Labour shortages, increases to the cost of materials, stimulus packages ending, and major international events have concocted the perfect storm – in the first 6 months of 2022 there have been 16 major collapses in the construction industry.
There has therefore never been a better time to consider whether your business and personal assets are sufficiently protected.
This article contains key information on how to best structure and protect your business and personal assets.
Types of Business Structures
There are various legal structures you can use to conduct your business.
Certain structures will be more beneficial to you and your business than others, so it comes down to selecting, together with trusted legal and financial advisors, the structure that is right for your business needs. The various types of business structures will be explored below with a view to how each can be used to protect your business and personal assets.
A sole trader is the simplest and cheapest form of business ‘structure’ there is – it is not even really a structure at all. It is, in effect, you going in to business as yourself.
It has virtually no start-up costs, there are no ongoing structure costs and as you are operating as an individual, you will be able to avail yourself of various tax concessions particularly in relation to capital gains tax (“CGT”).
However, the major downside of this structure is that it provides virtually no protection for your business or personal assets. As a sole trader you own everything. Your business and personal assets are intertwined, meaning everything is at risk if you are sued.
The company is the most common business structure.
Its popularity can largely be attributed to the protection it affords to its owners’ and members’ personal assets.
At law, the company is a separate legal entity from its shareholders and directors – the company is afforded a “corporate veil” which protects its members and directors from personal liability and asset exposure.
The main downside of operating as a company is the additional costs. As opposed to a sole trader, a company incurs greater set-up and ongoing costs in the form of company incorporation and registration fees. Companies also cannot avail themselves of the 50% CGT discount.
But, the company structure is popular for a reason. While slightly more difficult and expensive to set up (but still fairly modest compared to some other structures), the protection it affords to an owner’s personal assets is invaluable. Unlike a sole trader, the company structure allows for business expansion and the introduction of additional investors/owners, so it is normally an appropriate structure for an expanding business.
A discretionary trust is the cornerstone of effective asset protection planning. This is because the business assets are not owned beneficially by any entity – be it the trustee or any of the individual beneficiaries – so they are less vulnerable to attack.
It is important to note that a discretionary trust is not, of itself, a separate legal entity – it requires an individual or company to act as trustee. The legal entity which acts as trustee can hold assets and enter into contracts on behalf of, and in the interests of, the beneficiaries of the discretionary trust.
As the word ‘discretionary’ would suggest, the trustee has discretion in deciding to which beneficiaries to distribute the income of the trust, providing the trust great tax flexibility.
While trust structures have access to tax concessions (i.e., the 50% CGT discount and the small business CGT concessions) it is important to note that any income not distributed by a discretionary trust prior to the end of a financial year will be taxed in the hands of the trustee at the highest marginal rate. Because of this, a discretionary trust is NOT the appropriate structure if your goal is to retain income to use as working capital for a business.
Moreover, because the discretion of the trustee means beneficiaries are not entitled to fixed distributions, a discretionary trust is not an appropriate vehicle for (unrelated) business partners looking for a fixed return from the business.
A unit trust tends to have elements of a discretionary trust and elements of a company. As a trust, the trustee still legally holds all assets, with the unitholders only holding units in the trust. However, like a company, a unit trust gives rise to fixed entitlements – unitholders generally receive fixed entitlements in respect of income and capital.
While a unit trust can access the 50% CGT discount, you should be aware that transfers of units are likely to be dutiable under State duties legislation where share transfers may not be.
Like a sole trader, a partnership is not a separate legal entity. The main risk with this is that partners may have joint and several liability, which means that each partner, and all partners together, are liable for the debts of the partnership. A partner’s personal assets will therefore be exposed to the risks of the partnership.
While partnerships can access the small business CGT concessions and individual partners can claim the 50% CGT discount, partnerships are generally considered inflexible from a taxation perspective in that they are not taxed separately – it is the partners who are ultimately taxed based on their respective shares of the net income or loss of the partnership.
A joint venture is another structure that is not a separate legal entity.
