Taxation Law

ACC 304 Taxation Law Workshop 8 Partnership and Trust business structures

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Learning Objectives

• Determine if a taxpayer is in business

• Understand the fundamentals and tax treatment of partnerships

• Understand the fundamentals and tax treatment of trusts

• Understand/classify the income of minors

Learning Objective 1

Determine if a taxpayer is in business.

Business structures There are 4 main business structures in Australia: • Sole trader • Partnership • Trust • Company

Each have their advantages and disadvantages and the choice of structure will influence the tax outcome.

Business structures Income from a business’s core trading activities is assessable as ordinary income as it is in the ordinary course of business (s.6-5(1), Harris).

The business may also be able to claim general or specific deductions against the trading income.

The business may also include other assessable amounts as discussed earlier.

Business v Hobby • Under S6-5, ordinary income includes income from

carrying on a business. The existence of a business activity is relevant for determining whether:

• the receipts of the business are income and deductions can be claimed;

• or whether they are private receipts derived from a hobby (no income or deductions to be claimed).

What is a business?

Any profession, trade employment, vocation or calling, but not the activities of an employee (s.995-1).

The Courts have developed guidelines. A question of fact and degree and each case must be decided on its own circumstances.

What is a hobby?

• Hobbies are usually done for fun, not for profit.

• Hobby activities are usually performed by individuals in their spare time. • Hobbies are usually quite small in scale.

Business indicators Whether or not a taxpayer is carrying on a business is a

question of fact. The courts have developed a number of relevant characteristics for a business activity, remembering no one factor determines your in business:

(Ferguson v. FCT)

• Is the activity is conducted in an organised and systematic way?

• Is there continuity and repetition of transactions? • Is there a profit motive? • Does the activity has significant commercial character? • What is the scale of operations?

Class activity 1

• Max runs a coffee shop on weekends only (2 days per week). He sells coffee to the public at $6 per cup. The coffee is the best in the world and imported from Peru.

• Max has staff to assist him during the busy period of the day. He records all takings using MYOB. Max has an A.B.N. Max is not registered for the GST. Is Max in Business?

Learning Objective 2

Understand the fundamentals and tax treatment of partnerships.

Partnership • According to Section 995-1 of the ITAA (1997), a

partnership is defined as: "an association of persons carrying on business as partners or in receipt of ordinary or statutory income jointly but does not include a company."

• A partnership is not a separate legal entity in general law and does not pay tax of itself (s91).

• The partnership shall furnish a tax return of the income of the partnership (s.91) which will show the profit or loss and the distribution to each partner.

• The partners pay tax on the profits distributed to them.

Tax law partnerships • The tax law extends the definition of a partnership by

including those taxpayers in receipt of income jointly. The effect of this is joint owners of a rental property, shares, bank accounts etc are considered partners and each declares an amount of the income.

• The ATO’s default position is the income is shared equally between the partners.

• Only lodge a partnership return if carrying on a business.

Partnerships As the partnership is not a separate legal entity it

does not have taxable income. The partnership has:

• Partnership Net Income (PNI) defined in s90 as assessable income except net capital gains

• Income calculated as if the partnership was a resident taxpayer less all allowable deductions except personal superannuation contributions and tax losses of earlier years.

Tax treatment of partnerships • A partnerships net income or loss is calculated by deducting from

assessable income all deductions available under the Income Tax Assessment Act with a few exceptions. In other words, the normal rules for income and deductions generally apply.

• Refer to Partnership Readings 4.0

Partner Salaries

• See example at Partnership Readings 5.0

Other Matters • Interest on the capital of a partner is treated in the

same way as payments of “salary”. Any payment of capital interest to a partner is merely an allocation of profit prior to the general division among the partners. It is not, therefore, an allowable deduction in arriving at the net income of the partnership

• Interest on money lent by a partner to the partnership as distinct from interest on capital is an allowable deduction for the partnership provided the principal moneys are used by the partnership in producing its assessable income. The interest received by the partner from the partnership is assessable income of that partner.

Partnerships and CGT • Partnerships do not make capital gains for tax. The

individual partners need to declare any net capital gain in their tax return commensurate with each partner’s share in the ownership of the business. – Each partner’s capital gain or loss is worked out with

reference to the partnership agreement or general partnership law if no agreement s106-5(1)

• An interest in a partnership asset is a CGT asset in its own right (s.108-5(2)(c)).

Pre workshop question 1

Outline a partnership structure.

Pre workshop question 2

How are losses treated within a partnership structure? Students are to provide an example.

Class activity 2 • Matt and Mark are partners in a florist shop. After all

expenses, the accounts show a profit of $95,000 for the year ended 30 June 2018. This is after allocating $90,000 to Matt and $35,000 to Mark in salaries. The profit of the practice after salaries is to be split evenly. There is no interest calculated on capital accounts but each partner (as individual taxpayers) had an outstanding loan to the partnership generating interest of $5,000. These loans were needed to drive growth in PNI over time.

Question 1: How much will need to been included in the assessable income of each partner? Question 2: Would it make a difference if the salaries had not been physically paid to each partner?

Learning Objective 3

Understand the fundamentals and tax treatment of trusts.

Trusts Trusts were not interesting from a tax perspective until the late

1960’s. Prior to this point their primary role was asset protection and succession planning and they were highly restricted in terms of the riskiness of the investments they could make. Then these rules were relaxed

There are many different types of trusts – we are most interested in the discretionary trust in the tax/commerce field. The discretionary trust allows great flexibility in the distribution of amounts to achieve the best overall tax outcome.

Basic trust structure

Elements The various elements to a trust : • Trustee The trustee is the legal registered owner of the trust property. The trustee may manage a business. A trustee can be a natural person or a company. The trustee can be sued.

