FAQs on company structure and minimising tax
So you’re setting up a new business or thinking about changing the way your existing business is structured… do you go for the added protection that a limited liability company provides, or do you keep things simple and operate as a sole trader or partnership with fewer tax compliance obligations?
Tax expert John Shewan, formerly of Price Waterhouse Cooper, gives advice on structuring your business to minimise tax and meet your business and personal goals. He discusses the advantages and disadvantages of forming a company versus operating as a partnership or sole trader.
How should I structure my business?
We often get asked by people, should we form a company? It’s a very good first question. Our advice on that, generally, is driven by commercial considerations, but also there are tax considerations. On the tax side, companies, at the moment, have a lower tax rate than individuals. So, 28 percent, at the moment, relative to 33 percent top rate for individuals makes companies quite attractive.
However, you can’t just assume that that 28 percent is the end of the story, because, clearly, you are going to have to pay yourself out of the company and so your personal income will be taxed at your own rate.
But if you’re looking at setting up a business that’s going to expand and reinvest a lot of its profits, you probably would prefer to have a company than operate as a partnership or a sole trader, and especially if you are looking to bring in fellow investors – so buying some shares in your company – then obviously the company route is quite attractive.
- Lower tax rate
- Separate legal entity which offers better protection
- Good structure for growth
New Zealand does not have a capital gains tax and so if you are looking at a business such as a Trade Me, the next Trade Me of this world, then you may well obviously want to have a company structure and hopefully, in time, sell those shares off at a tax free capital gain.
What are the disadvantages of forming a Company?
On the downside, once you’ve got a company, you’ve got issues such as fringe benefit tax to worry about, the annual filing requirements, separate tax returns. They are much more expensive. They are like children. Having created them you have to look after them.
I’ve had situations where small businesses have just gone ahead and formed a company without really realising that companies take quite a lot of time to administer, you have to file separate tax returns, prepare accounts and all the rest of it and often it’s better for them just to stay as a self-employed or sole trader person.
In other circumstances, people have gone off and got into quite risky businesses as a sole trader and then have then found that they’ve got legal liabilities which they would have preferred to have been able to shelter behind a company for. So, it all depends on exactly what you’re getting into. Tax is generally a secondary consideration not a primary consideration.
How do you protect yourself as a Sole Trader?
If you’re a sole trader wanting to ensure that you minimise your tax, one of the key things you should do is make sure that your borrowings – as most people have got borrowings, typically against their house – you really want to get as much of your borrowings as possible against your business income, because then you can deduct the interest absolutely legally. Whereas, as we all know, the interest on our own home mortgages is not deductible.
One of the most common mistakes I see small businesses making is to have their own private debt against their own property, but they have equity, their own money, tied up in their own business. They’re better to try and structure that in a way that ensures that they match their borrowings against their business assets and can deduct the interest, because that can save them up to a third of the interest cost. So that’s such a basic, but fundamental point so often over-looked.
What about Partnerships?
The same basic rules will apply to partnerships as to sole traders, that is your tax basically in your own name on your share of the profits, but again making sure that you maximise the deductions that you could take. We often see examples of people in partnerships or in sole traders that don’t realise that they are able to deduct legitimately all the expenses that relate to that business activity.
So in summary what should you consider when setting up a new business?
Don’t want to rush off and form a company unless you really have to. It may well be best just to operate as sole trader for example. So the best advice around minimising tax is to get your commercial objectives lined up with your tax objectives. It’s actually very rare that you’ll be doing something for tax reasons alone, in fact if you are, you probably really want to push back and ask your accountant, should I really be doing this?
- Be clear about your goals: Be absolutely clear about what you are trying to achieve with your commercial operation. Only when we’ve got that information can we talk about tax.
- Maximise your deductions: Make sure that you do legitimately maximise the deductions against your income. The interest expense on your borrowings, genuine expense relating to the business.
- Choose the right business structure: Make sure that your structure accommodates your own family and their circumstances because they’re what really matters in most people’s lives. You want to make sure that you can deliver the benefits of your hard work to them in a tax paid way but with tax minimised, and often, for example, using a trust to own your company will be a good way of ensuring that objective is achieved.