Report on comparing Sole Trader, Partnership and New Zealand Company

structure differences

By Liling Cheng

25 September 2012

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Contents

Contents................................................................................................................... 2

Executive summary...................................................................................................3

Introduction of Project and Workplace.....................................................................3

General definition.....................................................................................................4

Comparison of business structure............................................................................4

Establishment procedure......................................................................................4

Liability of members..............................................................................................4

Control of the organization...................................................................................5

Ability to transfer ownership.................................................................................5

Comparison the Tax implications..............................................................................5

Conclusion.............................................................................................................. 10

Recommendations..................................................................................................10

Reference................................................................................................................11

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Executive summary

Before starting a new business it is important to consider about what structure owner will use to operate their business. This report is introducing the nature of the three business structure: Sole Trader, Partnership and Company. It is listing some factors which should be considered in relation to different forms of organization.

In the report, it is also comparing the taxation difference with these three structures. It covers how different business structures affect income tax payments. Being informed helps to determine which structure best suits a business and its owner.

Some suggestion will be given, before owner chooses an organizational structure, some factors based on their businesses should be considered.

Introduction of Project and Workplace

My workplace is Small Business Accounting (NZ) Ltd (SBA), SBA had around 46 franchises in New Zealand, and my workplace is one of them. It has developed a supportive accounting service for the sole trader, partnerships and small limited companies; it’s a formula that has been very successful in NZ.

SBA maintains an in-house computerized cashbook; prepares for the client, monthly profit summaries; calculates GST returns; produces a year-end Profit and Loss statement, Balance Sheet, Depreciation Schedule; and prepares the client's tax return. It has also developed as a specialist in rental property accounting. Few accounting companies are promoting this aspect, and the identification of this market niche is proving very successful (sba.2012).

The objective of the SBA is want clients who appreciate the value they can bring to them and their business. SBA believes a happy client is a lifelong client.

This project objective is to provide detail information about the difference of three organization structures(especially taxation difference) to owner who want start his or her business, help them to choice the best organization structure for their businesses.

The significance of the project to the organization is provide a formal and professional report to SBA‘s new clients who want start a business but confusion with

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organization structure choosing. Taxation difference is always the main consideration and it is also the most complex to understand for owner. The project report has been list the main information to help clients to understand what information they do need to know.

General definition

Sole traders – A Sole trader is owned by one person, it is the simplest form of the business organization. Compared to other business structures, it has a minimal amount of legislation to comply with. But, sole traders has unlimited liability, it means that they are personal liable for the debts of the business.

Partnerships - A partnership is defined by the Partnership Act 1908. There are two or more people in the Partnership that participate in the management and contributed capital and share profits. It is a relatively simple and flexible form of business organization. The partners have liable for the debts of the partnership. In most small business adopt this form.

Companies - Companies are an often used form of business organization. It is a complex with many rules and regulations. A company must have at least one shareholder and one director. It is a separate legal entity (IRD. 2012).

Comparison of business structure

Establishment procedure

Sole traders are very simple in terms of set up time and cost. They can start business immediately without incurring any cost. Only some practical problems should be considered, such as selecting a place to work from.

Partnership established that the main consideration is writing down the partnership agreement. It is governed by Common law and Statute law.

A company established procedure is more complex, more expensive and the more lengthy time delay. It will register a constitution which contains its governance and administration rules, these process is carried out by a lawyer.

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Liability of members

Sole trader and partnership have unlimited liability.

The sole trader controls, manages and owns the business; the owners may employ other people help run the business. The sole trader is personally entitled to all profits and personally liable for all business taxes and debts.

In a partnership, each partner is liable for any debts of the firm. Based on the agreement, each of them shares responsibility for running the business, and shares in any profit or loss equally.

The company owns the assets and liabilities of the business; it is responsible for any debts. Shareholders in a company have limited liability. Generally, a shareholder’s liability is limited to the amount of uncalled capital on the shares which he or she has contributed to the company (New Zealand Master Tax Guide.2012).

