The first thing that prospective business owners usually think about when choosing a business structure is “How can I pay less tax?”. As a result, they often choose incorrect structure for their business under impression that it would help them achieve tax advantage.
While it is important for the structure to be tax effective, it should not be the only concern. The factors you need to consider for making business structuring decision include:
- Asset protection
- Tax considerations
- Growth strategy
- Attracting investments and funding
- Succession and exit strategy
- Personal circumstances
These structures can be used alone or in combinations. We have summarised the key features of each structure.
Sole trader is the simplest structure to run a business and inexpensive to set up. If you are carrying a business as a sole trader, your business is not a separate legal entity from you. Your business is you.
You may register a Business Name but you do not have to if you choose to operate under your own name. As an individual, you can operate multiple businesses and have multiple business names but you only can one ABN (Australian Business Number).
You can engage other people as employees or contractors to work for your business but you cannot employ yourself. The term “self-employed” should not be taken literally.
- Profit from your business (assessable business income less allowable business expenses) is included in your personal tax return and is taxed at your individual tax rates. Drawings you make from business account are not your salary or wages and they do not have separate tax consequences.
- As you cannot employ yourself, you do not have any obligation to pay yourself Super Guarantee payments and have workers compensation on income you generate from your business. However, you still need to comply with your employee obligations in respect of your employees.
- As profit from your business is included in your individual tax return, it can be offset by other income tax losses you make, such as loss from negatively geared investments and prior year tax losses.
- If your business generates a loss, it may have to be quarantined due to application of Non-Commercial Losses provisions. Quarantined losses will be carried forward until they can be deducted from future years profit or until such time when deductibility criteria are satisfied.
- As a sole trader running a small business, you can take advantage of range of concessions, such as simplified depreciation, immediate asset write-off, Capital Gains Small Business Concessions, trading stock election and other.
- As an individual, you get benefit of CGT General Discount of 50% if you dispose of a business asset that you held for more than 12 months. This is in addition to CGT Small Business Concessions, which can potentially apply.
- As there is no separation of legal personality, sole traders are personally responsible for paying debts of their business. Liability is unlimited and extends to all personal assets, including any assets jointly owned with another person.
- Conversely, business assets do not have any protection in case of a family breakdown or if the owner is sued for personal debts.
- Having adequate insurance policies in place mitigates the risks but has limitation of extent.
- Sole traders cannot raise finance from equity of their business. Selling share of equity in your business effectively amounts to restructuring.
- Sole trader businesses do not have “perpetual succession”. As the business is not distinct from its owner, it ceases to exist if the sole trader dies or goes bankrupt. Is the person dies, the assets of the business are dealt with under the Will.
- Structuring as a Sole Trader is often the most appropriate option for individuals conducting Personal Service-based businesses if the income is mainly produced from their personal exertion due to application of provisions to prevent income splitting.
A partnership is not a separate legal entity. It is a relationship between two or more parties conducting business together. Partnerships may consist of Individuals and/or other entities.
A partnership itself cannot own assets. All assets of the partnership are owned by partners. Partnership is simply a vehicle allowing partners to run the business together and share a profit in proportion to their contribution.
The structure is inexpensive to set up and run but complications may arise in case of a dispute between partners. If you consider conducting business in a partnership, it is advisable to prepare a formal partnership agreement, which should include:
- each partner’s role and involvement in the partnership
- each partner’s financial contribution
- dispute resolution procedure
- procedure for dissolution or changing make-up of the partnership
Partnerships are regulated by Partnership Acts in each state.
- A partnership is not a taxable entity but it must lodge tax return to declare business income and expenses and must have its own ABN and TFN.
- The net income is distributed to partners, and each partner is liable to pay tax on their share of distribution.
- Losses incurred in a partnership are distributed to partners and can be claimed against other income unless they have to be quarantined under Non-Commercial Losses provisions.
- Capital gains on disposal of partnership assets are assessed to partners, not to the partnership. Partners are able to access CGT concessions, which apply to them.
- Each individual partner carrying on a business in a partnership can access Small Business Tax Offset up to $1000 if the business satisfies the relevant turnover threshold (currently $5 million).
- Like sole traders, partners cannot be employees of the partnership. It is common for businesses conducted in partnerships to pay a form of remuneration commonly called “partner salary”, to reward partners for their active involvement in the business. However, for tax purposes, such payments are treated as part of partner’s distribution. Payments of “partners salary” is not tax deductible to the partnership.
- Partners in a partnership are jointly and severally liable for debts of the partnership. Joint and several liability means that each partner is responsible for debts incurred by other partners on behalf of the business. The liability is not limited to partners’ share of partnership assets. If your partner defaults on their share of partnership debts, you will be liable for the debt, and your personal assets may also be at risk.
