Chapter 13 – Partnerships and Trusts
13.1.1 Overview
A partnership is formed by a contract between parties, to carry on business or commercial activities in common, with a view to making a profit.
A trust is a legal promise by a trustee or trustees to hold and administer property, sold or gifted by a settlor, for the benefit of identified beneficiaries.
13.1 Partnerships (ITA Subpart HG)
13.1.2 Application
13.1.3 Practical Issues
13.1.3.1 Husband & Wife Profit Shares
13.1.3.2 Advantages of Partnerships
13.1.3.3 Disadvantages of Partnerships
13.1.3.4 Reorganising Partnerships - Watch Out For Tax Consequences!
13.1.3.5 Payments to Spouses and Related Parties
13.1.4.1 Setting Up a Partnership
13.2.1 Overview
13.2.2 Application
13.2.2.1 Trusts For Holding Shares In Companies
13.2.2.2 Trading Trusts
13.2.2.3 Trusts for Estate Planning and Asset Protection
13.2.2.4 Different Types of Trusts (ITA HC 9 - HC 12)
13.2.3.1 Beneficiary Income (ITA HC 35 - HC 37)
13.2.3.2 Trustee Income
13.2.3.3 Payment of Tax
13.2.3.4 Foreign Trust Registration, Disclosure and Filing
13.2.3.5 Transfer of Shares into a Trust
13.2.3.6 Trading Trusts
13.2.3.7 Trusts for Estate Planning and Asset Protection
13.1 Partnerships (ITA Subpart HG)
The partnership structure can lend itself to smaller trading activities conducted by husband and wife or by close relatives. Likewise, partnership structures are commonly used by relatives and non-relatives alike for passive investment activities i.e. low risk activities such as property ownership.
While a partnership structure can be used for most types of businesses, considerable care should be exercised when the partners are non-related parties – see the disadvantages below. A partnership is required to file an income tax return (IR7), which records the income and expenses of the partnership and the amounts of that income (or losses allocated to the individual partners). It is the individual partners however who pay tax on that income (or receive the benefit of the losses). The individual partners record their share of profit or loss in their personal tax return.
13.1.2 Application
A practical example will illustrate the operation of a partnership structure.
Example
Eight individuals purchase a motel asset for $1,000,000. Each partner in the partnership contributes $50,000 cash and agrees to share profits and losses equally. The partnership borrows $75,000 per partner to finance the balance of the motel acquisition. On 31 March, at the end of the year in which the motel is acquired, the partnership must file its IR7 tax return. If the partnership return records an operating loss of
$40,000 for the year, then each individual partner’s tax return (IR3) filed with the Department will disclose a $5,000 loss from the partnership activity. This loss is offset against the partner’s other income including salary and wages earned from other sources for the year. As a result, the partners may receive a refund of PAYE.
Alternatively, if the partnership return records an operating profit of say $80,000 for the year ended 31 March, the individual partners will record income from the partnership of $10,000 each. (Refer to Chapter 17, “Provisional Tax” regarding tax obligations that will arise on receipt of this partnership income.)
13.1.3 Practical Issues
A number of practical issues are regularly encountered with partnerships and these are discussed below.
13.1.3.1 Husband & Wife Profit Shares
It is not uncommon to find a partnership deed, which records a 50/50 contribution of capital by spouses and a half share of the income distribution each. Such a partnership deed may be perfectly acceptable. However, where one of the partners does most of the work or provides a more valuable service, a 50/50 distribution may be adjusted by Inland Revenue.
Example
Dave Rainy and his wife run a painting and decorating business. Both spouses contributed $5,000 each to the capital of the partnership. Dave works full time and does all the painting and decorating work and his wife provides the administrative support approximately two days a week.
Inland Revenue is unlikely to accept a 50/50 profit split between the spouses. Rather, it may be that a proportionate split based on the value of services contributed results in an 80/20 distribution of income.
13.1.3.2 Advantages of Partnerships
Apart from drafting the original deed, partnerships do not have any incorporation costs or annual registration costs (compare that to companies – see Chapter 12).
