Whether you are starting a new business or looking at expanding your existing business, deciding on the commercial structure to adopt can seem daunting and the help of an advisor is likely to be sought. Irrespective of that help, the final decision will be made by you – based on your answers to the following types of questions.
What are you about to do? Is it a completely new venture or something similar to what you are doing now? Who are you going to do it with? How long are you going to do it for? Do you plan to exit and how? What is your propensity for financial and commercial risk? Where is the financing coming from and how much? Do you expect to make a loss before you make a profit? Will you have sole control or will it be shared? How will profits be split?
Taking into account some of these questions, attributes relating to some basic structuring options are provided below to help demystify why one option might be better suited than another.
Sole trader – without the benefit of limited liability protection, it is relatively rare to operate as an individual. However, if a business is small with little to no commercial risk, this might be a viable option.
Profits and losses are included in the person’s tax return. This could be beneficial during start-up if losses are incurred because they will be offset against any other income.
Company – a company is a separate legal entity and provides limited liability to shareholders, subject to personal (or other) guarantees to company creditors. Companies are taxed at the company rate of 28%, which is less than the top personal tax rate and the trustee rate (33%). This provides a timing advantage, as the 33% rate won’t apply until the company distributes its profits to its shareholders. However, capital gains can be trapped in a company because they are generally only able to be distributed tax free by liquidating the company.
If a company incurs a tax loss, it can only be carried forward or transferred to another company (subject to meeting criteria).
This is the most common structure used by New Zealand businesses. For this reason, they are well understood and easy to setup.
Partnership – a partnership arises where two parties carry on a business in common with a view to profit. Historically, partnerships were more common, for example doctors, lawyers, and ‘husband and wife farmers’ would generally operate in partnership.
A key downside of partnerships is that the partners are jointly and severally liable for the debts of the partnership. Hence, partnerships are typically only used in specific situations.
For GST purposes, the partnership is treated as a separate person, but for income tax purposes the assets, liabilities, income and expenses are attributed to the partner. These rules can be complex.
Limited Partnership (LP) – originally introduced to assist foreign investors wishing to invest in NZ ventures, they generally provide the benefit of tax transparency (as they are taxed as a partnership) combined with limited liability protection. LP’s are generally only used in quite specific situations, such as land developments.
Trust – trusts can be flexible as income distributions are decided by the trustees. But their formation and governance are prescribed by a trust deed, which can lead to problems and disputes from a legal perspective. Trustees may be liable for the debts of the trust.
Look Through Company (LTC) – LTC’s provide the benefit of tax transparency with limited liability protection. This enables losses (but also profits) to be included in the shareholder’s tax returns and offset against other income. However, they are defined as partnerships for tax purposes and subject to quite specific LTC legislation, which can lead to compliance costs.