A number of tax traps arise in family businesses. They are not only the concerns of the owners, to ensure their remuneration is tax effective. Tax traps also arise when there there is pressure to restructure to meet changing expectations of family members, or demands for greater distribution of the business’s wealth.
Unless tax liabilities are taken into account, all shareholders may suffer because of the actions, or particular needs, of one person. Such situations are often further complicated because emotion is not always separated from commercial and financial considerations.
Tax traps for family businesses generally fall into two main categories. The first relates to remuneration of, and drawings taken by, family members. The other covers issues relating to potential capital gains tax (CGT) liabilities arising from the sale of business assets or shares in a family business company.
The first category is important because it can hurt the cash flow of the business and weaken the capital structure, crippling the business’s growth. It is also likely to affect the good management of the business if family members start to squabble.
The second category is very dependent on how the business is structured. It’s not always possible to see at the outset what the family and business circumstances will be when the founders retire. Nonetheless, the time to get the structure right is when the company is set up. If not, planning and restructuring may be necessary to save significant amounts of tax.
- Take care when remunerating family members who work in the business
A common scenario in many family businesses is where some family members working in the business are also shareholders, while others work there but are not shareholders, and some family members are shareholders but are not working in the business.
Managing the different needs and expectations of these often diverse groups can be difficult.
For working shareholders it is not only the amount of remuneration that needs to be considered, but also how remuneration will be paid. The best approach to this will often depend on each person’s tax situation.
The different ways in which family members working in the business can be remunerated include:
- Salary
- Fringe benefits (e.g. cars, expense payments, entertainment, goods)
- Superannuation contributions
- Interest-free loans (see below regarding traps for loans)
- Dividends (if also a shareholder)
While it may be tax effective for working shareholders to draw a small salary and take the remainder of their entitlement as franked dividends, it is not always practical to do this when there are other non-working shareholders also expecting dividends.
Example – Working and non-working shareholders
A typical example would be three brothers who own equal shares in the family business Dragon Pty Ltd. Only Bert and Ernie work in the company. Elmo has no day-to-day involvement.
The brothers have agreed that Bert and Ernie should receive $75,000 each for their work in the business, with 60% of the remaining after-tax profit to be distributed as a franked dividend to all three brothers.
As long as circumstances remain unchanged, this sort of approach will work well.
- Beware of fringe benefits tax (FBT) on non-cash remuneration
Calculating and tracking each person’s remuneration can be made difficult where employee/shareholders receive non-cash fringe benefits, as these benefits will need to be valued both in the individual’s hands as well as the cost to the company. Directors often don’t appreciate the FBT cost to the company when giving executives benefits.
Example – Salary Packaging including Superannuation and Fringe Benefits
Using the circumstances of the previous example, instead of drawing a $75,000 salary Bert decides to reduce his salary to around $36,000, with his remaining entitlement taken as fringe benefits and an additional superannuation contribution. If his additional super contribution is $10,000, and ignoring the effect of GST, Bert could receive fringe benefits to the value of $15,000, (which would require the company to also pay FBT of $14,125) leaving a salary of $35,875.
Unless the FBT payable by the company is allowed for, Ernie and Elmo will be disadvantaged.
- Ensure loans from a company can’t be seen as dividends
As well as the liquidity problems that may come from family members taking excessive drawings from the business, some very serious tax problems can arise from individuals taking loans out of a company.
Unless a written loan agreement exists that shows the required interest and repayment terms, or it is repaid within the same financial year, a loan to a shareholder, or someone related to a shareholder, may be deemed to be a dividend.
If a deemed dividend arises because there is no loan agreement, the amount of the loan is treated as an unfranked dividend.
To make matters worse, there is a double-hit because there will be a corresponding debit to the company’s franking account resulting in credits from tax previously paid by the company being used up by the deemed dividend, without shareholders getting the benefit of them.
If a loan has already been made, a franked dividend may be paid before the end of the financial year to allow the shareholder to repay the loan. However, in this instance it is likely to be necessary to pay a dividend to all other shareholders as well.
Example – loan and franked dividend
On 1 March 2004 Dragon Pty Ltd made a loan of $70,000 to Ernie, one of three shareholders. There was no written loan agreement.
If Ernie does not repay the loan by 30 June 2004, Dragon will be deemed to have paid an unfranked dividend of $70,000. Being on the top marginal tax rate of 48.5%, Ernie will pay tax of $33,950 on this.
Dragon will also suffer a debit of $30,000 to its franking account, reducing the amount of tax credits that the company can pass on to the other shareholders when it pays future dividends.
Dragon could avoid the deemed dividend rules if, on or before 30 June 2004, it pays a franked dividend of $70,000 each to Ernie, Bert and Elmo, so Ernie can repay his $70,000 loan in full (assuming there are sufficient franking credits available).