• Trust Property The trust property refers to the property (assets) of the trust. This may be a business or real property.

• Beneficiaries The beneficiaries have the beneficial interest in the trust property. For example, the beneficiaries of a family trust are Mum, Dad, Children and other relatives in most cases.

• A Fiduciary Obligation The trustee has a fiduciary obligation to act in the best interests of the beneficiaries. These duties, obligations and powers are usually found in the trust deed.

Types of Trusts There are 3 common types of trusts: • Discretionary Trusts This type of trust gives the trustee the power to determine which beneficiaries are entitled to distributions of the income and/or capital of the trust. This can change from year to year. Each year, the trustee decides how much of the net income of the trust to distribute to each beneficiary. A discretionary trust is commonly called a family trust.

• Fixed Trusts A fixed trust is a trust where the beneficiaries’ entitlements to a share in the income or capital of the trust are fixed according to the trust deed. Beneficiaries receive a fixed percentage of the net income of the trust estate.

• Unit Trusts A unit trust is a subcategory of fixed trust. Unitholders have a fixed entitlement to the income and capital of the trust based on the number of units held. For example. A unit trust may have 100 units. If Mark has 50 units and Max has 50 units, then they are entitled to 50% each of the net income of the trust estate.

Taxation of trusts

Trusts have the following characteristics: • Not a separate legal entity but must lodge

a taxation return. • Has assessable income and deductions. • Profits are distributed to each beneficiary. • Losses are trapped in the trust and carried

forward

Taxation of Trusts Quite complex but briefly: Division 6 ITAA 1936 has 2 roles. 1. Calculate net income 2. Determine who is assessed.

1. Broadly, the “net income” is calculated in much the same way as a resident taxpayer. 2. To determine who is assessed, you must first determine whether each beneficiary is under a legal disability and presently entitled to a share of the net income of the trust estate.

Taxation of Trusts Legal disability • a minor who is under the age of 18 on the last day of the

year of income; • a bankrupt; or • an insane or mentally incapable person.

Present Entitlement • a beneficiary is presently entitled to a share of the net

income if they have a right to demand and receive immediate payment of their share of the net income.

Assessing provisions

Student discussion

Pre workshop question 3

Name the various parties to a family trust arrangement. Give examples of who these parties may be in real life.

Class activity 3 • The Federal Labour Party has released policy

that will have implications on family trusts. What are they and want impact would they have if successfully implemented?

• In your opinion, should this legislation be implemented. Discuss.

• Please refer to this document Labour family trust plan

Learning Objective 4

Understand/classify the income of minors

Income of minors • Special rules exist to discourage income splitting to

minors. Otherwise, taxpayers would give their 2 year old child $18,200 every year.

• These rules are found in Division 6AA ITAA 36 and were introduced to discourage income-splitting to children.

• 3 key terms: prescribed person, eligible taxable income and excepted assessable income.

Prescribed persons Section 102AC(1) ITAA 36: a “prescribed person” is any person under 18

years of age at the end of the financial year. These persons are referred to as “minors”.

Eligible Taxable income: The associated taxable income is taxed at the Division 6AA rates

Excepted assessable income: The associated taxable income is taxed at ordinary rates

• Division 6AA reduces the prescribed person’s tax-free threshold from $18,200 to $416. And then taxes their eligible income at 45% (apart from the 66% for the small branch between $417 to $1,307).

• So eligible income is basically taxed at an adult’s top marginal tax rate without the $18,200 threshold (see adult rates in appendix), removing any incentive to shift income from an adult to a child.

Table: Tax rates for residents who are under 18

Income Tax rates for 2018–19 income year

$0 – $416 Nil

$417 – $1,307 Nil plus 66% of the excess over $416

Over $1,307 45% of the total amount of income that is not excepted income

Eligible assessable income If an amount is not excepted assessable income it is eligible assessable income s102AE(1). Eligible assessable income is subject to the Div 6AA rates. Examples of eligible assessable income include: • Distributions from family trusts or partnerships • Income from gifts of money or property • Generally amounts received but not earned

Excepted assessable income Excepted assessable income is essentially amounts the minor has earned themselves, earnings from the investment of these amounts and other amounts specified in the legislation.

Examples include: • Employment or business income s102AE(2)(a) • Taxable payments from Centrelink • Income from a deceased estate • Business income where the minor is carrying on

a business

The effect The effect is a minor at school with a part time job

will be a prescribed person receiving excepted assessable income and so this receipt is not subject to the Div 6AA rates.

If they also receive a distribution from a family trust, this amount is eligible assessable income and is subject to the Div 6AA rates. (see slide 44)

The effect • This means two calculations are necessary to

determine the overall tax assessed. Each receipt received by the minor needs to be classified appropriately, unless they are an excepted person.

• If they are an excepted person all of their income is excepted assessable income.

Class activity 4 John, a resident, aged 16 at 30 June, earns the following amounts during the year: • Wages (KFC) $8,000 • Term Deposit Interest (Deposit from Grandfather)

$2,000 • Bank account interest (Savings from wages)

$350 • Distribution from family trust $10,000 Determine the tax treatment of the above amounts. Calculations are not required

Class activity 5

Appendix 1 – Resident adult tax rates Resident tax rates 2019–20 (these were unchanged from 2018-2019)

Taxable income Tax on this income

0 – $18,200 Nil

$18,201 – $37,000 19c for each $1 over $18,200

$37,001 – $90,000 $3,572 plus 32.5c for each $1 over $37,000

$90,001 – $180,000 $20,797 plus 37c for each $1 over $90,000

$180,001 and over $54,097 plus 45c for each $1 over $180,000