- Assets used in a partnership are owned by partners in proportion to their agreed share, which means they can be exposed if a partner runs into financial difficulties or in case of a marriage breakdown.
- When an existing partner leaves or a new partner is admitted to a partnership, it results in dissolving of the old partnership and forming of a new one. A “technical dissolution” occurs if assets of an exiting partner are transferred to a new partner, and the business continues without interruption. If changes amount only to a technical dissolution, the partnership can continue using the same TFN and ABN.
A company is a separate legal entity that is run by directors and owned by shareholders (which may or may not be the same persons). A company makes its own profit and is liable to pay its own tax debts, just like a natural person. Company can own assets in its own name. They are not assets of the company directors or shareholders.
All Australian companies are required to register with ASIC (Australian Securities and Investment Commission) and have an ACN (Australian Company Number).
- Taxable income generated by a company is taxed at flat rate, which is currently 27.5% for Base Rate Entities and 30% for other corporate entities. However, when taxed profit is ultimately distributed as a dividend to individual shareholders, it becomes assessable to the shareholders at their personal marginal tax rates. Amount of tax paid by the company attributable to a dividend (called Franking Credits) is added back as a taxable income of an individual, and the individual gets a refundable tax credit for the same amount (resident taxpayers only). This effectively reverses company tax rate and applies individual tax rate to income distributed to individuals.
- Ability to pass franking credits to shareholders depends on availability of franking credits in a company. If company generates tax free income on which it does not pay tax, it will not have enough franking credits to pass on. In most cases, such income will have to be paid to shareholders as unfranked dividend, which ends up being taxed at shareholders’ own marginal tax rates.
- If a shareholder attempts to extract company profit taxed at lower rate without paying tax on it at individual marginal rates, it triggers application of Division 7A provisions. As a result of these provisions, the amount will be treated as unfranked dividend, which means the shareholder will not get franking credits for the amount of tax paid by the company. Division 7A can apply to loans and other financial advances made by a private company to a shareholder, including forgiven debt.
- Income paid out to shareholders as a dividend does not preserve its character. Concessions applicable to certain types of income originally made by the company cannot be passed to shareholders.
- Companies are not eligible for General CGT Discount of 50%
- From February 2018, shareholders selling shares in their private companies have to pass additional requirements for these shares to be treated as Active Assets for the purpose of Small Business CGT Concessions. Too much passive investments held by the company may jeopardise eligibility of shareholders to access Small Business CGT Concessions on sale of shares.
- Losses made by a company cannot be passed to shareholders. They may be applied to reduce taxable income in future years, provided the company satisfies either the continuity of ownership test, or the business continuity test. You can choose when to apply company losses.
- Companies do not have to distribute income in the same year it is made. This provides flexibility of timing of distributions.
- Company structure provides protection of limited liability. This means shareholders of the company are legally responsible for debts of the company only to the extent of their paid-up shares.
- If a company gets sued by creditors, personal assets of the shareholders will not be at risk as it is a separate legal entity from its shareholders.
- However, company structure does not provide protection for equitable interest of shareholders in the event they are sued for personal debts.
- Company structure allows to raise equity financing through issue of shares.
- Company structure allows change of ownership without disruption of business.
- Some tax concessions are only available to incorporated entities (e.g. Research and Development)
- Company structure is more costly to set up and Annual Review fees are payable each year to ASIC. Fines apply to late payment of ASIC Fees.
- Incorporated entities face significantly higher penalties for not complying with their legal obligations compared to unincorporated entities.
- Directors managing the company have certain responsibilities under the Corporation Act 2001. They may be personally liable for certain debts of the company, and, in some cases, legally prosecuted for breach of director’s duties. For example, it is a criminal offence to allow a company to incur a debt if the director suspects the company is insolvent, and the failure to prevent the company incurring the debt is dishonest.
- Directors are often required to provide personal guarantee for company finance application.
- As a company director, you must make sure the company complies with its Tax Reporting, GST and Secretarial obligations. Under director penalty regime, directors can be personally liable for company’s unpaid liabilities for PAYG Withholding, Super Guarantee Charge, GST, Luxury Car Tax and Wine Equalisation Tax if they fail to ensure the company pays its tax liabilities.
Company tax law is extremely complex! We only covered the key issues you need to take into consideration before setting up a company. Even a simple inadvertent mistake can be costly. You should always consult an appropriately qualified professional who has knowledge and experience to deal with company tax matters. It is a Director’s Responsibility to seek professional advice when needed.
