People starting out in business often don’t want to consider that their venture may fail. Indeed having a positive outlook is often necessary to battle through the early years. And yet, experience tells us that giving some consideration to all possible outcomes is no bad thing.
Generally when setting up a structure to operate a business through, the first two considerations are minimising costs (including establishment costs and ongoing costs) and minimising taxation. The third consideration, which is sometimes overlooked, is what type of structure will provide the best asset protection in the event of failure.
As insolvency practitioners we get to see the good and bad of business structures, and what structures may have been better in hindsight. Here are a few useful examples that we have seen in recent times:
Consulting business and Cafe
A husband and wife were directors of a company which operated a consulting business. The husband was the sole employee of the business. An opportunity arose to purchase a cafe. A discretionary trust was established through which the cafe would operate. The existing company operating the consulting business became trustee of the trust. Using the company for this purpose seemed a good idea as it would not be necessary to spend the money on getting a new company and would also mean only one annual review cost.
Unfortunately the cafe operated at a loss and fell behind in the payment of its tax obligations. After accumulating ongoing losses, a decision was made to sell the business. A sale was achieved, however all of the proceeds from the sale were paid to the bank under various securities.
As directors of the corporate trustee, the husband and wife were issued with Director Penalty Notices (DPNs) by the ATO in respect of an accumulated PAYG withholding debt.
The directors were placed in a position where they had to put the company into liquidation or voluntary administration to avoid the ATO pursing them personally for the amounts under the DPNs. Remember the ATO debt related only to the cafe business.
Placing the company into liquidation enabled the directors to avoid personal liability to the ATO, however it adversely impacted on the consulting business which the company had been operating prior to becoming trustee of the trust.
Whilst liquidation may have been inevitable for a corporate entity operating the cafe, the consulting business became a casualty as a result of using the existing company as a trustee when consideration of a new corporate trustee may have been appropriate.
Two rules can be restated from this case:
1. Don’t have unrelated businesses trade under the same company structure.
2. If possible take advantage of the sole director option.
Retail Children’s store
A husband and wife had an opportunity to purchase a local baby and children’s retail business. The husband was a tradesman and was employed on a regular salary. The husband and wife set up in partnership and purchased the business. The business operated reasonably well for several years, however tougher retail times and issues with a major supplier resulted in cash flow difficulties.
The business reached a point where it was not financially viable and after unsuccessful attempts to sell the business, the doors were closed.
As the husband and wife were operating in partnership, they were jointly and severally liable for the debts of the business.
Unfortunately the only way out for them was to sell their home which had just enough equity to cover their creditors. Fortunately, they did not have to go bankrupt.
Whilst there is no guarantee that a different structure may have enabled the husband and wife to save their house, it is likely that their personal exposure would have been reduced by operating the business through a corporate structure. Alternatively, the business could have been operated by the wife as a sole trader.
Licensed Bar and Plumbing business
Two tradesmen were operating a successful plumbing business through a company structure and decided to purchase a bar. In doing so, they set up a new company to purchase and operate the bar. So far, so good.
It wasn’t long before the bar started to lose money. The losses were funded by the profits from the plumbing business. The bar’s trading did not improve and as a result, both companies started to fall behind in their tax obligations. Subsequently, the rent for the bar also fell behind and the landlord took possession of the premises.
The directors were then faced with a situation where they had creditors of each company pressing for payment. As the bar had ceased trading the directors sought advice and decided to place the bar company into liquidation.
This then left the directors needing to address their plumbing company which now had a significant tax debt as a result of using its cash flow in an attempt to prop up the bar.
Due to the plumbing business returning a consistent profit the directors were able to put forward a proposal to their creditors to enter into a Deed of Company Arrangement and therefore continue to trade.
In this case the separation of businesses in different corporate entities enabled the poor performing business to be isolated and the profitable business retained. Yet, this advantage was nearly lost by the decision to support the loss making business with the cash flow of the profitable business. Not only did this decision tend to negate the decision to separate the businesses, arguably it was also a breach of their duty as directors of the profitable company.
Whilst different structures will suit individual circumstances, people entering a new venture should ensure that they consider the costs and benefits of different structures, so that they are aware of their financial exposure in the event of failure.