Because the partnership is not a separate entity for tax purposes, the profits and losses of the partnership are taxed at the partner level. Where the partners are individuals, this will allow them to pay tax at marginal income tax rates, which may be lower than the corporate rate depending on the level of income earned. Further, partnership losses can be utilised by the respective partners and offset against other income (if any).
13.1.3.3 Disadvantages of Partnerships
Partners with high income levels will be taxed on partnership profits at the highest marginal tax rate. In such situations, it may be more practical for a company to conduct the business with shares held by individuals or family trusts.
There are inconvenient consequences of changes in partners. See 13.1.3.4 below.
Normal partnerships do not offer any form of limited liability protection. That is, the debts of the partnership are the debts of the respective partners. If one partner is unable to pay their share, the remaining partners are liable. Further, generally speaking, when one partner incurs debts and undertakings, all partners are liable for these amounts. This would suggest that a partnership should not be used for general trading activities between non-related partners. There is an exception for limited partnerships (See Section 11.5). Here, a limited partner may invest in the business with liability limited to that partner’s investment. Limited partners are excluded from most of the management decision-making which is left up to the general partners whose liability remains unlimited.
13.1.3.4 Reorganising Partnerships - Watch Out For Tax Consequences!
In a normal partnership, any admissions or retirements of partners effectively mean the dissolution of the existing partnership and the formation of a new one. This can give rise to tax consequences such as adjustments on disposal of assets, depreciation recovery and trading stock adjustments. A limited partnership may, however, be formed with perpetual existence so that it is not automatically dissolved when the composition of the partnership changes. It continues as a separate legal entity much like a company that has a change in its shareholders.
If you are involved in an existing partnership, substantial care should be taken before a partnership restructuring. A partnership restructuring could include an existing partner being bought out by other existing partners, or an existing partner being bought out by a new partner.
Whenever a restructuring of this type arises, it is important to consider the tax effects relating to trading stock, depreciable assets and debtors (money owing to the business) which may be subsequently written off.
13.1.3.5 Payments to Spouses and Related Parties
The partnership might employ the services of a spouse or relative of one of the partners.
When a spouse or relative receives remuneration or profits under a bona fide contract of employment or partnership agreement, the Department’s ability to reallocate income is reduced. If you are intending to pay a spouse or relative, ensure that your records provide evidence of the contribution the spouse or relative has made to the business. This could include contracts, wage records and other documentary proof.
13.1.4 Practical Hints
13.1.4.1 Setting Up a Partnership
To establish a partnership between two or more persons (for example a husband and wife partnership) you would require:
a partnership deed (this is not mandatory but recommended). The deed would outline capital contributed by the partners, other funds required to be advanced by the partners, the payment of interest by the partnership to each partner, and the requirement that both partners approve in writing any major business transactions
a partnership bank account. You should ensure that all partnership cheques require two signatures
obtain a partnership IRD number. If the partnership’s taxable supplies are likely to exceed the registration threshold, the partnership should also register for GST (See Chapter 20).
the partnership should maintain an accounting system to record receipts, payments, assets and liabilities of the partnership.
at year end, the partnership is required to file an annual income tax return that discloses partnership income and distributions made to the respective partners. This annual income tax return should be accompanied by a partnership profit and loss and balance sheet
13.2 Trusts (ITA Subpart HC)
13.2.1 Overview
A trust is a legal promise by a trustee or trustees to hold and administer property (trust property) for the benefit of other persons (the nominated beneficiaries).
A person known as the settlor of the trust establishes a trust. The settlor gifts or sells property to the trustee to be held on trust for the benefit of the nominated beneficiaries.
While trusts have a wide range of potential uses, three uses are especially typical at the present time:
Trusts holding shares in trading companies: This structure allows company profits (after payment of reasonable salaries to shareholder employees) to be distributed as dividends to the trust. The trust is then able to distribute the income to beneficiaries who are taxed at their own marginal tax rates. Income that remains in the company is taxed at the company tax rate of 28%. Furthermore, the structure allows any increase in the company value, due to improved trading etc, to accrue to the trust and not to the shareholders personally. This can be an advantage from an estate planning and asset protection perspective.
