Firm structures

There are general matters to consider when choosing and establishing a structure.

Asset protection

• Consider holding investment and personal assets separately from at risk business exposures
• Consider the full range of insurance cover for various business risks, not just professional indemnity

Regulatory compliance

• CPA Australia By-Laws
• Accounting Professional and Ethical Standards Board standards
• TASA, ASIC and ATO requirements in Australia
• Inland Revenue requirements in New Zealand
• Other licensing and regulatory requirements

Critical business formation documents

• Partnership agreement
• Company constitution
• Shareholder agreement
• Management deed
• Trust deed
• Unitholder agreement
• Service agreements
• Other legal requirements

Key events

Your constitution documents should include the management approach for critical events and issues to mitigate the risk of future disputes between commercial partners. Common issues include:

• working capital
• gearing policy
• formal voting resolutions
• dispute resolution
• profit share
• valuation of the practice
• partnership changes
• entry and exit rules.

A sole practitioner, also known as a sole trader or sole proprietor, is an individual undertaking business and/or investment activities in their own name for their own benefit. The legal status of a sole practitioner is not separate from the individual.

Liability

A sole practitioner is exposed to the risk of unlimited liability associated with their practice. If the business is sued (for example because of negligent work or representations made about work to be undertaken) the assets of the individual will be available to litigants and creditors to settle a claim. If the individual is sued personally, the assets of the business will be available to creditors or the trustee in bankruptcy.

Succession

During the lifetime of the sole practitioner, a transfer of business assets will result in potential tax liabilities in both Australia and New Zealand. In Australia, significant capital gains tax concessions or rollover relief may potentially be available to reduce or defer any capital gain.

Method of accounting

In Australia, if a practice only consists of the sole practitioner’s income, then the cash method of accounting should be adopted. If the practice has the same number or more non-principal practitioners as principal practitioners, income is considered as sourced from the business structure. That means it should account for income on an accruals basis.

The cash accounting approach should be applied if services provided by employees are secondary to the professional work for which the practitioner’s fees or costs were charged to clients.
For New Zealand entities, the cash method of accounting applies in a very limited number of circumstances. As a rule, a full-time sole practitioner would use the accrual method. This will consider amounts to be derived at balance date if there is an entitlement to bill, even if no actual invoice has been issued.

Losses

Tax losses can be offset against assessable income. For Australian entities, non-commercial loss rules defer tax deductions for losses incurred from business activities, unless specific criteria can be met.

GST

A sole practitioner must be registered for GST if they are conducting business activities and their projected annual turnover is $75,000 for in Australia or NZ$60,000 in New Zealand.

Superannuation

In Australia, sole practitioners can claim a deduction for personal superannuation contributions made to a complying superannuation fund if specific criteria are met. Alternatively, sole practitioners can create an administration companies that provides them with access to employer-sponsored superannuation contributions.

Financing

Any working capital contributions from the practitioner to the practice will be sourced from ‘after tax’ dollars for Australian entities.

Interest deductions are available where a nexus exists between incurring an interest expense and deriving assessable income for New Zealand entities.

Analysis

Sole trading is the least expensive of all forms of practice structure and meets all forms of registration. The main disadvantage of a sole practitioner structure is unlimited liability, which many of the other structures can limit. You should also consider personal asset protection, such as a family trust.

See the tax considerations section below.

A general law partnership is an association of at least two people or entities that carry out business in common with a view to making a profit.

A partnership agreement should be struck which sets out the contractual relationship between all participating parties. It can be a verbal agreement or put into writing.

In New Zealand, a limited partnership is a separate legal entity but is treated as a general partnership for income tax purposes. A limited partnership must have at least one limited partner and one general partner and all parties are required to have a written partnership agreement. Restrictions on the management of the partnership may limit CPA Australia members from using such a structure. You should seek legal advice in this regard.

CPA Australia requirements

Under CPA Australia By-Law 9.3(a)(i), the partners of the partnership should be:

i. “only Members who hold a Public Practice Certificate; or
ii. at least one Member who holds a Public Practice Certificate together with only the following persons (Approved Controllers):
A. Members (who do not hold a Public Practice Certificate but who are also members of a body specified in Appendix 1 and are permitted by the constitution of such body to provide Public Accounting Services);
B. such members of a body specified in Appendix 2 as shall be permitted by the constitution of such body to provide Public Accounting Services; and/or
C. such other person or entity as the Board may, upon such terms and conditions as the Board may in the discretion of the Board determine, approve either generally or in any particular case taking into account, in the case of a natural person, the following matters:
1. the tertiary or other professional qualifications possessed by the person;
2. competence, experience or skill demonstrated by the person in their profession or calling;
3. the commercial, community or educational status of the person; and
4. such other matters as the Board may prescribe either generally or in any particular case;
iii. a body corporate or bodies corporate complying with By-Law 9.3(b); and/or
iv. a trust or trusts complying with By-Law 9.3.”

