Fencing Off Your IP: Asset Protection - Part 1
In addition to ensuring that your intellectual property assets are created or secured, registered (if necessary), and then used properly, considerable thought should be given to who (or what) will own those assets. This is the first in a two-part series of articles posts in which we examine some important considerations when setting up your intellectual property protection strategy.
Your Ownership Structure is an Important Part of Your IP Protection Strategy
In this Part, we explain the main principle of asset protection: the separation of ownership and operations. This is done by showing the dangers of failing to separate the two.
In Part 2, we will look at some of the more common ways to divide ownership and operations while focusing on some of the advantages and disadvantages of each structure.
Asset Protection is Important, but it’s One Piece in the Puzzle
Before continuing, we should explain that although we are mostly concerned with intellectual property protection in this series, it is impossible to escape from other considerations. These include:
- Practicality: Different business structures involve differing levels of expense and ongoing effort to comply with regulatory requirements. It is important to consider whether the expense and demands associated with any given business structure are justified in light of the benefits it will deliver.
- Income Tax Planning: Some business structures are better than others at helping owners to minimise income tax through income splitting (i.e. allowing them to distribute to individuals on lower incomes and charities) or transfer pricing.
- Exit Strategy: Income tax is just a part of the equation. If you are expecting a high level of capital growth, you will need to ensure that your ownership structure will allow you to minimise capital gains tax when you eventually sell up.
- Investment Readiness: Arms length investors such as business angels or venture capitalists will often expect to see key revenue generating assets placed in particular structures.
- Bureaucratic Reasons: For larger companies and corporate groups, it may be important to comply with the requirements of particular government grants that certain companies own certain assets (e.g. R&D Development Grants or Export Market Development Grants).
- Partnership Issues: Certain structures (e.g. discretionary trusts) are unsuitable for ‘arms length’ business partners who have separate families or personal commitments.
The Risk of Undivided Ownership and Operations
Typically, businesses are started by one or two people with an idea. Rather than registering a company with ASIC, a single entrepreneur will often start as a sole trader and two or more will often start as a partnership.
We will use two hypothetical entrepreneurs (a husband and wife team) as an example. They have started a business which involves the manufacture of a new type of pool fence. The production of the fencing material requires expensive equipment (a custom made mould). The business also has a patent application and a registered trademark.
As shown in Figure 1 above, all of the entrepreneurs’ business assets are held by them jointly, along with their personal assets such as their family home, shares and cars etc.
- This is the simplest way to hold assets. Sole Traders don’t require any structure to be set up, and it is the cheapest to implement. Partners may choose to sign a partnership agreement, but this is optional.
- This involves a relatively low amount of ongoing compliance work. Sole traders don’t need to complete separate tax returns for a different business entity (although they would need to complete the ‘Business and Professional Items Schedule for Individuals’ when completing their personal tax returns). Partners do need to complete a separate tax return for the partnership.
- Individuals do benefit from a significant capital gains tax concession (50%) if they dispose of assets which they have held for at least 12 months.
- It is often difficult to attract outside investment with such an informal structure. Venture capitalists and other arms-length investors usually require the use of a special purpose vehicle (often a company) in which they can take shares and appoint directors etc.
- Tax planning is very difficult using this structure. If the business does very well, it is difficult to distribute the income in a tax effective way. Further, if the assets are sold off at a later date for a lot of money, the entrepreneurs might end up paying nearly 50 cents in the dollar to the tax office.
- If the business is successfully sued (perhaps by a competitor, a trading partner or a customer), or if it becomes insolvent, the business owners could lose everything: their equipment, their intellectual property and even the family home.
The Need for a Better Way
The third disadvantage – the risk of ‘losing it all’ in the list above - is so significant that it nearly always outweighs the advantages for certain businesses. These are businesses with a significant level of product or trading risk, such as the example used above.
In Part 2 of this series, we look at some common ways to protect key personal and business assets.