So you want to start your own business?
Assuming you have chosen what you are going to do, and when you’re going to do it. Before the first business transaction takes place, you should think about what structure (business entity) you should use to run your business.
You may think it’s just a matter of getting out and selling your first product/service. But getting the business entity wrong can cost you in the long run, particularly if the business is successful, which is what we’re all aiming for. Its not just the tax aspects that you should consider. As much thought should be given to the exit scenario as is given to the entry.
Often it’s just yourself who is starting the business. More often than not you have a supporting spouse who may also be working but not in the business. If it’s just yourself you will be using what is called a sole trader template. This is where the only person involved will be yourself. Mostly you would be working from home using your own vehicle.
This is the easiest type of business to advise on and requires low setup efforts.
It is important to have a separate area in the home to set up your admin office. It may be just a desk and computer, but you should keep your business items separate from your personal home area. This helps to keep your work focus as its easy to be distracted by non-work activities. This also helps you claim a proportion of your home expenses in your business to reduce the tax you pay.
It is recommended that you draw up a plan of the house showing the work and personal areas. This helps you calculate the percentage of home expenses to include as your business expenses.You can claim a percentage of the following Mortgage interest, telephone, power, rates and insurance. For those with a large mortgage it can have significant benefits in reducing the tax you would otherwise pay.
So should you be GST registered? It depends on whether your business has a turnover of $60,000 (at which point you are compulsorily required to be GST registered) or less (where its voluntary) and what proportion of your client/customers are also GST registered.
Another benefit is being paid 13.04% of the value of the car that you are using for the business (subject to apportionment) It is advisable to get this set up from the beginning and keep receipts for all those expenses that you are claiming in your business GST. There are advantages in being GST registered as you can claim 13.04% of any business expense (that includes GST). The Department of Inland Revenue (IRD) pay this back to you in your GST returns. The other side of being GST registered of course is that you have to pay the IRD 13.04% of your sales revenue.
More often than not, you will have the support of a partner who may work in the business on a part-time basis or who may work full time.
A partnership enjoys the same aspects of working from home as the sole trader. But it adds a dimension of complexity. For example how do the partners get paid? You should consider:
- the cash contribution each partner brings;
- the time spent by each partner in the business;
- the expertise of each partner.
This can determine the percentage of profits allocated to each partner.
If the partner is a spouse of the main partner, any wage paid would need the approval of the IRD.
If the spouse has another income, it may be advantageous to set up a company rather than a partnership.This provides a better tax planning tool.
The business can be set up as a look through company which can offer benefits of better tax planning for the partners. Under this structure any loss in the business is transferred to each shareholders other income and has the result of reducing the tax they would otherwise pay.
Some situations require a more formal ownership and profit sharing setup. A company structure should then be considered as this provides more control over who contributes what, and what happens with each person’s share of the business should they want to leave. A partnership structure can possibly do this as well but a company structure is more efficient.
Often you aren’t going into business on your own. It may be a mate or a colleague that you share the idea with. Both (or more) of you share the same desire. But what if one continues working their existing job and can’t commit full time until the business gains traction? What if one partner has more capital? What if one partner wants to exit the business, how are their shares valued?
A company provides the flexibility for partners to:
- have different ownership percentages of the business according to the capital contributions of each partner;
- transfer of shareholding if more capital is required or if there is a change in the dynamics of the business. You can decide on a way that the shareholding is to be valued or transferred or whether the shares can be sold outside the original partners;
- enables you to have a shareholding that is not dependant on capital contributions. For example if one partner contributes $5,000 for a 50% shareholding, the other may contribute $0 for 50% shareholding but contributes instead the expertise or the intellectual property of the company;
- Your “share” of the business becomes very important if the business is sold for a profit. The proceeds are then paid in the ratio of your share;
- Provide a formula to which the company is valued for the purposes of one party's share being bought by another or sold to an outside party
- Can provide for the existing shareholders to have pre-emptive rights, ie The shares have to be offered to existing partners first
- Define how major decisions are to be made. This can be put in the company rules or “constitution”;
- Determine who are to be directors. Directors have liability for the actions of the company in their capacity as directors. Shareholders do not have liability beyond their shareholding and any uncalled capital (unless they sign personal guarantees on behalf of the company eg bank loans or building leases).
What type of company?
There are several types of companies that give different results
- Ordinary company
This is a limited liability business entity that is a totally separate legal entity from the owners. The rules of the company are set out in the Companies Act 1993.
- Look Through Company
This has the legal structure of an ordinary company and is governed by the Companies Act 1993 but has the tax characteristics of a partnership. The tax legislation looks through the company structure to the shareholders, hence the name Look Through Company or “LTC”
When a company has a taxable loss, the loss is “attributed” to the partners and offsets the partners other income resulting in a reduced tax bill. Many taxpayers have used an LTC to own their investment properties for that very reason
Assets used by the business
If you have personal assets that you will use in the business, the business should purchase them from you. If there is a private and a business use, how is this to be managed? It depends on how much business use there is to make it practical for the business to own it. The most common asset is the vehicle. The most practical business structure if a vehicle is used for both business and private use is as a sole trader/partnership as a simple apportionment of expenses reflected by a log book is easy to initiate. If a company is to own the vehicle there is tax to be paid for private usage. There are exemptions but by and large it’s a tax that would be onerous on the business and is a regime that should be considered carefully.
Firstly there has to be a profit, although payment can be financed by capital input by the partners. For example if one partner is working they should be paid for their efforts at an agreed wage. If there is not enough capital to pay for the partners wage, consideration should be given to this being paid from capital contributions from the partners. This would provide a fair compensation for the effort/expertise of the partner. If this occurs capital should also be rewarded by paying interest on the amount lent. These ground rules should be laid down at the start. If after the end of the year, there is profit to distribute to the partners it can be distributed by various means in the ratio of their shareholding. This way, all partners are paid compensation for their contribution whether it be capital only or time and effort or a mixture of both.