Managing your tax liability is an important and necessary part of operating a business. The tax that you must pay and the tax discounts and concessions available to your business will depend on the way you structure your business. A common structure used to operate a small business is a partnership. Before setting up as a partnership, it is important for you and your partners to understand how to manage the taxation of your partnership. This article will explore:
- what it means to set up as a partnership; and
- the taxes your partnership needs to pay.
What is a Partnership?
A partnership is an association of two or more individuals or entities that are carrying on a business together.
A partnership is not a separate legal entity from the partners who constitute the partnership. As a result, the partners are jointly and severally liable for the partnership debts. That means a creditor can pursue one partner for the entire amount of the partnership’s debt to that creditor, even if that partner only owns a fraction of the partnership.
Who Makes Up a Partnership?
The main participants in a partnership are the partners.
Individuals can go into partnership together, as can entities. For example, two or more companies may set up a partnership together in order to establish and operate a business.
Joint and several liability is a huge risk in a partnership so it is important that you understand this risk and the responsibility and trust involved for all members.
Using a separate legal entity such as a company as a partner can limit the exposure to unlimited personal liability. That is, liability is joint and several at the partnership level but the company itself has inherent asset protection benefits.
What Governs a Partnership?
A partnership is governed by general law as well as your state or territory’s Partnership Act.
The Partnership Act includes provisions which apply by default to partnerships, subject to any agreement entered into by partners. For example, the Partnership Act 1892 (NSW) states that partners are to share equally in the capital and profits of the partnership. This default provision may not apply for your business situation as you may want to split the profits differently.
Accordingly, you should prepare a partnership agreement for your partnership that accurately reflects the particular terms of your arrangement.
This will ensure partners are on the same page as to:
- the management of the partnership; and
- each partner’s capital contribution and entitlement to profit.
Taxation of a Partnership
A partnership is not a separate legal entity and so does not pay tax in its own capacity. However, a partnership still must complete and lodge a tax return each financial year.
This is for compliance reasons and to ensure the income the partners report aligns with what the partnership has reported. Accordingly, a partnership’s tax return is a data-matching tool used by the Australian Taxation Office (ATO) to cross-check the amounts it returns to the partners in their personal tax returns.
Tax Liability of the Partners
Partnerships are ‘flow through’ vehicles, meaning that the income of the partnership is taxed in the hands of the partners.
Partners will pay tax on their individual share of the partnership’s profits and losses. This means that the amount of tax they pay will depend on the tax rates for each partner (whether an individual, company or other entity).
Furthermore, losses in the partnership flow-through to the partners and may be offset against that partner’s income from other sources. Therefore, losses are not considered ‘trapped’ within the partnership, as they are in a company.
Managing Tax Liability
It is important to bear in mind that you can manage, and possibly reduce, tax liabilities by using combinations of different structures.
For example, having a partnership constituted of companies rather than individuals will affect the taxation of the partnership. This may be beneficial for you depending on your overall tax situation.
It is important to get legal and accounting advice to work out the best structure to meet your specific commercial and tax goals.
Capital Gains Tax (CGT)
As well as the tax you pay on the income you make, businesses also need to pay tax on gains relating to capital assets. For example, the disposal of goodwill on the sale of a business.
Is My Partnership Eligible for the 50% CGT Discount?
Subject to meeting various conditions, certain taxpayers may be eligible for the small business CGT concessions, that is, they may reduce their capital gain by half, taking the first half completely tax-free and only paying tax on the remaining half.
Individuals are eligible to access the 50% CGT discount and, therefore, individual partners may be eligible for the CGT discount.
What Small Business CGT Concessions Apply to my Partnership?
A small business entity is a partnership that carries on a business. Additionally, it has aggregated turnover of less than $2 million. If you are a small business entity, you may be able to access the small business CGT concession if the:
- CGT asset is an interest in a partnership asset;
- CGT asset is an asset you own that is not an interest in a partnership asset but one you use in the business of the partnership; or
- total net value of the CGT assets owned by you does not exceed $6 million.
An active asset is an asset you use in the course of carrying on a business or an asset inherently connected with the business. The small business CGT concessions allow you to disregard or defer some or all of the capital gains made from an active asset in certain circumstances:
- where you sell an active asset, your business has continuously owned it for 15 years, you’re aged 55 or over and you’re retiring or permanently incapacitated. In this situation, you can reduce the capital gain on that asset by 50% (in addition to the 50% CGT discount as discussed above); or
- you can use the small business retirement exemption to shelter up to $500,000 from tax. Although, if you are under 55, you must pay the sheltered amount into a complying superannuation fund; and/or
- you can defer all or part of the capital gain for two years or longer if you acquire a replacement active asset or incur expenditure on making capital improvements on that active asset.
The taxes your partnership needs to pay will depend on individual partners. This is because income from a partnership is taxed in the hands of the partners on their share of the business’ profits and losses.
Accordingly, it is important to consider your individual tax liability resulting from the partnership business. If you want more information on partnerships or tax advice relating to your partnership, contact LegalVision’s taxation lawyers on 1300 544 755 or fill out the form on this page.
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