Start-up Checklist - Sept 2002

As a business and tax consultant, there is nothing more satisfying than when a client's business is proceeding along in a profitable and efficient manner.

However, this outcome doesn't just "happen" - it's generally the result of hours of planning, by both the consultant and business person, especially in the all important start-up phase.

This article will focus on the more important issues a breeder should consider when starting up a taxation business. For easy reference, I have prepared this article in the form of a "Start-Up Checklist".

This checklist emphasises the importance of plannng in the start-up phase as I'm sure there are issues you could not have reasonably considered, many of these being the result of numerous changes to our taxation law in the past five to ten years. Furthermore, there are numerous tax laws specific to primary producers/horse breeders, which will make adherence to the checklist all the more important.

I'd like to think that by following this checklist your breeding business will have the foundation for success in the future. One thing I can assure you - it will ease the stress involved with starting the business and help you focus on the important operational aspects of your business, such as mating policies and broodmare acquisitions.

Start-Up Checklist

1. Choosing a tax structure

Easily the most important start-up issue, thus it deserves the most comment.

There is a range of factors to consider when choosing a structure, but there are three key factors on which most weight should be placed, those being:

asset protection;
income tax minimisation; and
ease of administration.
My thoughts on each of these factors are noted below:

Asset Protection

It is important that a creditor is limited from attacking the assets of the business, and is not able to pursue the assets of the owners, or any of the structures the owner controls.

Horse breeding is a high risk pursuit and very much subject to the vagaries of the market, thus asset protection is a critical consideration when tax structuring.

Example

An individual owns a house worth $2.5M. He also owns a business which has failed. If the business is owned in his own name, the house is at risk to the creditors.

If the business is operated through a company, the house is likely not to be at risk.

It is also important for the owner of a business to protect assets of the business from their own personal creditors.

Example

Fred is going into a horse breeding business and is committing significant funds to the venture. The horse breeding business will own a significant amount of assets, such as a breeding property and broodmares. Fred also has a property development business that he personally operates.

Fred will want to protect the assets of the horse breeding business from claims of the creditors of the somewhat risky property development business.

Income Tax minimisation

If a business is to derive taxable income, planning to minimise income tax will be an important factor.

Income tax minimisation can take the form of ensuring that income derived by a tax structure is taxed at the lowest possible rate. This can be done, for example, by ensuring low individual marginal rates and tax-free thresholds are taken advantage of and that other income is taxed at a corporate rate.

Example

A business is conducted through a trust rather than a company. In the company the tax rate would be 30%. The trust instead can distribute to individual beneficiaries whose marginal tax rate is only 18.5% (inc Medicare Levy).

Husband and wife breeding partnerships can also be very effective, especially where one spouse derives nominal income, which is taxed at a lower marginal tax rate.

Example

Judy is a successful obstetrician who earns over $400,000 per annum. Her husband, Darren, works part time as he stays at home to look after their two children.

Judy wishes to commence a horse breeding business, a passion that Darren also shares.

Assuming Darren can argue that he is a partner at tax law, this couple should give consideration to forming a partnership to run the business. In this regard, profits can be split between them so that the low tax rate of Darren can be taken advantage of to reduce their overall tax burden.

Warning - when considering income tax minimisation, the application of the general anti-tax avoidance provisions should be considered.

Ease of administration

Any structure put in place will result in costs arising. Such costs include but are not limited to:

• The cost of purchasing an entity;
• The cost of initial registrations (e.g. ABN, GST, Tax file number, Workers Comp etc);
• The costs of ongoing renewals (e.g. business name); and
• The cost of accounting, tax return and BAS requirements.

In general the more complex a structure, the harder it will be to administer.

Before putting any structure in place you should weigh up the benefits to be derived against the administrative burden it carries.

In this regard I have a useful warning - if you don't understand the tax structure a tax adviser puts to you, don't go in it! A tax structure is only as effective if it is operated properly. If a principal does not understand the tax structure, the principal will not operate it properly, and therefore, the tax benefits will not be obtained.

What are the common tax structures?

In the context of a horse breeder, the tax structures that should be considered are:

1. Sole Trader
2. Partnership
3. Company
4. Discretionary Family Trust

The structure that is best for your horse breeding business is best determined by weighing up the following advantages and disadvantages of these commonly recommended tax structures.

Sole trader - advantages

1. Inexpensive to establish and run
2. Easily understood
3. Income assessed at own tax rate (advantage if considerable losses in the early years, a reality with a horse breeding business)
4. Able to obtain 50% CGT discount. Beneficial if "hobby" horses or a breeding property is involved.
5. Breeding losses can be easily carried forward (subject to new "Non-Commercial Loss" rules - see articles on my website for more details).

Sole trader - disadvantages

1. No asset protection so creditors of the business could have access to the sole trader's personal assets
2. Income splitting not available
3. Breeding profits assessed at your marginal tax rate - disadvantage if on a high tax rate
4. Substantiation rules re car and travel expenses must be complied with
5. Possibility of tax implications when a partner is admitted (e.g. making your spouse a partner).

