, who are income earning, and have

    younger children, who do not have custody of the children, will

    be accountable to the Revenue for child maintenance payments.

    (5) Government Risk. This is the risk of not being able to receive a

    benefit or subsidy, you would otherwise be entitled to, because

    the Government criteria is breached. This can result when the

    applicant‟s income and/or assets are too high for entitlement to

    the benefit or subsidy . This disqualification can occur for a

    whole range of Government

    benefits including children‟s

    tertiary education

    allowances, long term

    hospital care, and aged care

    subsidies. For example in

    situations where an elderly

    person requires long term

    care, and owns their own

    home, but no other assets of consequence, they would in effect

    have to sell their home, and fund their own care until their funds

    were exhausted. Only then, would they qualify for the full

    Government subsidy. In the future this list may also potentially

    include Government superannuation, which may be no longer

    be universally available. It may instead become available only

    subject to an income and/or asset test.

    (5) Estate Planning- including Claims on your Estate. Estate

    planning can be achieved particularly through trusts. Often trusts

    are referred to as „living wills‟. Estate planning is achieved by

    transferring ones assets to one or more trusts. Then arranging

    during the lifetime of the initiator of the trust, or alternatively after the initiators death, to transfer income and/or assets to

    beneficiaries in an orderly and managed succession. Trusts

    formed appropriately at the correct time can also successfully

    protect against claims on ones estate.

    2) Maximum Deduction of Business Expenses

    1) The formation of a business structure, to operate a separate

    independent business can be rewarding in many ways. Tax

    deductions may not sound that exciting. However for those

    who can operate a business, they can gain financially. Wage

    and salary earners cannot obtain any deduction of expenses

    off their income, for taxation. However the ability to deduct

    business related expenses, is one of the prime reasons any

    individual who had the opportunity, would want to have a

    business structure formed, and proceed, to operate in

    business. People who are mere employees of companies or

    corporations earn wages, pay taxes and out of what remains,

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    spend. Others, who have their own business structures

    operating a business, earn income, spend, and only then pay

    taxes on the residual. The tax rules relating to the

    deductibility of expenses, is that any business expenditure is

    deductible, providing the expenditure has a relationship to

    the earning of assessable income. The range of expenses is

    as wide as ones imagination, but it must always satisfy this

    overriding test. For example if you claimed the costs of

    alcohol for a business function to promote a new product to

    existing and potentially new clients, this expenditure would

    clearly meet the test. However alcohol purchased on

    Christmas Eve to be consumed over the holiday period by

    friends and family would not satisfy the test. Expenses in

    certain cases are subject to specific restrictions or may be

    subject to Fringe Benefit Tax, can include motor vehicle

    operating expenses, internal and overseas travel and

    accommodation, newspapers and periodicals, entertainment,

    use of part of the home as office. These examples are not

    exhaustive. (see section on Taxation for additional detailed

    information)

3) Ring Fencing Property Trading, Property Development and

    Property Subdivision Activities.

    Under the N.Z. tax legislation, any one of these commercial property

    activities can create large tax difficulties for the individuals, who are

    associated with the particular structure carrying out these activities, if

    they also own rental properties.

    Only the most appropriate and

    correctly formed structure can

    overcome these difficulties. (see

    section on taxation).

    Types of Business Structures

    The different types of entities and structures are:

1) Sole Trader

    This of course is not a formal structure. It is the most basic form of doing

    business. The fact that that there is no setting-up cost may be seen as an

    advantage. However in reality operating in business like this could be

    likened to visiting the South Pole in shorts and a tee shirt. There is

    absolutely no protection for the operator. No incorporation, no limited

    liability, no registered business name. All the operators personally owned

    valuable assets including: home, holiday home, investments, vehicles, are

    effectively exposed to the business risk. If the operator experiences a

    business loss, as well as the business loss, they will also lose their non

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    business assets. Also all taxable income will be assessed in the operator‟s name. There is no opportunity of distributing income to another family member, or charity, or shielding from the high personal tax rates. Currently in N.Z. the top rate of personal tax is 39% on income over $60,000. The rate applicable to companies, and trustees of trusts is 33%. By not incorporating the operator cannot split income between

    himself and any other person, (or for example a

    company or trust), and would therefore be

    disadvantageously treated for tax. A sole trader

    operation is definitely unwise. However one could

    imagine an individual who had sought no professional

    advice, had little cash, had negligible business risk, no

    assets at risk, and total net taxable income of under

    $38,000, and therefore on the lowest 19.5% tax rate,

    considering trading in this format.