Liability

Individual partners are exposed to the risk of joint and several liability for the debts of the partnership and that liability is unlimited. If the partnership is sued, the assets of the individual partners will potentially be available to litigants and creditors. However, a Trust Deed will generally limit the trustee’s personal liability provided they are acting honestly and in accordance with their duties as trustee. 

Succession

It’s not easy to change control of partnerships between generations. Significant tax planning and tax elections must be used to cost-effectively pass control to another generation.

In Australia, the ATO will treat a changed partnership as a reconstituted continuing entity if the original partnership agreement included the provision for a change in membership and several other factors are met. In other circumstances, such as if an existing partner retires or a new partner is admitted, the partnership is deemed to cease, and a new partnership created. This requires two tax returns to be lodged in the income year the change occurs, among other steps.

In New Zealand, ITA 2007 provisions define thresholds for when disposing of a partner’s interest will result in tax liabilities.

Method of accounting

If an Australian practice consists solely of partners’ income, then the cash method of accounting should be adopted. If the practice is conducting an accounting business with multiple employees, then the accruals method of accounting is more appropriate.

The cash method is not appropriate for professional service firms operating through a general partnership in New Zealand.

Losses

Tax losses are allocated to the partners, generally in the same proportions as partnership income is distributed. In certain circumstances in Australia, the application of the non-commercial loss rules will need to be considered.

GST

A partnership is required to register for GST if its projected annual turnover meets the registration turnover threshold of $75,000 for business taxpayers in Australia and NZ$60,000 in New Zealand.
The Australian Tax Office view is that a general law partnership carries on an enterprise and may register for GST from the time it is formed. The exception to this is a partnership carrying on an activity without a reasonable expectation of profit or gain. Once formed the partners each acquire an interest in the entity. The partners’ consideration for their interests can include capital contributions or the promise to provide services, labour or skills.

Superannuation

In Australia, individual partners can claim a deduction for personal superannuation contributions made to a complying superannuation fund, subject to conditions, including capping concessional contributions to $27,500 (or $25,000 prior to 1 July 2021).

Alternatively, individual partners can set up administration companies to access employer-sponsored superannuation contributions, if the company is established for the purpose of providing employer-sponsored superannuation benefits for professional practitioners. Individuals automatically include an amount equal to the sum of any excess concessional contributions in their assessable income but can claim a non-refundable tax offset equal to 15 per cent of their excess concessional contributions.

Finance

In Australia, capital contributions can be made from after-tax profits of each partner. Interest deductions on any borrowed funds are available where a general law partnership borrows to refinance partnership capital. Only the partners’ contributed capital can be refinanced using interest deductible loans. Interest incurred on borrowings used to finance a distribution from an asset revaluation reserve or an unrealised profit isn’t deductible.

In New Zealand, interest deductions are available where a nexus exists between incurring an interest expense and deriving assessable income.

Analysis

CPA Australia regulations restrict partnerships to suitably qualified parties holding a public practice certificate. Partnerships must otherwise meet all form of regulatory requirements.

In Australia, as most partnerships have the size to meet the taxation business test, taxation planning using service trusts (or other service entities) is possible. Individual income tax rates apply to a partner’s share of a partnership’s net income but capital gains tax rollovers and exemptions are potentially available.

In New Zealand, individual income tax rates apply and there is unlimited liability of individual partners for the debts of the partnership.

There are further details on tax considerations below.

Company

A company is a legal entity formed by registration under the Corporations Act in Australia and the Companies Act in New Zealand. It is a legal person that acquires legal rights and liabilities (i.e. it can sue and be sued in its name). A company acts through its management, directors and members. Directors and management of a company are its controllers. Members (i.e. shareholders) hold shares in the ownership of the company.

New Zealand members may consider a look-through company structure, which is a company that has filed an election with the Internal Revenue Department. It provides for a transparent entity which is a hybrid of a company and a sole trader or partnership. It acts through its management, directors and members. Directors and management of a company are its controllers

CPA Australia requirements

Under CPA Australia By-Law 9.3(b)(i), being a body corporate:

"the directors of which comprise:

A. only Members who hold a Public Practice Certificate; or
B. at least one Member holding a Public Practice Certificate together only with Approved Controllers; and

any change in Control:

A. must be notified to CPA Australia by no later than 10 Business Days prior to the change occurring, accompanied by the Structural Profile applying after the change; and
B. will not be effective unless so notified to CPA Australia; and

Public Accounting Services shall be provided at all times in accordance with the minimum professional, ethical and technical requirements from time to time contained in these By-Laws, Code of Professional Conduct and all other rules and pronouncements contained in or made under authority of the Constitution."