A trust is not a separate legal entity. It is a fiduciary relationship between a trustee, being a legal owner of the property, and beneficiaries for whose benefits the property is held. These relationships are governed by the terms of the Trust Deed.
Trusts have traditionally been used for asset protection purposes but are also a popular option for business structure. A trustee carries on a business on behalf of beneficiaries. The trust income is derived from the trust property (trust estate) and is distributed to beneficiaries. Trustee is legally responsible for debts of the trusts and has a right to be indemnified from the trust’s assets. Appointing a company as a trustee helps achieve protection of limited liability.
There are many types of trusts but the most common ones used for carrying on a business are:
- Discretionary Trust
- Unit Trust
- Hybrid Trust
The discretionary trust is a popular choice as it offers both flexibility of distribution of income and asset protection.
- Trusts do not pay taxes but they must be registered for TFN and ABN if conducting a business, and for GST if the annual turnover exceeds certain thresholds. Trustees are responsible for lodging Trust Tax Returns and pay tax liabilities.
- Trust income calculated according to accounting principles is not always the same as its “net income” (taxable income). This occurs, for example, where the trust has discount capital gains or receives franked dividends. The amount of taxable income is required to be allocated to each beneficiary on a proportional basis, which creates certain practical complexities.
- Trust income preserves its character when distributed to beneficiaries allowing to pass certain benefits to beneficiaries, such as imputation credits, small business offsets and capital gain discounts. Concessions are applied on beneficiary level.
- Trusts are entitled to 50% General CGT Discount (provided minimum holding period is met) and are eligible for other CGT Concessions, which can be passed to beneficiaries.
- If trust incurs tax losses, they cannot be passed on to beneficiaries but must stay in the trust to be applied against income in future years.
- Loss utilisation provisions apply to trusts unless Family Trust Election is made.
- A trustee of a discretionary trust has a flexibility over income and capital distribution, which allows to minimise taxes by distributing income to beneficiaries in lower tax brackets.
- There is an ability to stream capital gains and franked dividends to particular beneficiaries who would get the most tax advantage from these sources of income.
- Trustee is required to make a resolution by 30 June of the current year regarding the distribution of income to beneficiaries. If the trustee fails to make a resolution by that date, no beneficiary will be presently entitled to trust income, which will result in trustee being assessable on the trust taxable income at the highest marginal rate plus the Medicare Levy.
- Distribution of certain of non-assessable (tax-free) amounts from the unit trust, can result in CGT Event E4, which reduces the cost base of the units in the unit trust
Taxation of trusts is a complex area. As trusts are governed by trust deeds, the terms of the deed have legal and tax implication. It is important to ensure trust deeds terms are adhered to when making resolutions to make them effective.
- When the trust is set up correctly, it can be very effective for asset protection. Care must be taken when drafting a Trust Deed to ensure no beneficiary has equitable ownership in the assets of the trust.
- Due to their effectiveness for asset protection, trusts are commonly used by businesses holding significant assets. It is also common to use discretionary trust in a combination with other types of entities to structure a business.
- A trust can be costly to set up and run. You may need to seek legal advice from a lawyer to review the terms of the trust deed to ensure it offer maximum asset protection. You will also need to pay registration and renewal fees for the corporate trustee. In addition, you may have to get the Trust Deed stamped and pay a Stamp Duty, depending on your state.
- Even if the corporate trustee is not a trading entity, its directors still have to comply with directors’ obligations.
- In case of a discretionary trust, the trustee is required to make a resolution on distribution of income by 30 June of the same year to avoid the trustee being assessed on the income at the highest marginal rates.
There is no cookie cutter solution when it comes to business structuring. What structure is right for you depends on your overall objectives.
When considering business structure, you should ask yourself the following questions:
- Will I be running business alone or with other people?
- How am I planning to generate funding for my business?
- Will my family members be involved in the business?
- What type of income will my business generate?
- How risky is my business?
- Will my business require significant investment in purchasing business assets?
- Is my business likely to generate losses?
- How much assets do I have in my personal name (including jointly owned assets)?
- What are the potential implications of family breakdown?
- What plans do I have for future of my business?
- How important is it for me to retain control over my business?
- Can my business continue operating without me?
Professional Service Businesses
If you are running a business of providing personal services, you may be a subject to special tax provisions, such as PSI Rules and General Anti-Avoidance provisions in Part IV, which are designed to prevent splitting of income from personal exertion. You have to take these provisions into account when deciding on a business structure.
Structuring decisions are often complex and should not be taken lightly. As each taxpayer’s situation is different, it is important to seek professional advice from appropriately qualified professional.
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