2) Partnership

    A partnership of individuals has all the disadvantages of

    the sole trader, and even greater risk. There is still no

    incorporation. This is merely a group of sole traders

    operating collectively in business. Each partner is exposed to „joint and several‟ liability. This means an extension of each sole trader‟s potential liability, beyond their own personal exposure. In the event of say one partner‟s business activity causing liability, each of the other partners assets in the Partnership, as well as their other personally owned assets would have to jointly contribute to the losses. In other words one partner‟s

    business actions, which have caused loss, can jeopardise all the assets of all the other partners, even if the other partners had no contributing involvement. We have seen how an Upper Hutt legal partnership was destroyed by two, of several partner‟s activities. In the 1990‟s the majority

    of professional partnerships (where their professional body permitted) have incorporated. In the year 2002, only lawyers and optometrists are still not yet able to incorporate according to their professional bodies codes. Partnerships of limited liability companies (normally termed joint ventures) if structured wisely by forming an umbrella company to operate the business, are generally considered to be acceptable.

3) Company

    Standard Company.

    This company provides a basic level of asset protection, because the shareholders have limited their liability through the number and value of shares they have selected. However this limited liability is often diminished by the operator‟s personal guarantees to banks and other major creditors.

    This type of company is typified, by being incorporated with a low number of shares, and most often is not well structured, because the directors traditionally own the shares in their own names. As a result of director‟s risk of being pursued for trading recklessly, and/or while the company is insolvent, then the very shares representing the business value, are

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    exposed and vulnerable in the event the directors are sued alone or

    together with the company in a joint action.

    It is much superior structuring, on incorporation to issue say 98% of the

    shares to the operator‟s passive family trust, which would be formed on

    the same day as the company. This results in:

    1) The shares being issued to the trustees of the trust, at the low issue

    price of the shares, (which is normally $1 per share, if this is a new

    company). This low issue price can be substantiated, because the

    company will not yet have traded. Also this low value enables the

    gifting of the value of the shares to be achieved in a shorter time frame.

    2) The 2% of the shares subscribed for by the directors personally, enable

    them to be classified as „shareholder/employees‟. This in turn allows

    the directors flexibility to receive some, or all of their remuneration by

    way of credited salary after the year end accounts are drafted. On this

    portion of their income they can pay „provisional tax‟ (which is payable

    in 3 instalments per annum) If they did not follow this method, they

    would instead have to receive all income by way of p.a.y.e. income.

    3) Realistic protection of assets. The trust is in effect a separate entity,

    which is separate from the directors/shareholders. Once 2 years has

    elapsed since they have gifted the value of the shares to the trust, then

    the total value of the shares is untouchable by any creditors and is free

    from litigation.

    Companies have limitations in transferring

    a share of company profits to other

    members of ones family, such as a non

    working spouse, children, relatives and

    charities. This is termed „income splitting‟,

    whereby income is spread, to reduce the

    total tax. An individual can only be paid

    salary or director‟s fees, for the work

    provided, and this work needs to be

    justified and is accountable to IRD, should

    one be put on inquiry. The only other

    method of distributing profits is by way of

    paying dividends to the shareholders. Unfortunately all dividends are pre taxed at 33% (the company tax rate),

    which is higher than the 19.5% personal tax rate for those persons earning

    less than $38,000. The result in this situation is that these shareholders are

    not provided with a cash refund of what would seem overpaid tax. The

    outcome is therefore often not tax efficient.

If standard companies make a tax loss, then they cannot distribute this loss to

    shareholders, unless they are separately registered with IRD as loss

    attributing qualifying companies (L.A.Q.C.).

4) Loss Attributing Qualifying Companies (L.A.Q.C.)

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    These are conventional registered companies with the Companies Office.

    However a special tax registration (L.A.Q.C.) is necessary with the IRD. The

    main advantage of this type of company is that during the period when a

    company is making a net loss, this loss can be attributed to the individual

    shareholder, and thus offset against any other taxable income the

    shareholders may have in that same year. The loss is allocated to the

    shareholders in proportion to each shareholder‟s holding. In other words a

    company with $10,000 loss in a year, with one shareholder owning 25%, and

    the other 75%. They would share the loss $2,500 and $7,500 respectively. An

    L.A.Q.C. company can only have a maximum of 5 shareholders, although

    various members of a family collectively only count as 1 shareholder. These

    companies were originally introduced in the 1980‟s to provide an improved

    partnership, by allowing any loss to be allocated to the shareholders, year by

    year, and at the same time providing limited liability protection for the

    shareholders. They were introduced for operators involved with businesses

    such as forestry investment. Losses could be anticipated for say 24 years with

    an expected profit in year 25. More recently L.A.Q.C. companies have been

    utilized to purchase rental properties, which will be expected to make a tax

    loss for the initial 8-10 years (caused by primarily by non-cash, depreciation

    expense).