Partnership - advantages

1. Less costly to run than a company or trust
2. Can provide some flexibility in the partnership agreement, e.g. paying salaries
3. Income splitting between partners
4. Partners can obtain new CGT 50% discount
5. Partnership "losses" can be distributed to partners

Partnership - disadvantages

1. The partners are joint and severally liable
2. No asset protection
3. Partners cannot claim input tax credits when paying partnership expenses
4. Superannuation deductions are restricted
5. The "Non-Commercial Loss" rules apply
6. The substantiation rules apply to car and travel expenses
7. The admittance of a new partner can cause many tax complications

Companies - advantages

1. Asset protection. If the company business fails, personal assets of the shareholder generally protected
2. Company can employ, thus extra superannuation deductions potentially available.
3. 30% tax rate from 1 July 2001
4. Substantiation rules do not apply
5. "Non-Commercial Loss" rules do not apply
    

Companies - disadvantages

1. Costly to run and set-up
2. 50% CGT discount not available.
3. Cannot distribute losses to individuals
4. Can be severe tax penalties if paying loans to shareholders and directors
5. Complex rules regarding carrying forward of losses
6. New Small business CGT concessions difficult to satisfy.

Family Trusts - advantages

1. Excellent asset protection, especially where a company trustee is present
2. Tax flexibility in terms of "income splitting" amongst beneficiaries
3. "Non-Commercial Loss" rules do not apply
4. The 50% CGT discount is available. A good entity to hold a breeding property
5. Substantiation rules do not apply
6. Able to stream income to minimise tax. Example, a capital gain on the sale of a "hobby" horse can be distributed to a beneficiary with capital losses

Family Trusts - disadvantages

1. Costly to establish and run and difficult to understand
2. Cannot distribute losses to a beneficiary. Losses trapped in the trust
3. Complex trust loss rules apply
4. Not easy to admit partners. A partnership of trusts can overcome this
5. Nominated beneficiaries do not have direct ownership of its assets.

2. GST - the issues

The important GST start-up issues are as follows:

• ABN and GST Registration - to be able to register, the breeding business must fulfill the "enterprise" test;
• Though conducting an "enterprise", not compulsory to register if your annual current or projected turnover less than $50,000;
• If significant costs in start-up phase, generally best to register and claim back the GST paid;
• Be sure to nominate the correct business start date. You can retrospectively register;
• Nominate the "cash" basis of GST accounting if you carry a lot of debtors at any given time. To be eligible, turnover must be less than $1 million dollars;
• Ensure you have proper "Tax Invoices" when selling stock; and
• If you don't like bookwork, don't nominate the "monthly" basis for lodging BAS returns.

3. Record Keeping

Any books of account, records or documents relating to the preparation of your income tax return must be retained for a period of at least five years. If a company, records must be retained for a seven years after completion of the transaction to which they relate.

Basic records for a breeder to maintain are:

• Receipts for supplies you make, including records of supplies, deposit books and bank statements.
• Acquisitions and other expenses, including expense payment records, receipts from small cash acquisitions, cheque butts and a log book for car expenses.
• If travel extensively, and away from home more than six nights in a row, a travel diary;
• GST records - tax invoices and adjustment notes.
• Year-end records, such as creditors lists, debtors lists and depreciation schedules.
• Records of assets that may be subject to capital gains tax (e.g. breeding property)-these records need to be kept for five years.

4. Tax File Number

If using a new entity to run your business, acquire a tax file number. This can now be applied for on the same form as your ABN/GST application.

5. Register a business name

Gives your breeding business a good commercial "feel" and an identity. Very important for sole traders and partnerships.

6. Are my activities a "business" for tax purposes?

No tax business - no tax deductions!

Over the years I have dedicated many a word in the "Tax File" to what factors the ATO wants demonstrated for a breeding business to be accepted. For a more detailed discussion visit my web site, but the major factors are:

• whether the activity has a significant commercial purpose or character;
• whether the taxpayer has more than just an intention to engage in business;
• whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity;
• whether there is repetition and regularity of the activity;
• whether the activity is of the same kind and carried on in a businesslike manner such that it is directed at making a profit; and
• the size, scale and permanency of the activity.

7. Transfer of breeding stock - get it right!

Special rules now apply where a former "hobby" horse (e.g. broodmare) first becomes business trading stock. Where this occurs, the breeder is treated as having sold the item at either cost or market value (at the taxpayer's option), and as having reacquired it for the same amount. If you are going to use "cost", ensure you provide your accountant with the proper records to establish this figure.

If transferring stock to a new business entity, the entity will acquire the stock for its market value.

N.B. There may be capital gains tax implications when transferring stock to a new business.

8. Buy and sell in the right name

I can't tell you how many times I've seen a new business set-up, yet sale invoices are issued in the name of the wrong entity, wrong ABN's are quoted and suppliers issue invoices in the name of the wrong entity. To the ATO it looks confusing and it could limit the amount of deductions you can claim or, worst case, put your business status at risk.

You are welcome to contact me if you would like me to clarify or expand on any matters I have raised in this article.

PAUL CARRAZZO CPA
CARRAZZO CONSULTING CPAs
22 BLACKWOOD ST, NORTH MELBOURNE VIC 3051
PH: (03) 9329 7044
FAX: (03) 9329 8355
MOB: (0417) 549 347
Email: This e-mail address is being protected from spambots. You need JavaScript enabled to view it

DISCLAIMER

Any reader intending to apply the information in this article to practical circumstances should independently verify their interpretation and the information's applicability to their particular circumstances with an accountant specialising in this area.

Reproduced with permission from the Australian Bloodhorse Review © Copyright 2002