Trading Trusts: A trading trust involves the conduct of a business by the trustees of a trust as opposed to the more usual form, where the business is operated by a company, partnership or sole trader. The primary benefits of a trading trust operating a business are:
Flexibility with regard to distribution of profits to beneficiaries who are taxed at their own marginal tax rates; and
The increase in value of the business (wealth) accrues to the trust rather than to the individuals who would be shareholders, partners or a sole trader under a more traditional structure.
Trusts For Asset Protection And Estate Planning Trusts continue to be used for a traditional role in estate planning (building wealth within the trust) and asset protection (i.e. holding core assets such as the family home in a trust and away from potential business risk).
13.2.2 Application
13.2.2.1 Trusts For Holding Shares In Companies
This option offers one of the most efficient and flexible structures available for many businesses. It provides opportunities to benefit from the advantages available to companies, trusts and individuals. The structure makes good business sense for a number of reasons and is not solely tax focused. In fact, one key tax benefit is removed with the top personal tax rate being lowered to the trust rate of 33%. The structure is illustrated below.
$200,000
*$80,000
$120,000
$33,600
**86,400
Trading Co Income Before Shareholder Salaries
Shareholder salary
Trading Co Profit Before Tax
Tax at 28%
Cash (after tax profit)
* A market value salary for services must be paid.
** This cash can be distributed to the trust as an imputed dividend that may need topping up to 33% tax in the trust.
A new business can be set up with this structure. For existing businesses, individual shareholders transfer their shares in their trading companies to their respective trusts. Care needs to be taken because there can be practical issues regarding share transfers (See 13.2.3.5).
The shareholder employee must retain a few shares in the trading company for minority protection and to allow payment of non-PAYE shareholder employee salaries.
The benefits, as previously discussed in 12.2.1 above, include income splitting opportunities, asset protection and estate planning. If you are looking at structuring or restructuring your business affairs, be sure to discuss this option with your advisor as one possibility.
13.2.2.2 Trading Trusts
As with any other trust, a trading trust also requires a trustee or trustees. Because of the business risk associated with trading, it is general expected that the trustee of the trading trust will be a limited liability company, referred to as “Corporate Trustee”. The business is conducted by the Corporate Trustee and generally parties dealing with the Corporate Trustee are not aware that they are dealing with anything other than an ordinary company. This can be illustrated as:
The actions of the Corporate Trustee are generally controlled by the Directors of the Corporate Trustee. The Directors are usually the family members involved in operating the business. The shareholder of the Corporate Trustee may be or include an independent person such as a professional advisor.
The beneficiaries of the trading trust will often be the family members (as appropriate) and possibly a second (asset protection) trust that is used to hold investment assets such as the family home and surplus profits from the trading trust.
Trading trusts can be very useful from an income splitting perspective. In particular, the trading profit remaining after market value salaries to employees is available for distribution to beneficiaries. The marginal tax rates applying to these beneficiaries may be lower than the trustee rate of 33%. See comments “minor beneficiaries” below.
This is a business vehicle that has attracted some attention from the IRD. Before establishing a trading trust, be sure to involve your accountant or business advisor.
13.2.2.3 Trusts for Estate Planning and Asset Protection
The estate planning and asset protection benefits of a traditional trust are best illustrated as follows:
Example
Let’s say you operate a successful panel beating company. You own the commercial premises from which your business operates. You receive $50,000 p.a. net profit from renting the premises to your panel beating company.
In addition to the above, you have two children attending University for the next four years. You will pay for your children’s University fees, accommodation costs and living expenses plus you are encouraging them to start saving for a first home.
You are concerned that your personal and investment assets will be at risk in the event of a business failure. Having taken professional advice, you sell your commercial property to a family trust. (In recommending this transfer, your advisor has considered depreciation recovery and all other implications).
As a result of this transfer, the trust (which is now the owner of the building) receives $50,000 rental income for the year. To take advantage of lower tax rates available to the beneficiaries, you have distributed the rental earnings to the beneficiaries prior to the 6 month deadline after year end. (Income held in the trust more than 6 months after year end becomes trustee income and is taxed at the trust’s rate, currently 33%)
As a result of the restructuring referred to above;
increases in the capital value of the building owned by the trust will accrue to your trust. If for whatever reason your business is sued or you are sued as a director, all your assets are isolated in the trust; and
the tax saving could be over $38,000 over the course of your children’s University education. This assumes that you are in the top tax bracket and your children are over the age of 16 and are not earning otherwise.
