An entrepreneur starting a new business has a choice to make – how should she structure the business legally. In Australia, there are actually four alternatives to choose from: sole proprietorship, partnership, company or trust. The reasons for choosing a company or trust often include limiting legal liability, protecting personal assets, or ease of sharing or transferring ownership. And, in the wake of recent caps on superannuation contributions, more financial planners are recommending family trusts to hold savings that cannot be put into the superannuation system. What are these structures? How do they work in a purely Australian context? And what problems or challenges might arise when a US taxpayer tries to do exactly what her Australian neighbour would find optimal?
This is the fourth instalment in our series of posts discussing the ways US tax laws constrain the investment choices of US taxpayers living in Australia. These are the areas we will be covering:
- Superannuation
- Homeownership
- Real Estate
- Australian Managed Funds
- Australian Shares
- Business Ownership Structures
- Investing in the US
- Record keeping
This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action.
6. Business Ownership Structures
The disclaimer above is particularly apt for this topic. While writing this post, I found myself in a rabbit warren of rules, details, and complexity. It is too easy to get lost in all the detail – so the focus of this post is on giving a broad overview rather than delving into all of the nuances. This is an area where personally tailored professional advice is essential.
For Australians starting a business, the ATO website is not a bad place to start looking for information. This overview video will introduce you to the main concepts.
In addition to taxes, there are two concerns that are addressed by using a company or trust: asset protection and estate/succession planning. The idea of asset protection is to make sure that non-business assets (such as principal residence) are not put at risk should the business be unsuccessful. Both companies and trusts can be used to ensure that business creditors only have a claim on the assets of the business. Companies also make it easy to transfer ownership of the business – either as an exit strategy or for estate planning – through a sale of shares in the company. Trusts are a natural estate planning tool and can be used to protect family assets in the event of a beneficiary’s personal bankruptcy or marriage breakdown.
So, what are the differences between using a corporation or a trust? To form a company, the founder(s) transfer assets to the company in return for shares. Shareholders are generally entitled to elect a Board of Directors, which oversees company activity and hires management to run the company. In a small start-up, the founder usually wears many of these hats simultaneously. A company is a separate taxpayer and pays tax on income at a rate of 27.5% or 30% depending on size. Income can be retained inside the company , or distributed as dividends. To the extent that the income inside the company is taxed in Australia, the company will be able to distribute franked dividends, and shareholders (owners) will receive a credit for the Australian tax paid by the company. Dividends, however, are all ordinary income and companies do not receive any discount on long term capital gains like individuals do. There are costs to setting up the company, maintaining separate accounting records, documenting board meetings, and reporting to ASIC.
A trust is created by transferring assets to a trustee and is governed by a trust deed which specifies how much discretion the Trustee has in managing the assets and distributing income. The trust deed will specify the trust’s beneficiaries – that is, the people or entities that are entitled to distributions from the income or assets of the trust. For tax purposes, a trust doesn’t generally retain income – income is distributed to the beneficiaries. So, while a trust will file a tax return and may be required to pay tax on behalf of some beneficiaries, it doesn’t generally pay tax on its income. Instead, income is taxed to the beneficiaries on their individual tax returns. Income distributed to beneficiaries retains its character – that is, capital gains can be distributed and taxed as capital gains on the beneficiary’s tax return. The trust deed can give the trustee discretion to stream income to specific beneficiaries in order to minimise the overall tax liability of the beneficiaries. Trusts are often recommended when structuring a family-owned business, or as a tax-advantaged way to own investments that cannot be placed inside superannuation (which is more important with the new lower caps on super contributions).
A trust where all of the beneficiaries are in a single family can elect to be treated as a Family Trust, which gives even more flexibility[1]. However, care must be taken when beneficiaries include minors, as children under 18 are generally taxed at the top marginal rate on passive income. As always, tax rules change over time. Current Labor proposals will limit the effectiveness of Family Trusts for some.
Still confused? This video explains the difference between a company and a family trust:
Of course, all of this is what a purely Australian financial planner or tax adviser would advise an Australian client. But, once you add a US connection into the mix, the advice will be very different. The US tax code is extremely xenophobic – almost everything “foreign” requires either time-consuming intrusive disclosure or punitive tax treatment, or both.