Liability

If the business is sued, only the assets of the company are available to creditors. The shareholders’ other assets are protected other than for unpaid share capital. However, shareholders need to be aware of their potential personal liabilities.
In some circumstances, a director may be personally liable for certain tax debts. If this situation occurs, the director’s personal assets may be used to pay those outstanding amounts. If the director doesn’t have sufficient assets they could be made bankrupt.

Succession

Companies have perpetual succession, subject to legal compliance. Succession planning with a company structure allows the shareholdings and directorships of a company to gradually pass to the new management and directors. The death of a shareholder does not affect a company. In Australia, the CGT consequences of passing shares to another generation will vary depending on the transfer method used.

Method of accounting

For Australian entities, the cash accounting basis would typically be appropriate only if a sole practitioner is conducting a practice via a company. This is because the income will be attributed to the practitioner’s personal efforts. If the practice is conducting an accounting business with multiple employees, the accruals method of accounting is more likely to be appropriate. But if the company has no fee-earning employees, the cash method should be adopted.

For New Zealand entities, the cash method is not appropriate for professional service firms operating through a company structure.

Losses

Complex rules govern the way companies can use previous and current year tax and capital losses. Losses are quarantined, meaning they stay within the company and can’t be distributed to shareholders.

For Australian companies, the continuity of ownership test (COT) or the same business test (SBT) must currently be satisfied for it to use or carry forward prior year losses. Losses cannot be transferred between companies in a wholly owned group, unless the companies are part of a consolidated group for income tax purposes.

For New Zealand companies, the continuity of ownership test must be satisfied for it to carry forward or offset losses. From the 2020-21 income tax year, businesses may carry forward losses despite not meeting the continuity of ownership requirements if the business continuity test (BCT) is satisfied. This is similar to the Australian SBT. A look-through company does not retain any losses. Instead, the losses are passed on to the look-through owners.

GST

A company must be registered for GST if its projected annual turnover meets the registration turnover threshold. This is currently $75,000 for business taxpayers in Australia and NZ$60,000 in New Zealand.

The Australian Tax Office view is that a general law partnership carries on an enterprise and may register for GST from the time it is formed. The exception to this is a partnership carrying on an activity without a reasonable expectation of profit or gain. Once formed the partners each acquire an interest in the entity. The partners’ consideration for their interests can include capital contributions or the promise to provide services, labour or skills.

Superannuation

In Australia, individual partners can claim a deduction for personal superannuation contributions made to a complying superannuation fund, subject to conditions, including capping concessional contributions to $27,500 (or $25,000 prior to 1 July 2021). 

Alternatively, individual partners can set up administration companies to access employer-sponsored superannuation contributions, if the company is established for the purpose of providing employer-sponsored superannuation benefits for professional practitioners. Individuals automatically include an amount equal to the sum of any excess concessional contributions in their assessable income but can claim a non-refundable tax offset equal to 15 per cent of their excess concessional contributions.

Finance

In Australia, a company can refinance its working capital and deduct interest on the replacement borrowings. A company will not, however, get an interest deduction on funds borrowed to finance a distribution of unrealised profits.

In New Zealand, a company has an automatic deduction for interest incurred. This rule does not apply to a qualifying company or a look-through company.

Analysis

In New Zealand, the company structure provides a member with the protection of limited liability and can separate management and ownership of a practice. It provides for easy transfer of ownership but is administratively more difficult than some of the other structures. A look-through company offers the benefit of limited liability while remaining a tax transparent entity attributing all income and losses to the look-through owners. Tax or BAS services and financial advisory services can be conducted by a company, however audit and insolvency services must be conducted by individuals either as a sole practitioner or in a partnership.

In Australia, if the practice sources income which is regarded as PSI, the sole benefit of incorporation is the potential for limited liability to apply. For practices that satisfy the PSI rules, the lower corporate tax rate needs to be compared with potential capital gains tax disadvantages on sale, as a company is not eligible to claim the 50 per cent CGT discount on the disposal of assets.

Companies can provide services for tax, BAS services, audit and financial advisory. But currently insolvency services must be conducted by individuals, either as sole practitioner or partnerships. Only an authorised audit company formally registered with ASIC can conduct audit services.

See the tax considerations section below.

Capital gains tax (CGT)

• Consider your ability to access the 50 per cent CGT discount under Division 115 of the ITAA 1997
• Consider your ability to access CGT small business concessions

Income splitting

When you’re deciding on the most appropriate structure for your practice, you must consider the tax law dealing with alienation of personal services income, known as income splitting. These arrangements can be challenged under the Income Tax Assessment Act 1936 (the ITAA 1936).