13.2.2.4 Different Types of Trusts (ITA HC 9 - HC 12)
There are different types of trusts and the distributions are taxed differently. A trust may be a:
Complying Trust (formerly Qualifying Trust); or
Foreign Trust; or
Non-complying Trust (formerly Non-qualifying Trust)
Complying Trusts
Most trusts settled by New Zealand residents with NZ trustees will be complying trusts. A complying trust is defined as one which has been taxed in New Zealand on all its trustee income since the date it began. These include:
Estates of people who were New Zealand residents when they died
Other trusts which have elected to become complying trusts.
A trust is not a complying trust if the trustees earn foreign sourced income that is not assessable for New Zealand tax or all of their income is non-resident withholding income.
If the tax on a complying trust’s trustee income is not paid or it fails to comply under the definition in any year, it loses its status as a complying trust and will most likely become a non-complying trust from that year. This results in distributions of trustee income becoming taxable at a punitive rate of 45%.
Foreign Trust
A trust is a foreign trust if none of its settlors has been resident in New Zealand since the later of:
the date that the trust was first settled; and
17 December 1987
A trust no longer qualifies as a foreign trust if it makes any distribution after a settlor becomes a New Zealand resident, or if a New Zealand resident makes a settlement on the trust. The term settlement has a very wide definition so that where property is disposed of or services are rendered to the trust for less than market value, a settlement is deemed to take place.
Non-complying Trusts
If a trust is not a complying or foreign trust, it is a non- complying trust. The test is applied at the date a distribution is made because that determines the tax consequence of the distribution.
13.2.3 Practical Issues
Income earned by a trust will be classified as either beneficiary income or trustee income.
13.2.3.1 Beneficiary Income (ITA HC 35 - HC 37)
Beneficiary income is income earned by a trust in an income year which:
is paid to (or applied for the benefit of) the beneficiary during that year or within a period after the end of that year as described below; or which
vests in the beneficiaries in terms of the trust deed during that year (i.e. they become entitled to it then).
The income may be allocated after year end in the longer of the following periods (s HC 6):
six months after the end of the income year; or
the earlier of the date on which:
the trustee files the tax return for the year, or
the tax return is due.
The beneficiary is treated as deriving the income in the same year as the trustee’s income year.
It is taxed at the beneficiary’s marginal income tax rate unless the beneficiary is under the age of 16 (See below). This is advantageous if the beneficiaries are 16 years or over and on a low marginal tax rate, which is one of the reasons why trusts can be used for legitimate income splitting purposes.
Distributions to minors aged under 16 (“minor beneficiary rule”)
Special rules apply for distributions of beneficiary income to New Zealand resident minors who are aged under 16 on the balance date of the trust. These distributions are taxed as trustee income at 33% and not the minor’s marginal tax rate. This applies where the income is over $1,000 in an income year and is derived from property settled on the trust by the minor’s relative or guardian, or their associates. If the beneficiary income is over $1,000, all of it is subject to the rule. There are exceptions for distributions from a group investment fund, the Maori Trustee or a Maori authority and for minors receiving a child disability allowance from Work and Income.
13.2.3.2 Trustee Income
Trustee income is income earned by a trust that is not paid out or applied to beneficiaries within 6 months of the trust’s balance date. Trustee income is taxed at 33%.
13.2.3.3 Payment of Tax
Trustees are responsible for tax payments on trustee income. Additionally, trustees are liable to deduct income tax from distributions of beneficiary income. This requirement to deduct tax in respect of beneficiary income does not apply if the beneficiary notifies the trustee they will pay the tax.
Distributions from trusts can be made to beneficiaries from different sources as follows:
beneficiary income
trustee income accumulated in previous years
capital profits or gains
by supplying trust property or services to the beneficiary for less than market value
by acquiring property or services from the beneficiary for more than market value
from the trust’s corpus which is the capital of the trust, equal to the market value of property settled on the trust at the date of settlement.
