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ACBUS301A Case Study Solutions on Applied Income Tax
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Letter of Recommendation and Advisory
Dear Melitta and Jordan,
I have studied your case and observed that you as a couple are running a small business of providing bookkeeping services to your clients in a partnership structure by sharing profit and losses equally or in the ratio of 1:1. Before discussing the taxation consequences on you (individually) and your partnership business structure, it would be wise to discuss other various business structures for taxation purposes.
When starting a business, the most important decisions that an entrepreneur is required to make is to choose an appropriate legal form of the business which can be a sole proprietorship, partnership firm, limited liability company, company or corporation, etc. However, the business structure is not fixed and can be changed as per business requirements. Because as the business grows, it might be required to change the prevailing business forms to accommodate a larger number of owners, to implement a different structure of capital, or to protect the growing wealth of the business from business liabilities. Also, while selecting an appropriate business structure, it is very important to evaluate the tax consequences associated with the type of business type that has been chosen (Australian Government. 2020).
Various business structures considering tax consequences are discussed as follows:-
- Sole proprietorship tax considerations
This is the simplest form of business structures and attracts minimum legal compliances. As per Australian laws, the owner and the business is a sole proprietorship are considered to be the same. From the ATO’s perspective, the business in a structure of sole proprietorship is not a taxable unit. Instead, the overall assets and liabilities in the business and its earnings are considered as direct belonging to the owner of the business.
- General partnership tax considerations
When there are more than a single owner associated with a business, then the suitable structure of the business is a partnership entity. Similar to a sole proprietorship, the owner (two or more) and the business are not considered as separate but the same legal entity. As per ATO, there are primarily 3 types of partnerships structures:
1. General partnership (or GP): In this structure, all the partners have equal responsibility towards managing the business. Also, every partner possesses unlimited liability for obligations and debts that the business may incur.
2. Limited Liability partnership (or LLP): In this structure, general partners possess limited liability up to the amount of contributed capital to the partnership. The partners with limited liability are passive investors that do not play an active role in business’s daily operations and management (ATO. 2020).
3. Incorporated Limited Partnership (or ILP): In this structure, partners can possess limited liability for the business’s debts or liabilities. However, under ILP, it is compulsorily required to make at least one partner with unlimited liability called the general partner. That means, if the business when to remain incapable of meeting its obligations, then that general partner(s) will become personally liable for the obligations that remain unfulfilled.
To set-up a business with partnership structure, the following key elements are required to be considered:-
- Partnerships are inexpensive and easy to set up and have lesser reporting and legal requirements
- Partnerships will require separate TFN (tax file numbers) and must apply for ABN (Australian business number) and utilize it during all the business dealings (Braithwaite 2017).
- Partnerships are not required to pay any income tax on their earnings. Instead, all the partners are liable to pay tax (individually) on the share of income they receive. However, partnerships are required to file a partnership tax return with the ATO (Australian Taxation Office) per financial year
- Partnerships are also required to compulsorily register under GST if the business’s turnover exceeds $ 75,000.
- Company tax considerations
The business structure in the form of a company has been considered to be a separate legal entity, unlike a partnership firm or a sole trader structure. In other words, the company as a separate legal entity possesses the same (or similar) rights as are possessed by a living natural person. That means a company can incur debt, it can sue some other party or can be sued by a third party (Business Victoria. 2020).
A member of the company in the form of a shareholder with substantial interests is not personally liable (in the capacity just as a member) to pay any of the liabilities or debts accumulated by the company. The single most financial obligation of the member is to make timely payment of any unpaid amount on the shares issued by the company in the favor of the company itself if the management of the company has called the member for such payments. It is important to note that the directors are not compulsorily the members of the company but are employees of the company. Therefore, such management personnel can be held personally liable when the company is found under a breach of some legal obligations.
Companies are generally expensive to set up and involve complicated procedures and legal obligations. It is usually suited by the people that expect the income of their business to be highly volatile, and want some options or alternatives to use the current period’s losses in offsetting profits of future periods.
As per the above discussion, the best business structure is indeed a partnership firm as you are conducting a small consultancy firm and providing bookkeeping solutions. The division of ratio is purely based on the consent of the partners, but since the overall income of the firm belongs to the same family, there partnership profit sharing ratio can be modified for taxation purposes. Therefore, we will further discuss the earnings of the firms, the tax liabilities of all the family members of your family and then decide the best possibilities and/ or solution (ITAA-1997. 2020).
From the given information it is clear that the net fee income from the partnership firm under s 90 ITAA36 is $ 215000. Section 92 ITAA36 states that both the partners Melitta and Jordon have to include their respective share (in the ratio of 1:1 respectively) of net profit of the firm in their assessable income. Since both Melitta and Jordon are considered to be residents of Australia, therefore, they will be required to include their whole shares in partnership’s income as follows:-
|Total Fee Income||240000|
|Net Income of the Partnership Firm||215000|
Melitta will include $ 107500 in her assessable income, while Louise will also include the same amount of $107500 in his assessable income.
Division 5 of Pt III ITAA36 states that partners are individually liable for taxation on partnership firm’s income rather than partnership firm itself. That means a partnership firm can lodge the income tax return, but the obligation of payment remains with partners individually (s 91 ITAA36). Therefore, Melitta and Jordon both will individually file their incomes from the partnership as well as from other sources. Salary received as a partner is another form of profit distribution hence it is an assessable income (ATO. 2020).
Melitta earned a salary of $56000, and Jordon earns a salary of $ 14000. Apart from that Melitta and Jordan also own an investment property as joint tenants, which generate earnings as follows:
|Received as profit distribution from Firm||107500||107500|
|Received as salary distribution from Firm||56000||14000|
|Other Sources (Rental income from Investment Property)||38000||38000|
|Total Taxable Income||201500||159500|
As per ATO, the Medicare levy surcharge (MLS) gets levied upon every taxpayer of Australia that does not have a private patient hospital covers and has earnings exceeding a certain level. As per the case study, the family has private health insurance. Also, the couple has dependents in the form of two children in the age between 21 and 24 years old and studying full-time at university. Therefore they can receive an exemption from MLS (ATO. 2020).
A trust is an obligation imposed on a person (a trustee) to hold property or assets (such as business assets) for the benefit of others, known as beneficiaries.
If you (Melitta and Jordon) wanted to set up a trust, keep in mind the following points:
- It can be expensive to operate and set-up
- It requires a written trust deed outlining the way the trust operates
- It requires the trustee to take periodical administrative tasks
ATO. 2020. Partnerships. https://www.ato.gov.au/forms/partnership-tax-return-instructions-2012/?page=15#:~:text=A%20partnership%20is%20not%20a,in%20their%20own%20tax%20returns.
ATO. 2020. Work out your tax residency. https://www.ato.gov.au/individuals/international-tax-for-individuals/work-out-your-tax-residency/
Australian Government. 2020. Australian Taxation Office. https://www.ato.gov.au/Rates/Individual-income-tax-rates/
Australian Government. 2020. Business structures. https://www.business.gov.au/planning/business-structures-and-types/business-structures
Braithwaite, V. ed. 2017. Taxing democracy: Understanding tax avoidance and evasion. London: Routledge.
Business Victoria. 2020. Partnership: Register the most suitable structure for your business. https://www.business.vic.gov.au/setting-up-a-business/business-structure/partnership
Income Tax Assessment Act 1997. 2020. Act No. 38 of 1997 as amended. https://www.legislation.gov.au/Details/C2006C00472/d6093a59-8622-46b1-8d5b-6575302e5592