There are specific rules for alienation of personal services income (PSI). PSI is when more than half of an individual’s income is gained from their personal efforts or skills.
Where the PSI is derived through a company, partnership or trust, the entity is regarded as a personal services entity (PSE) under the PSI rules. The PSI may be attributed by the PSE to the individual providing the services in some circumstances.

If the PSI rules apply, it affects how your PSI is reported to the ATO and the deductions you can claim. If the PSI rules don't apply, your business is a personal services business (PSB). When you're a PSB, there are no changes to your tax obligations, except you must declare any PSI on your tax return.

You can receive PSI even if you're not a sole trader. If you're producing PSI through a company, partnership or trust and the PSI rules apply, it will be treated as your individual income for tax purposes.

The first thing you need to do is work out if any of your income is classified as PSI. If it is, you then need to understand if special tax rules (the PSI rules) apply to that income. There's a series of steps to follow to help you do this.

More information about PSI

• Working out if the PSI rules apply
• What to do when the PSI rules apply
• What to do if the PSI rules don’t apply
• How to attribute PSI for companies, partnerships and trusts

Non-Commercial Losses (NCL)

Tax losses of an individual or an individual partner in a partnership may be disallowed as non-commercial losses (NCL) under Division 35 of the ITAA 1997 in certain circumstances. These rules don’t apply to trusts or companies but they are subject to their own loss recoupment rules.

Under the NCL rules, the loss cannot be offset against the individual or partner’s other income, such as salary and wages. It must be deferred until a taxable profit is returned from that activity (for example as a sole trader or individual partner carrying on a business as an accountant).

Typically, NCL is an issue when businesses start operating rather than when it’s more established. However, there are four general exemptions that may potentially apply to an accounting practice and satisfying any of these four tests allows the loss to be claimed in the year it’s made.

1. Assessable income test
2. Profits test
3. Real property test
4. Other assets test

An individual can only deduct the tax losses that meet any of the above tests so long as they also satisfy a personal income requirement.
Failing these tests, including the income requirement, the individual or partner can request the Commissioner to exercise his discretion and allow the loss under section 35-55 of the ITAA 1997.

More information about NCL

• Determine if you offset or defer the loss
• Four NCL tests
• Commissioner’s discretion

Service trusts

Service trusts (or other service entities) operate alongside the practitioner’s practice to provide services such as plant and equipment, staff hire, the payment of overheads and utilities, leasing premises, and debt collection. Service trusts can be an individual, partnership, company, trust or any combination of these.

Registered tax practitioners must disclose services outsourced to any third party including a related service entity or trust. They must disclose this in their engagement letters so that clients are notified of any services provided by a service entity.

More information about services trusts

• What is a service arrangement?
• ATO non-binding guide: Your Service Entity Arrangements

Substantiation

Consider the substantiation rules for the following:

• Car expenses and business travel expenses

Allocation of professional practice income

The ATO assesses the risk of the general anti-avoidance provisions of Part IVA of the ITAA 1936 applying to the allocation of an individual practitioner’s share of profits from a professional services firm carried on through a partnership, trust or company to associated parties, where the income of the firm did not constitute PSI under Divisions 84 to 87 of the ITAA 1997.

Individual professional practitioners contemplating entering new arrangements are encouraged to engage with the ATO through:

• early engagement
• email at [email protected]

Converting structures

When a practitioner decides to convert their business structure, the potential tax implications should be considered. You should consider whether there is a disposal of a valuable asset for CGT purposes and whether the CGT rollovers or discount and the CGT small business concessions can apply to defer, reduce or eliminate any capital gain. You should also think about whether the new structure is likely to be eligible for these concessions on any eventual sale. The transfer of work-in-progress may be separately taxable and the sale of the business will be subject to the GST provisions.

More information about converting structures

• Changing business structure
• Changing, selling or closing your business – things to consider
• Small business restructure rollover
• Small business CGT concessions

Goods and Services tax (GST)

Regardless of the business structure, an entity must register for GST if the projected annual turnover meets the registration threshold, currently NZ$60,000.

Income splitting

When you’re deciding on the most appropriate structure for your practice, you must consider the tax law dealing with income from personal services and income splitting.

These arrangements can be challenged under the Income Tax Act 2007 (the ITA 2007).There are specific rules to disallow excessive renumerations being paid to relatives

General anti-avoidance rules limit the ability of taxpayers to structure their affairs in a manner which would alter the incidence of tax. The Inland Revenue Department has a strong focus on schemes which attempt to reallocate income from personal services.

More information about tax avoidance

• Inland Revenue: Revenue Alert RA 11/02

Converting structures

If you decide to convert your business structure, you should consider the possible tax implications. For example, depreciation recovered and tax avoidance. The transfer of work-in-progress may be separately taxable and the sale of the business may be subject to GST.

More information about converting structures

• Choose a business structure
• Starting a new business