So, that Australian company that protects assets and perhaps allows income to be retained at a 27.5% or 30% tax rate? On a US return Form 5471, will be required at a minimum. This is the form that tripped up a Canadian resident recently[2] (discussion at Isaac Brock Society). Form 5471 is required if you are a US taxpayer (citizen, resident, green card holder) and you are either the direct owner of 10% or more of a non-US corporation, or you are an officer or director of a non-US corporation which has a US shareholder who owns 10% or more of the company. The actual disclosures required vary depending on how much of the company you own. Furthermore, the rules are even more complex if the company is a “Controlled Foreign Corporation (CFC)” under US tax rules. An Australian company would be considered a US CFC if the sum of the ownership of all US persons owning 10% or more of the corporation adds up to more than 50%. So, if the company is owned equally by 9 shareholders (11.11% each), 5 of whom are US persons, then the corporation is a CFC. However, if the company were owned equally by 11 shareholders (9.09% each), they could all be US persons and the company would not be a CFC (assuming that there’s no relationship between the shareholders). If the company is a CFC (which is highly likely if it’s a business you’re running yourself), then you need professional help as you have fallen into one of the most complex parts of the US tax code, known as Subpart F. The Subpart F rules will tend to undo any tax planning achieved by creating the corporation. [3]
US tax rules for trusts [4] depend on who provided the assets for the trust – in the US this is called the Grantor of the trust. If the grantor retains control, then US tax rules disregard the trust and all income is reported on the Grantor’s individual tax return. Most Australian Family Trusts would probably be classified as Grantor Trusts for US tax if the grantor is a US taxpayer. And, since the trust is constituted under Australian law, it is a Foreign Grantor Trust, and would be required to file Form 3520-A as well as Form 3520 each year. Again, these information returns generate very high penalties if they are omitted from a US tax return. Foreign Grantor Trust status will negate all of the Australian tax benefits of establishing the trust. Self-Managed Superannuation Funds (SMSFs) would also be treated as Foreign Grantor Trusts [5], completely undoing the tax benefits provided under Australian law.
I’m well over a thousand words, and I’ve only scratched the surface. If this post gives you an idea of the complexity involved, then it will have served its purpose. Australian residents who are subject to US tax rules would be well advised to seek professional help (ideally someone expert in both US and Australian tax law) if they have any of the structures mentioned in this post. In the next and final post in this series, I’ll cover some of the considerations and difficulties of investing directly in the US, as well as a brief recap of the record keeping required for all of the types of investment covered in this series.
[1] Australia’s rules around Family Trusts allow a much greater degree of tax planning than similar rules for US domestic trusts.
[2] Australia does not have the same mutual collection agreement with the US that Canada has. Furthermore, Canada will not collect on behalf of the IRS if the taxpayer was a Canadian citizen when the tax liability arose.
[3] Note that Australia has its own CFC rules.
[4] For a somewhat technical summary of US foreign trust rules see this information sheet from Deloitte.
[5] There are some who argue that all superannuation, including SMSFs, should be treated as Social Security for US tax purposes, and is therefore exempt from US tax under the Australia / US tax treaty.
Karen:
This is a well constructed post because it demonstrates that the use of corporations and trusts provides “life advantages” for residents of Australia. These “life advantages” are NOT available to those U.S. citizens who wish to be compliant with the Internal Revenue Code.
This comment will focus on the use of Australian corporations by U.S. citizens. I will not discuss the issue of “trusts”.
The message is simple:
U.S. citizens in Australia should NOT carry on business through an Australian corporation.
The perspective of the United States of America …
Americans are simply different. They are special people. They are better than other people. They need to to separated from those who are not American. Special rules have been designed to ensure their freedoms. Special rules have been designed to encourage their separateness from others. These rules assume that all things foreign are evil and are undertaken for one purpose. That purpose: to avoid or evade U.S. taxes.
The Internal Revenue Code (the Bible of American Life) is premised on the following basic principles:
1. The United States is hostile to “all things foreign”. (If you see the word “foreign” in the Internal Revenue Code, the word “penalty” is sure to to follow.)
2. The United States hates all forms of deferral (with the exception of IRAs and that sort of thing).
3. The United States hates leakage from the U.S. tax base. (This principle is at the root of the hostile treatment of the “alien spouse”. No ability to make unlimited gifts to the “alien”. Punishment for using the “married filing separately” category, etc.)
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When thinking about the use of Australian corporations by U.S. citizens, one must consider:
“The 3 H Words – “Hate”, “Hunt” and “Hurt”
Hate:
As Karen says the U.S. tax code is extremely Xenophobic. The “Foreign Corporation Rules” were enacted in 1962 and were intended to apply to large corporations. With the help and education of the “tax professionals” they are now applied to very small business.
Hunt:
Remember that Americans are required to report all their activities to the U.S. government. The reporting requirements for for foreign corporations are simply unbelievable. If a U.S. citizen is the owner of a small Australian corporation, he/she is required to report more information to the U.S. government about that corporation than he/she is required to report to the Australian government.
Form 5471 is NOT a form. It’s a separate tax return with a number of schedules.
It’s important also to know that that the U.S. citizen may have ownership of Australian shares attributed to him under the “attribution rules”.
Note further that pursuant to the FATCA IGAs the U.S. is hunting for people with foreign corporations.
There are severe penalties for not reporting the existence of your Australian corporation on the Form 5471 – automatic $10,000 per year. Toronto Resident Donald Dewees learned this the “hard way” – $120,000 penalties imposed for not letting the U.S. Government know he had a small corporation in Canada (where he lives).
It’s worth noting also that if you don’t file Form 5471, the statue of limitations runs forever on your return. But, I digress …
So far, I have described ONLY that there are reporting requirements. I have not described any punitive taxation.