One disadvantage is shareholders have to personally guarantee any non

    payment of company tax. For example, if a company recorded, and allocated th year and collapsed losses for say 5 consecutive years, made a profit in the 6thin the 7 year. Then no company tax would have been paid, and assuming

    the company did not have funds to pay the tax on the profits, the shareholders

    under their guarantee would have to meet the payment. If operating this type

    of company, it is essential that the directors monitor when the company

    changes from loss to profit, and proactively deregister from L.A.Q.C. There is

    no other structure for which guarantees are required from shareholders by the

    IRD.

    The other main disadvantage is that

    this structure does not provide any

    asset protection for the shareholders.

    In other words the people owning the

    shares (which represent the value of

    the business) still have all the value in

    their own names. Because of all the

    risks, (including but not limited to,

    directors risk) individuals are better

    advised not to hold assets in their own

    names. The operators of the business

    utilizing an L.A.Q.C company are motivated entirely by tax considerations, and not by any asset security.

    Shareholders may have the intention of holding the shares personally until the

    company turns the corner and starts making profits. Then have the shares

    valued and transfer these shares to a family trust. The difficulties encountered

    could well be, that because of the delay of several years, the share values will

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    have greatly increased. This results in a longer period for the individual to gift the higher value of shares, to the trust. Also the vulnerability from IRDS contesting that the transfer was proceeded with, primarily to achieve tax advantages. This would be hard to argue against, as the individual had claimed the losses during the loss period, and then wanted to use the trust to achieve lower tax through „income splitting‟.

5) Trading Trust with Corporate Trustee

    This combination of a trust, operating with a sole corporate trustee, combines the best advantages of a trust and a company. In this structure the company is necessary to „do the business‟ but does this in a trustee role, rather than trading for itself. In a trading trust, instead of having persons acting as personal trustees, they instead become directors and shareholders of the corporate trustee. It is possible to run most types of businesses through this type of trading trust. This structure

    provides limited liability for the

    trading, and for the individuals

    involved in the company. It also

    provides a company name as the

    trading name.

    The main advantages of trusts is

    that asset protection can be

    achieved, and a trust is the best

    vehicle for splitting income

    between beneficiaries who can

    include spouses, children,

    grandchildren, other family

    members, long term friends, other

    trusts (where there is one or more of the beneficiaries are common, and charities. As long as the beneficiaries income is paid to the beneficiaries, it is unnecessary to justify any payment to the IRD. (see separate paper on Trusts for more detail)

    6) Passive Trust with People as Trustees (or Corporate Trustee as

    Trustee)

    A passive trust is one which owns passive assets. These can include assets such as: home, holiday home, shares in a family trading company, investment shares (but not trading shares), rental properties, fixed assets used in a family trading business, vehicles used in a family trading business (which would be leased from the passive to the trading business). Asset protection is achieved (subject to a gifting program). Also income made by the trust can be „spread‟ to other beneficiaries in a very efficient manner. The trustees of a passive trust can be either people or a corporate trustee. The choice would depend on the number of shares owned and number of land titles and mortgages involved. If there were several registrable titles involved, then a corporate trustee would be the most economical, in the event there was a change of personnel acting as trustees. (see separate paper on Trusts for more detail)

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    7) Charitable Trust

    A Charitable Trust can provide advantages for certain individuals who have a desire to assist the general communities needs for charitable purposes such as: welfare, health or religion. There are two main alternative types of trusts available. One which has a membership of interested members. The second which is made up of initially the original Board members. These members then vote in (or vote out) additional members. This second variety affords closer control for the initial members. These members can vote for different issues pertaining to the trust. The second One of the main features is that by registering the charity with the Registrar of Companies, the charity obtains legal recognition and status independent of the Board of Trustees. Therefore the individual trustees obtain effectively limited liability status. The charity has to be provided for a large section of the community. Individuals responsible for initiating the charitable trust, can be employed by the trust, but their remuneration must be based on market rates for the type of employment. Other criteria are that the charity must provide that in the event it be discontinued, then the remaining assets have to be provided for an alternative charity with similar aims.

    In addition to the registration with the Registrar of Companies, there are two separate registrations available from the Inland Revenue Department. The first is „donor charitable status‟. This provided that donors can receive tax relief for donations made to the charity. The second is „income charitable status‟ whereby income received by the trust (from say business operations or interest, dividends or royalties received) will be tax free on receipt to the charitable trust.

    Disclaimer 'Considering Commencing a Business in New Zealand’ is prepared by Company

    Solutions Limited. It is not intended to be fully comprehensive nor is it intended to be a substitute for individual structuring advice.

Your Company Solutions Limited advisor can update you with the most current

    information. Professional advice should be sought before applying the information to particular circumstances. Whilst care has been taken in the preparation of this guide, no liability is accepted for any errors.

    Copywrite for this material is retained by the proprietors Company Solutions Limited 412 Lake Road, Takapuna, Auckland, New Zealand. www.company-solutions.co.nz

    service@company-solutions.co.nz

    ? Company Solutions Limited 2001

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