How to overcome business partner conflict over equitable profit sharing
Business partner conflicts are commonplace. The critical thing is how they are managed to a satisfactory resolution.
One area where conflict abounds is disputes over equitable profit sharing. Circumstances can change from when the original shareholder or partnership agreement was made. If that’s the case, it’s a compelling indication that it's time to review the business agreement and structure.
At the beginning of their life, businesses are often most concerned with cashflow and simplicity and create their structure and agreements accordingly. But as the business grows, creating a structure that takes into account a more extensive range of factors becomes necessary. Possible structures include partnership, trust or company and potentially other entities to receive excess profits, hold assets or employ staff.
Fortunately, with the introduction of small business restructure rollover relief, it is easier for a new business to restructure if the initial structure is no longer appropriate. For example, a very small business may start off as a partnership or a trust but then realise a company will be better for the growth of the business. Under the rollover relief provisions, if the restructuring is genuine, there will be capital gains tax rollover relief with the transfer of assets to the new structure.
Once the business owners have set up their structure or join a business venture, they will then nut out the key issues below in a Partnership or Shareholder Agreement with their accountant and lawyer;
- Division of Profits– this includes the division of profits and funding of losses, and how and when each partner will be paid.
- Contributions to the partnership/company- is each partner contributing the same?
- Business Decision making– what authority does each business partner have?
- Who does what– the division of management duties?
- Dispute Resolution Procedure– for when you can’t agree.
Profit share conflicts between business partners can often emerge when there is an unequal division of work and unequal financial investment and profit-sharing.
Your shareholder/partnership agreement should address:
- How much of the company/partnership does each partner own?
- What are the specific terms of your profit share agreement? The written agreement should detail them precisely.
- How is each partner contributing? If someone is investing their own money, say how much and how often. If one partner gets a more significant share because of their specialised expertise, detail what that is along with the value of it.
Your business may need to be restructured to ease the conflict so that:
1) effort is appropriately rewarded and;
2) the business structure is most tax effective.
Structures, profit sharing and tax
If you start as a partnership, the profits of the business (sales less expenses), will be split between the partners in accordance with their Partnership percentage. Tax will be paid on this accordingly.
Generally, in the first financial year, these profits are not taxed within the year but may be exposed to a large tax bill at the end of the year. Once your first tax return is lodged, the ATO will then issue Quarterly instalment notices, so that your profits will be taxed as you go. Tax in year two or three can be nasty, as you not only pay the last year’s tax, you also need to pay the current year’s tax. It’s a cashflow challenge that has to be managed and overcome.
If you have formed a company or a trust, you will have more options on the way to distribute profits. But even with these structures, the trick is to determine how much to pay yourselves in the early years, when cashflow is most likely tight.
Cashflow forecasting needs to allow for GST, superannuation obligations, annual insurances and late-paying customers.
Business Partners will often inject funds into their company. From a tax perspective, it will make sense to repay those loans before taking wages.
Sometimes a cash injection is retained in the business and interest is paid to the business partners. An interest arrangement may be a good idea when there is unequal share ownership, or a profit bonus percentage paid as wages could be introduced.
Where business partners are not working equal hours, they may need to do timesheets. Most accounting packages, like Xero, offer a simple timesheet system and other cloud-based timesheet systems are available on a month-to-month subscription basis.
With a company structure, there are opportunities to defer and possibly reduce taxes for your personal compensation. In a partnership, you simply get your share of the profits each year. When profits fluctuate from year-to-year, this can create an unfair result. One year you may pay tax at the highest marginal rate and the next you could be on the lowest marginal tax rate. A company structure with its flat tax rate allows income to be earned more smoothly. Also, as a director of a company, you can receive market wages for your role and any excess profits via franked dividends can be paid to you, your spouse, or trust or other related entity.
Where possible and provided that it is not inconsistent with market salaries, business partners can be paid the same rate of pay per hour to avert conflict.
Where business profits are more than sufficient to cover market salaries, don’t be too clever with profit assignment arrangements, particularly in professional firms. The ATO has suspended guidance on the allocation of profits within professional firms and has warned against methods that lack meaningful commercial purpose. The new guidance may be released in 2020.
With a straightforward combination of dividends and wages, you can structure a tax-effective package that will stretch your cashflow and reward you and your business partners appropriately. It’s a proven way to minimise conflict.
If you would like assistance, please contact us.