Control of the organization

In a sole trader situation, he or she owns and operates the business and makes all the decisions.

In a partnership, partners’ authorities are equally, but the final decisions must be made jointly by the partners and some decisions require unanimity.

For company, its board of directors has the authority for running of the business. The shareholder does not have any proprietary interest in the assets of the business. However, a large shareholding may give control over the board.

Ability to transfer ownership

For sole traders, there are few restrictions on the ability to transfer ownership of the business. The selling price will be set by negotiation between the buyer and seller.

It is not easy to transfer an interest in a partnership. Normally require the consent of the all parties before an ownership interest can be transferred to another party.

Interest in companies is normally freely transferable. In small private companies,

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ownership interests may only be transferred with the consent of the other shareholders.

Comparison the Tax implications

Sole traders

In the first, as a sole trader, you need is a personal IRD number, complete IRD number application form (IR 595). Being a sole trader, you may employ people to help you in the business, so you also need to register as an employer with Inland Revenue, complete an Employer registration form (IR334)..As a sole trader, your business doesn’t exist as a separate legal entity; in your first year of business all you need do is file a personal IR3 income tax return at the end of the financial year. How to calculate tax pays for sole traders? Your net profit (total profit minus tax deductible business expenses) is simply taxed at individual tax rates. The rates in the table below apply from 1 April 2012 to 31 March 2013 (IRD sole trader.2012).

If you use money from business for personal use, these takings are called drawings. These drawings are a part of your profit and taxed accordingly, but not a deductible business expenses. These drawings need to be carefully recorded for Inland Revenue so it clearly states which were for personal use and which were tax-deductible business expenses (New Zealand Master Tax Guide. 2012).In your second year of business you may have to pay provisional tax.

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Real case in the placement- Sole Trader

In 2012 financial year, total income is $35,448 from this sole trader’s business. And no deductions in this year, the income tax payable are $5,223.40, calculation method as follows:

$0--$14,000 10.7% $14,000* 10.7% = $1,470$14,000--$48,000 17.5% ($35,448 - $14,000)*17.5% =$3,753.4

Income tax payable $5,223.40 Then, income tax payable – provisional tax paid = tax need to pay in the end of financial year

Partnership

In the partnership, the partnership itself does not pay income tax on its profits. Instead, each partner taxed on their individual share of the net profits at the end of the financial year.Each partner can draw funds from the profits of the business when they need them for personal use, just like a sole trader. However, at the end of every financial year, the net profit of the business is shared between the partners before their share of the year’s income is taxed as individual profit, along with any other income they may have received.Income, expenses, tax credits, rebates, gains and losses – it all gets accredited to each partner in proportion to their share set out in the deed of partnership.

How to calculate a salary or wage to a partner? Typically, it is makes up of two parts: the bona writing in contract and agreed to by all partners pay a salary or wage to a partner, and deduct PAYE (IRD partnership.2012).

All the partners need complete individual tax (IR3), include the salary or wage, along

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with their share of any profits or loss from the partnership. And they also need claim the salary or wage as a deductible expense in the partnerships’ income tax return-partnerships (IR7).

Real case in the placement- Partnership

This partnership organization has two partners, A and B. in the 2012 tax year; the partnership total income is $2,970. Each partner share $1,485 profit from the partnership, partner A and B need pay tax as individual profit.

Company

As the company is a separate entity, it owns all the assets and all the liabilities itself.You need pay tax at the company rate; all income you receive from the start of your 2012 income year is taxed at 28%. And you should complete companies form (IR4).

Company can distribute profits to shareholders, who are then taxed individually on their overall personal income. Shareholders can choose three ways to pay tax on their income from the company. These ways are: Shareholder –employee, give themselves a salary or wages and pay PAYE to

Inland Revenue. These salaries are deductible as a business expense for company.

Shareholder can draw money periodically from the company. At the end of the year, the company calculates a salary amount on which the shareholder will have to pay income tax.