13.2.3.4 Foreign Trust Registration, Disclosure and Filing
Foreign trusts with one or more New Zealand resident trustees must register the trust with the IRD and comply with ongoing disclosure and annual return filing requirements. Trusts formed on or before 21 February 2017 must comply with the rules and new trusts formed thereafter have 30 days in which to comply. A concession for trustees who are non-professional individuals allows four years and 30 days to comply. Failure to comply exposes the trust to New Zealand income tax as it may lose its foreign trust status. For an overview of the information requirements and links to the forms that must be filed, go to the IRD website.
13.2.3.5 Transfer of Shares into a Trust
Care should be taken before shares in a trading company are transferred to trusts. It is likely that the share transfer will breach imputation and share continuity requirements. As a consequence, preventative action such as payment of dividends before share transfer, may be required. Tax losses may also be affected. You may not be able to carry them forward if shareholder continuity is breached. Since gift duty has been scrapped, you may need to take advice on whether it is best to gift the shares to the trust or not in your particular circumstances.
13.2.3.6 Trading Trusts
Because Trading Trusts allow a very flexible distribution of business income to beneficiaries on lower marginal tax rates, Inland Revenue can be expected to closely scrutinise trading trust arrangements. If a Trading Trust structure is used at the outset/initial establishment of the business and defensible market salaries are paid to the family/related employees, the tax risk associated with a trading trust would be relatively minor. Inland Revenue are likely to consider using anti-avoidance provisions, however, if existing businesses are transferred into trading trusts without sound commercial reason and in addition, associated employees are not paid market value salaries.
13.2.3.7 Trusts for Estate Planning and Asset Protection
Again, the key issue when establishing a traditional trust is the transfer of assets (family home etc) into the trust for the purpose of estate planning and asset protection. Since gift duty has been removed, there could be a temptation to gift all assets to a trust. We have published various articles in our journals since the abolition of gift duty to demonstrate how important it is to seek advice before making this call, as it could have costly implications in certain circumstances. One factor to consider is the effect on eligibility for a rest home subsidy. These articles are available to members on our website.
13.2.4 Practical Hints
13.2.4.1 Establishing a Trust
The sequence of steps involved in establishing a trust are:
Clearly identify the primary objective of establishing a trust. Is it for asset protection, income splitting or the building of wealth outside your own name? Your advisor may recommend different types of trust depending on your objective.
Identify the parties to the trust. Ordinarily the trustees would be you and spouse (or perhaps a partner) plus an independent trustee. The trustee could instead be a separately incorporated “Corporate Trustee” and this is particularly recommended for trading trusts.
Identify the trust beneficiaries. Ordinarily, trust beneficiaries would be persons closely related to the settlor (the person establishing the trust). Forgiveness of debt can be taxable unless it is in favour of someone for whom the creditor has natural love and affection. The IRD will look through the trust to the beneficiaries.
So anyone forgiving the trust debt must have natural love and affection for all the beneficiaries. Otherwise the forgiveness can be treated as taxable income in the trust. Many family trusts therefore do not include charities in the list of beneficiaries.
Establishing a trust is a significant step and it is recommended that you approach a solicitor with expertise in trust establishment.
Once the trust is established, assets can be transferred into the trust at fair market value. It is likely that the trust will not be able to pay for these assets. So instead, the assets will be gifted or the trust will owe a “debt back” to the person selling the property.
Ensure the forgiveness programme is conducted in conjunction with a professional advisor who can examine all tax and other consequences and ensure that any forgiveness of debt does not give rise to taxable income to the trusts. For example, where forgiven debt is subsequently distributed to a person for whom the creditor does not have “natural love and affection”, this could lead to a tax liability.
The creation of a trust is a significant legal step, which may have implications for many areas of your financial affairs other than tax. The relationship between trusts, matrimonial property rights, wills, and the rights of potential creditors is a complex area for which professional advice should be sought.
13.2.4.2 Trust Losses
Trusts are very useful for distributing income among beneficiaries on a tax effective basis. The same cannot be said for losses incurred by a trust. If a trust incurs losses, it is unable to distribute those losses to its individual beneficiaries. As a result, the losses of the trust have to be carried forward until such future time as the trust earns profits.
For this reason, it is not tax effective to have a trust purchasing a negatively geared asset. That is, if the interest costs of the borrowings exceed the income from an asset a trust will be tax inefficient.