Published in Proctor, December 2011, page 34-35.
A financial overview of incorporating your legal practice.
Incorporating your legal practice can have several benefits, some of which are not immediately obvious.
The opinions of lawyers on incorporation for law practices vary greatly, but almost all of their comments reflect a surprising lack of understanding about its pros and cons.
Here are some of the facts:
- You only need to transfer goodwill, and fixtures and fittings to the incorporated legal practice (ILP), not work in progress and debtors. This keeps the stamp duty cost down.
- The ILP provides a layer of asset protection.
- An ILP simplifies partner entry and exit, as it is only shares that are bought and sold, not partnership assets.
- If you are eligible for the small business capital gains tax (CGT) concessions – which most partners in partnerships or sole practitioners are – then depending on the value of your net assets, CGT can either be completely eliminated or significantly deferred to ultimately exit from the business. Even better, with correct shareholding structured, you can maintain your access to the small business CGT concessions into the future.
- With appropriate asset structuring and funding in place, debt can be restructured into the ILP to provide personal debt relief and repaid from after-tax profits of 70percent, with interest being tax deductible.
- By utilising correct shareholding structures, you can spread your share of business profits over your family members, including a non-working spouse, children over 18 and even cap your tax at 30percent in a corporate beneficiary.
- You will receive fully franked income as dividends. If the ultimate recipient has a tax rate higher than 30percent, you only pay the top-up. If the tax rate is less than 30percent, you get the difference back from the Australia Tax Office (ATO).
- If you are on the precipice of payroll tax, with the way that the payroll tax calculations work, by including directors’ salaries in the equation the payroll tax is not significant. On a payroll of $1.2million, the Queensland Payroll Tax liability is $11,875, that is, less than 1percent of the total payroll.
Consider the following scenario:
A two-partner firm has goodwill of $750,000, WIP of $350,000, debtors totalling $300,000, fixtures and fittings of $50,000, a wages bill of $700,000 and a profit before partners’ salaries of $450,000. The practice has bank debt of $200,000. It is operated as a partnership of individuals and has a service trust which has a profit of $50,000 (minimal benefit these days due to the ATO’s view on service trusts and mark-ups).
One partner is 46 and the other is 54. The younger partner has two children over 18 at university and a spouse who earns $50,000 a year from other employment. The older partner is in a second marriage with a non-working spouse and three young children, and needs to continue working. Both partners meet the small business CGT basic requirements for applying the concessions.
The firm is considering succession and is looking to restructure on 1 July 2012 into an ILP with the shareholders being two discretionary trusts.
By restructuring to an ILP, the following is achieved:
- The bank funds the purchase of the goodwill, fixtures and fittings for $800,000 which provides the partners with $300,000 each in cash to apply for their own use after paying off the $200,000 practice debt. This cash could be used to reduce home loan debt, purchase another investment asset, or put into superannuation.
- No capital gains tax is paid or payable by the partners. The younger partner will need to contribute $93,750 to his super fund in two years’ time after the sale to the ILP. Alternatively, he could pay the CGT at his marginal tax rates on 15 May 2016 (that’s right, 2016). This contribution will be tax-free on the way in and out of super. No contributions are required by the older partner.
- In year one, the partners bill their old firm WIP and collect all old firm debtors. The tax is already paid on the debtors and the WIP is taxable when billed. Profits in the ILP are reduced while WIP accumulates until it is billed. Any profits are taxed at 30percent in the ILP.
- When the franked dividends are paid out, and $150,000 in wages paid to each director, assuming the same level of before-tax profits as the old firm, the tax positions for each partners’ family compared to that under the old firm structure is:
- 46-year-old: $78,175 before restructure, $64,300 after restructure
- 54-year-old: $81,400 before restructure, $72,150 after restructure
- If the profit is retained in the ILP for debt reduction or working capital, it is only taxed at 30percent instead of 46.5percent to the principals.
- Due to the way that the PAYG instalment systems works, the ILP will not have to start remitting tax to the ATO until the first quarter after the first income tax return is lodged for the company. If the ILP commences business on 1 July 2012, then the first tax return would not be required to be lodged until 31 March 2014. The 2012/13 tax would be payable at this time, and the first instalment for the 2013/14 year would be payable in July 2014. The ILP will need to retain cash to meet its 2013 and 2014 tax liabilities.
- From a costs perspective, the stamp duty on the transfer is $29,025, once off, but the other savings are annual.
So, this could be your action plan:
Assess what the overall impact is for you to restructure, not just the immediate cost. There can be significant personal benefits.
Think of it like an investment – a 10percent tax saving a year via correct structuring is the same as receiving an after-tax 10percent income return on your investment each year. Find me an investment that can provide this year on year!
Seek advice from someone who understands the rules and opportunities from both a business and personal perspective.