Receive dividends from the company from the profits left over after tax. The dividends are taxed at the shareholders’ tax rates, with a credit allowed to the shareholder for tax already paid by the company on the profits (IRD company.2012)

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If a company’s total expenses exceed its income, the company will make losses for tax purposes. If a company has losses it may not have to pay tax and may be carried forward to be set-off against subsequent year’s income or group with other companies. But, these losses cannot be offset against the shareholders’ other income for tax purposes.

If a company became a “look through company”, it will be taxed like sole traders or partnership, tax is paid by the shareholders on the company profits at the shareholders’ tax rates. And any losses can be allocated to shareholders to reduce their overall tax liability. But, a company want to become a look through company must meet some criteria: The company must be a New Zealand tax resident company. All the company’s shares can only be owned by individuals, trustees or another

LTC. The LTC must have five or fewer shareholders.They also need complete the form of Look-through companies (IR879), to make an election with Inland Revenue to become a look through company (IRD LTC. 2012).

Real case in the placement- Company

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In the end of financial year, this company has total income $27,936, minus the deductions $14,446, the total taxable income is $13,490. So income tax payable is equal to $13,490*28% = $3,777.20. No provisional Tax paid in this month, so the company needs to pay tax $3,777.20.

The provisional tax payable for a tax year can be calculated using one of the following methods: the standard (uplift) method; estimate of RIT on or before the due date of an installment; or use of the taxpayer’s GST ratio (New Zealand Master Tax Guide.2012). This company was liable for residual income tax (RIT) of $3, 777.20, using standards method; the company provisional tax for the 2012/2013 income year would be calculated as follows:

RIT* 95% =$3,777.20 * 1.05 = $3,966

The company must pay provisional tax for the 2012/2013 income year in three instalements. The company’s balance date is 31 March, so the due dates are 28 August 2012, 15 January 2013, and 7 May 2012.

Conclusion

There are many forms of business organization and a number of factors must be borne in mind when deciding on the most appropriate organization structure for an owner.

A sole trader is the simplest form of business organization. However, the owner has unlimited personal liability for debts and for negligence. It can’t stop other businesses from using their name, but they can trade mark their brand as protection.

Partnerships are often used for income-splitting purposes. It combines flexibility and ease of operation with tax advantages. Partnerships do not pay tax, partners d, so partnership losses can be offset against a partner's other income.

Companies have significant financial and legal advantages; they are taxed at a flat rate which is significantly lower than the upper ranges of the marginal tax rates applying to individuals. But are also closely regulated and involve a number of formalities.

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Recommendations

Choosing an organizational structure is a crucial decision facing a business owner or partners preparing to form a company. Deciding which structure will work depends on the size of the company being formed, tax implications and the level of legal complexity with which owners are willing to deal. The owners need to determine these factors of their business, for example, organization size and strategy.

Business size - In reality, if the organization is very small, it may not even have a formal structure, such as a retail store, or a restaurant, its business structure can be simple. The owner may prefer sole trader or partnership. In many cases, a simple structure will suffice, but the simplicity of a sole proprietorship or partnership has its risks.

Business Strategy - How a business is going to position itself in the market in terms of its product is considered its strategy. A business may decide that it will produce a product already on the market more efficiently and more cost effectively (cost-leadership strategy). The organization structure must fit the strategy. Many business owners incorporate their businesses because it can add credibility in the eyes of clients, consumers and other businesses. Having limited liability status also makes a company a safer bet for investors.

Reference

New Zealand Master Tax Guide for Student (2012). CCH New Zealand.

Small business accounting (2012). Retrieved fromhttp://www.sba.co.nz

BUSINESS.GOVT.NZ. (2012). Retrieved fromhttp://www.business.govt.nz/starting-and-stopping/business-structures

Business income tax. (2012). Inland Revenue.http://www.ird.govt.nz/business-income-tax/paying-tax/tax-rates/bit-taxrates-companytax.html

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