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Tax, income implications for family business succession

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Tax, income implications for family business succession

HLB Mann Judd partner, Peter Bembrick

A business adviser has opened up on some of the core tax and other related factors in need of consideration when family businesses plan for generational succession, including potentially costly mistakes that often catch unsuspecting leaders off guard.

Last year, Michelle De Lucia of KPMG, who co-authored the Family Business: The balance for success report in conjunction with Family Business Australia, told My Business that planning for such a succession “should start at least five-plus years out” in order to deliver the business, the family and other stakeholders a smooth transition.

Speaking to My Business about the issue of succession planning this month, Peter Bembrick (pictured) of HLB Mann Judd said that, in addition to the operational aspects of the business under new leadership, family business owners should also factor in the various tax and other related considerations that form part of any ownership transition.

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Distribution of income and ownership

If there is only one child to take over the business, or all siblings will take over in equal measure, the succession can be a bit more straightforward. But added complexities arise when only some of the leader’s children will take the reins of the business.

“There is often a balance that must be found between helping out the next generation and passing on the ‘family jewels’ to them, and providing sufficiently for the founders of a family business to enjoy a comfortable retirement and benefit from the fruits of all their hard work in building up the business,” Mr Bembrick explained.

As such, he said that it is “important to be clear as to which assets and the extent of income distributions that will go to the children during your lifetime, as compared to assets and funds that will be retained and distributed only after your death”.

“The difficult process of dividing the family wealth amongst the members of the next generation can include:

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  • Balancing the relative value of giving.
  • Transferring or leaving ownership in the business assets/entities to one or more family members who are involved in the business.
  • Providing other family members with non-business assets.

“It can also be more difficult where some receive funds earlier than others (either due to their age or their personal needs/circumstances), even more so where some effectively receive a portion of their ‘inheritance during their parents’ lifetimes, in which case their siblings may need to receive a greater share of the assets under their parents’ wills in order to maintain equity.”

Mr Bembrick added: “Alternatively, if the shares in the companies through which a family business are to be carried on are simply left equally to all of the founders’ children, but not all of the children are involved in running the business, this can sometimes produce a difficult situation where at some point there must be a negotiation between the siblings to agree a buy-out of some of the shares, and funding such an acquisition is not always straightforward.”

Is a business restructure required?

Adequate planning for the succession should include a review of the structure of the business, Mr Bembrick said, which will simultaneously determine current suitability as well as determine the optimal business structure for the intended succession arrangements.

“This may include putting in place entities for holding investments, as part of the process of building up family wealth separate from the business, and/or as a vehicle for investing the proceeds of a future business sale,” he said.

When examining the structure of the business, he suggests also looking over the following aspects:

  • The level of risk arising from the business operations for the operating entity/(ies) and the directors/owners.
  • The extent to which non-business assets are, or can be, separated from business assets.
  • Where applicable, separate the operations of one business within the group from another business.
  • The financing of current/future business operations and capital acquisitions, to meet ongoing cash flow and working capital needs while appropriately managing risk.

“If some restructuring is required, a review will then be needed to determine the most effective way to restructure, taking into account the possible application of concessions and exemptions such as the small business capital gains tax (CGT) concessions, and also remembering to analyse other tax implications such as GST and stamp duty (especially where real property is owned),” Mr Bembrick said.

“The structure review should include any other assets related to the business, such as the business premises, certain intellectual property (IP) such as patents or trademarks, and other intangibles, which are often owned separately to the business operations (or if not, perhaps they should be).”

Regardless of what form a restructure may take, and whether shares will be issued to family or non-family members, Mr Bembrick said that it is important that “appropriate valuations” of assets are obtained.

These valuations should cover not just the relevant business entities and assets they hold, but also the market value of “goodwill and other intangibles and real property”.

“And for these transactions to be undertaken at market value so as not to fall foul of the tax rules, which generally deem transactions to take place at an arm’s-length market value, regardless of the actual consideration paid,” he cautioned.

Tax considerations

As previously outlined, restructures can impact tax concessions and considerations for the business and the family.

Mr Bembrick said that particular consideration should be given to CGT.

“Special tax considerations will arise when the business was established prior to September 1985 (i.e. pre-CGT), or key business assets such as real property were acquired pre-CGT,” he said.

“In these cases, there should be no tax payable by the founding shareholders under a restructure, and the CGT cost base of any new holdings in the business entities under the new structure would be ‘reset’ at their current market value.

“A similar outcome would arise if there is no restructure, or only a partial restructure, with the result that pre-CGT interests in the existing entities are simply left to the founders’ children in their wills.”

Small business may also be eligible for CGT concessions where ownership was acquired after the introduction of the tax. But Mr Bembrick warned that there are “several key requirements that must be satisfied, and quite a few pitfalls to be avoided”. These include:

  • Different classes of shares on issue, which he said can lead to “one of the most costly pitfalls”.
  • The often-overlooked issue of a “significant individual” — i.e. someone who holds at least 20 per cent of the voting, capital and dividends of the company — when applying the small business CGT concessions.

“This is a topic in itself, but suffice to say that the process includes a careful review of the shareholding structure of the operating entities and the nature and market values of their assets,” he said.

Another tax issue arises where a business owns property — either as the business premises or unrelated properties.

“The landholder duty rules can apply in the relevant state/territory to both a transfer of shares in the company and to a new issue of shares in the company,” Mr Bembrick noted.

“This arises when the company holds land valued at $2 million or more, and the transaction results in someone holding an interest in the company of 50 per cent or more.

Therefore, it should not be a concern where shares are issued to a new owner involving relatively small percentage holdings where all shares are of the same class, although care should be taken when the company has different classes of shares on issue as to how the relative percentage ownership of each individual has been determined.

“If duty is payable, the same rate scale applies as for direct transfers of real property, and the amounts involved can be significant, so careful planning and awareness of these issues is important. Similar outcomes will arise when issuing or transferring units in a unit trust that owns real property.”

Employee share incentives

Another factor Mr Bembrick noted is worthy of consideration is the issue of employee shares in the business.

“Consider whether there are key employees who have been and/or will be critical to building up, maintaining and continuing to grow the business, and whether providing them some ownership interest in the business will help incentivise them and make it more likely that they can be retained,” he said.

“Keep in mind that this may need to be balanced off against the expectations of the family to retain control or even complete ownership in the medium and long term.

“One option may be issuing shares to a key employee but with a mandatory buy-back period and other conditions that allow the family to take back complete ownership in due course and/or on certain events occurring.”

According to Mr Bembrick, issuing shares to select employees is a “tricky area” given that it requires a look at the commercial, tax and practical implications from all three parties: the business, the current shareholders and the employee(s).

“One common recommendation to clients is to structure the transaction as a new share issue, rather than a transfer of existing shares (which would generally have tax consequences for the holders of any shares to be transferred),” he said.

“Shares can be issued to the employee personally, but more commonly they will be issued to a nominated discretionary trust or company controlled by the employee, allowing dividends and any potential future capital gains to be distributed within the family group in a tax-effective way.

“The shares could also be issued directly to another family member (e.g. the employee’s spouse) with a lower taxable income and lower marginal tax rate, which can be helpful in saving tax, but lacks the flexibility that can be gained by using a trust or company.”

Another factor to examine is whether to issue the shares for nil or at current market value, and if it is to be the latter, how the acquisition will be funded. Each has its own and varied tax implications, including fringe benefits tax (FBT).

The above information is intended as a general guide only and does not constitute financial advice.

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