If the brothers are all in the top tax bracket, they would each pay tax of $18,500 after claiming the franking credit of $30,000. Ernie’s tax bill on a franked dividend is therefore a little over half what he would have paid on a deemed dividend.
However both Bert and Elmo have paid tax at the top marginal rate on a dividend that they might not otherwise have received in the 2004 financial year. If Elmo, who is not employed by Dragon, knew that his taxable income will be significantly lower for 2005, he may have preferred to defer his $70,000 dividend until later when he would pay a lower marginal rate of tax.
- Have a controlling individual to maximise small business CGT concessions
There are several very useful CGT concessions for the sale of small business assets, which can be used to eliminate, or substantially reduce, the CGT payable on the sale of a business, but only if the business is structured appropriately. Thus care needs to be taken when allocating shares to family members.
To attract the CGT concessions, the combined net value of the business and investment assets should be held by one person, his or her immediate family, and any controlled entity cannot exceed $5 million. The main exclusions from the test are the family home, and amounts held in complying superannuation funds.
One of the most common traps is, where a business is carried on through a company or trust. The maximum benefit from these concessions is available only when there is a ‘controlling individual’ of the relevant entity.
Where the business entity (ie the company or trust) is sold, rather than the business assets, these concessions will not be available unless there is a controlling individual.
A person will be a controlling individual if his or her shares give at least 50% of the voting, dividend and capital rights. For example, if Dragon Pty Ltd is owned 50% by Bert and Ernie, they will each be a controlling individual.
But if Bert, Ernie and Elmo each hold one-third of Dragon’s shares, there is no controlling individual and the CGT concessions will not be as attractive.
For discretionary trusts the test is easier to satisfy. The controlling individual simply needs to receive at least 50% of any distributions of income and 50% of any distributions of capital that are made by the trust during the year in which the sale of the business or entity occurs.
The CGT concessions can also be used by the spouse of a controlling individual. For example, if Bert owned 90% of the shares in Dragon Pty Ltd and his wife Jill owned the remaining 10% of the shares, the full extent of the concessions can still be available for Jill’s share of the business.
- Watch the effect of multi-level structures on CGT concessions
CGT concessions are designed for very simple structures, such as a business operated by a single company, and do not recognise indirect interests. Where the business structure is more complicated, for example where there is a multi-level trust structure or a holding company with one or more operating subsidiaries, it becomes more difficult to take full advantage of the concessions.
Example – Multi-Level Trust Structure
Bert and Ernie carry on a business through the Dragon Unit Trust, with 50% of the units being held by the Bert Family Trust, and 50% of the units being held by the Ernie Family Trust. All of the business assets of the Dragon Unit Trust – but not the Trust - are sold to Rusty Pty Ltd.
As Bert received 100% of the distributions from the Bert Family Trust for the relevant year, he would be a controlling individual of his family trust. While the end result is that Bert has indirectly received 50% of the income from the Dragon Unit Trust, he cannot be regarded as a controlling individual of that (the Dragon) unit trust.
This means that Bert is unable to get full benefit from the small business CGT concessions in respect of the sale of the business. If Bert and Ernie had instead sold their units in the Dragon Unit Trust to Rusty Pty Ltd, they may have been able to take full advantage of the CGT concessions.
- Beware any change in ownership of pre-CGT businesses
Business entities set up before September 19, 1985 may have pre-CGT assets such as land and buildings, and business goodwill.
For private companies, these assets will remain pre-CGT only as long as there is a group of individual shareholders that have held more than 50% of the company’s income and capital, at all times since 19 September 1985. It will be more difficult to show this if there are several classes of shares with different entitlements to income and capital.
If the 50% test has failed at any time, the effect will be that all of the company’s pre-CGT assets will be deemed to be post-CGT assets from that time. Each asset will be deemed to be acquired at that time for its market value, which becomes the CGT cost base for the purposes of any subsequent sale of the asset.
Some examples of the common ways in which the shareholding of a family business company may change, so as to cause the test to be failed, include:
- Bert, transfers all of his shares (representing 50% of the total) in the family company Dragon Pty Ltd to an external party, Zaphod, that did not previously hold shares in the company.
- Bert transfers all of his shares to his brother Ernie so that Ernie now holds 100% of the relevant entitlements. As Ernie’s interest was not previously more than 50%, the company would fail the test. If Bert retained just one of his ordinary shares, the test would be passed.
- Ernie transfers all of his shares to the Ernie Family Trust, a discretionary family trust. Even though Ernie may receive distributions from the trust, it is not possible to attribute ownership of shares to beneficiaries of a discretionary trust, so the test cannot be passed.
An exception to the rule is where shares have been inherited by the current shareholder from the deceased estate of an individual who held the shares at 19 September 1985. In these circumstance, the beneficiary will be treated as having held the shares since the time that the deceased acquired them.
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