This structure is normally used as a special purpose vehicle, brought into existence for a specific project as opposed to an ongoing business (e.g., it is often used in property development or in a mining endeavour).
Unlike the joint liability under a partnership, the JV documentation will provide that each venturer is severally liable on the basis of their interest in the venture, and that no venturer may bind another.
Protecting Business Assets
Having canvassed the various company structures, we will now explore how they may be used to protect your business assets.
A trading (discretionary) trust
As mentioned above, a discretionary trust provides great asset protection benefits stemming from the fact that no individual can be said to own the assets of the trust.
A company may choose to capitalise on these asset protection benefits and utilise the trust structure to carry out its business, not in its own right, but rather on behalf of the trust.
A practical downside of using a trading trust structure is that third parties, such as suppliers, may be suspicious and require key individuals to provide personal guarantees as part of their contractual arrangements. That said, personal guarantees are now becoming a more normal part of any day-to-day dealings irrespective of the structure used.
A company with discretionary trust shareholder
You can utilise a discretionary trust in setting up a trading company by making the shareholder of the company a discretionary trust.
While it is possible to have an individual act as trustee of the discretionary trust, we generally suggest that the trustee itself be a company. This is due to the many advantages associated with the company structure, and because it allows for a clear distinction between the assets and income of the trust and those of any individual beneficiary who might act as trustee of the trust.
The trading company will:
- trade and receive business income; and
- declare dividends to the trustee of the discretionary trust, as shareholder,
and the trustee will determine which is the most tax effective way of distributing the dividend income to the beneficiaries.
Beyond the tax effectiveness of this structure, the main benefit of having a discretionary trust hold the shares in a trading company is that it protects the trust’s main asset, being the shares. So, again, if a beneficiary of the trust becomes bankrupt, the shares in the trading company cannot be said to be owned by that beneficiary, or indeed, by any other beneficiary or the trustee.
A dual company structure
Beyond the individual company setup discussed above, a common method of protecting business assets is to establish a dual company structure.
A dual company structure consists of:
- a holding company, which owns all of the valuable assets of the business; and
- a trading company, which leases the assets owned by the holding company and carries on business as a wholly-owned subsidiary of the holding company.
To ensure you reap the full protective benefit of this arrangement, you must ensure that the holding company takes a security interest over the assets licensed or leased to the trading company and that this security interest is correctly registered on the Personal Property Securities Register.
Provided this is done, if the trading company becomes insolvent the holding company will be able to enforce its security interest and gain possession over the assets that have been leased to it.
The key benefit in terms of asset protection here is that, while the trading company assumes all risk by engaging with third parties like customers and suppliers, it does not actually own anything if it is sued or faces insolvency.
Other Business Asset Protection Strategies
There are various other asset protection strategies that you should consider that are less related to entity structuring. For example, you should generally ensure that:
- your business’ intellectual property is registered: trade marks, patents and designs can all be registered with IP Australia. This will provide your IP with a strong base of protection, and also shore up the value of those assets in the event of a sale;
- your business’ confidential information is safe: you can also protect your confidential information, including IP and trade secrets, by requiring third parties (including employees) to enter into binding confidentiality or non-disclosure agreements;
- you have properly registered and documented your business’ security interests: it is important to have proper documentation and registration in place to take security over assets, such as registration on the PPSR;
- you have appropriate levels of insurance: it is important to have the appropriate types and levels of insurance in place to protect your business assets.
Protecting Personal Assets
In respect of protecting your personal assets, there are various actions you can take to ensure any business liability you incur does not jeopardise your personal assets.
Considerations when operating as a company
While a company structure generally provides for personal asset protection you should still consider the following:
- from a director’s perspective, you should be wary of providing personal guarantees. Directors should also be aware that there have been significant legislative erosions to the corporate veil – one way of mitigating this risk is by taking out directors and officers insurance;
- if you are married, rather than both spouses acting as directors of a company, consider having only one – and that one being the one who has minimal personal asset ownership. However, be aware that if a spouse is making decisions for the company without being an appointed director (i.e., a ‘shadow director’), the Corporations Act deems that person to be a director;
- documenting your personal use of company money. For example, be sure to always label any transactions as either a director’s drawing, a wage, or a shareholder’s dividend, as applicable.