Hurt:
This is the punitive taxation part. Why would the U.S be interested in this information at all?
The answer is that the purpose of the rules is to actually ATTRIBUTE certain kinds of income earned by the corporation to the individual shareholder. This is what Karen refers to as Subpart F income. This is the “Hurt”. This is the pain. And this is why an American in Australia should not carry on business through a corporation.
If this upsets you, you can sleep well knowing that all of these rules are necessary to preserve Americans’ freedoms around the world.
America has been preserving your freedom through the “Foreign Corporation Rules” since 1962. In 1964, the legendary investor Sir John Templeton (who pioneered investing in foreign companies) renounced his U.S. citizenship. I simply cannot understand why he would have done this. Can you?
Form 5471 might be a good reason for you to renounce your citizenship too.
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Thanks for your comment, John.
While the Foreign Corporation rules have been in the US tax code for over 50 years, my understanding is that the original target was foreign subsidiaries of US corporations. As recently as ten years ago, I doubt there were many US expats who were aware that these rules even existed, much less what the impact would be on their own “foreign” business – organised under the laws of the country they live in, and created without any thought of US tax consequences. I’m sure very few of the tax professionals dealing with everyday US expats had any idea of the onerous Form 5471 reporting requirements until US enforcement of CBT began under FATCA. So, many people will be in the situation where they set up a company years (maybe decades) ago and (if US-tax compliant) have been reporting this on their US returns pretty much the same way they reported to the country they live in (taking dividends into income and omitting Form 5471). These people are now entrapped (similar to this post). Realising your prior returns are incomplete (and possibly under-report US tax due) is a life changing event, especially when you’ve thought you’ve been doing the right thing all along by filing US returns.
Karen you write:
“I’m sure very few of the tax professionals dealing with everyday US expats had any idea of the onerous Form 5471 reporting requirements until US enforcement of CBT began under FATCA.”
Even today, most of the “tax professionals” do not understand these rules. The rules are difficult, arcane and are a “stand alone” tax specialty.
Many of those with a “working understanding” of the rules, don’t understand exactly why and how filing Form 5471 (with all of its schedules) disables Americans abroad from the opportunities to available to others.
This is a very serious problem. An American abroad needs to understand the implications of filing Form 5471 BEFORE making the decision to come into U.S. tax compliance. They need to understand the extent to which it affects them:
– for past years
– for present years
– for future years
The situation for Americans abroad (particularly in Australia because of the weak tax treaty) is as follows:
There is simply no way they can live as a “U.S. tax compliant” American citizen outside the USA.
Therefore, coming into U.S. tax compliance is (whether they know it or not) the first step toward renunciation.
For anyone looking for a more technical explanation of Subpart F and its history, John Richardson has published an informative post on his blog:
http://www.citizenshipsolutions.ca/2017/08/21/the-use-of-corporations-as-a-way-to-reduce-or-defer-taxation-for-individuals/
I am an Australian receiving an Australian Age Pension.
I also have a superannuation pension payed in USA and on which I pay 30% tax.
My understandin is that under the 2001Tax Agreement any such net payments are not classified in Australia as assessable income for the purpose of the ATO and Centrelink.
The whole area appears very grey and would appreciate your comments on the above
Regards
Hi Bob Harrison,
I’m not sure I understand what you mean by “superannuation pension payed in USA and on which I pay 30% tax.” Is this an IRA or 401(k) you contributed to while working in the US? Are you a US citizen or green card holder?
I’m not an expert on the means tests for the Age Pension, but I would expect that US retirement savings would be treated exactly the same as Australian Super for both the assets test and the income test.
Since the ATO does not recognise US retirement savings as foreign super, any withdrawals are taxable in Australia as they come out. On the US side, it might be possible to use Article 18 of the treaty to get a zero tax rate… it depends on whether the payments constitute a pension, and I’m not sure exactly how that is determined.
This is a very informative post. Thank you for writing it.
– I operate a freelance business as a “Sole Proprietor”.
– My life partner and I also operate a small business listed as a “Partnership”.
My interpretation of this article is that both of our business entities are not subject to the xenophobic and punitive measures dished out to “Trusts” and “Companies”.
Is this true?
If so, for sole proprietorships and partnerships – is income just treated the same as if we were employees?
Thanks!
Yes, you escape the transition tax and GILTI (and all of subpart F rules for controlled foreign corporations). For sole proprietorships and partnerships, the rules are somewhat different than for employee income. You report a sole proprietorship on Schedule C, and a foreign partnership requires form 8865. Your income from these may be classified as “Foreign Branch Income”, which is a new category for foreign tax credits created by the Tax Cuts and Jobs Act (TCJA – the 2017 tax reform) – this may or may not cause additional tax liability depending on everything else in your tax return.
Thanks very much for the additional information Karen. Much appreciated.
Do you know how an Australian Unit Trust would be classified? I understand that it is treated as a PFIC and so requires yearly filing of form 8621. However, if a US shareholder owns at least 10% of the unit trust, is there an initial information filing requirement as with corporations and the 5471? Thanks!