Considerations when operating via a discretionary trust
If you are operating under a discretionary trust, it is important to consider the tax implications of holding a beneficiary’s property inside the trust. For example, if the family home is held inside a discretionary trust, its sale will not attract the principal place of residence CGT exemption.
Trustees in bankruptcy are generally unable to pierce the protective capacity of a discretionary trust. However, there have been a few instances where the court has attacked the asset protection nature of the discretionary trust. Importantly, if you are thinking of using a discretionary trust structure to provide protection for family law purposes, you may wish to think again, because the Family Law Act provides the Court with significant powers to look through structures, including discretionary trusts, to determine the true ownership of assets.
Considerations for asset ownership
Another way of protecting personal assets is to ensure that they are owned by appropriate individuals. This may be a useful strategy with spouses, where the spouse least exposed to litigation risk is made the legal owner of the assets. There are, however, some risks to transferring ownership to other parties, such as:
- if property is held in the name of your spouse, a trustee in bankruptcy may argue that a constructive trust is established where an insolvent spouse, not legally owning an asset, has contributed monies toward the asset;
- if you are looking at transferring personal assets into other people’s names you will have to be aware of potential CGT and duties implications;
- obviously, there is also the inherent risk of giving someone else – even if they are your trusted spouse or a child – legal control of your assets; and
- you should also be aware of the ability of a trustee in bankruptcy to claw back preferential or undervalued disposals of assets and, in New South Wales, any such dispositions which are done to defeat the claims of potential beneficiaries under wills.
Given the various advantages and disadvantages of each business structure, there may be several reasons why you may think about restructuring your business. One reason for restructure, and the focus of this article, is the protection of your assets. If you do decide it is time to restructure there are multiple ways to go about this, two of which we set out below.
Establishing a separate legal entity
In order to actually begin the restructuring process, you might first establish a separate entity to be an asset holding entity and transfer business assets to it. There are important considerations in doing this, including whether this will give rise to any capital gains tax and/or potentially duty implications. Having a separate entity might also make it more difficult to sell the whole business to a third party, or to create a tax consolidated group.
So, there are some downsides to this restructuring approach, but generally it is quick, simple and relatively cheap.
Interposition is a more intricate form of restructuring process which involves a holding company being inserted, or interposed, between the shareholders and the existing company. This creates a holding entity owned by the shareholders, and a trading entity wholly owned by the holding company.
This mechanism is useful for the creation of a tax consolidated group, under which transfers of assets between members of the group will not attract CGT or duty.
There’s also the ability to obtain CGT rollover relief so that the process does not give rise to a CGT event or liability. This makes a sale to a third party easier in the future as the buyer will only need to buy the shares in the holding company to own the whole business.
Interposition is admittedly more work and more expensive at the outset, but it can give rise to longer term benefits.
Specific Legal Requirements
As a final note, it is always important to remember that with each type of business structure, there are certain specific legislative requirements that must be adhered to, both when establishing the business and throughout the business’s life. For example, company directors owe various fiduciary duties, trustee actions are governed by State trust legislation and there may be complex licensing requirements for both companies and trusts.
For this reason, it is always important to seek legal advice before establishing your business or undergoing any restructure.
Overall, there are many ways to protect both your business and personal assets. To ensure you achieve the maximum protection possible, you should be sure to:
- seek legal (and financial) advice before establishing a business;
- choose a structure that is appropriate for your business needs;
- consider future direction, plans and the expansion/ownership of your business as well as a potential exit strategy;
- bear in mind general legislative requirements for maintaining structures and specific requirements that may apply to your business, e.g., licensing;
- use structuring to protect both business and personal assets; and
- restructure if required but ensure tax relief is obtained where possible.