Start up businesses need to make one important decision from the outset – what type of business set- up will suit you best?
You’ve got a choice of four basic business structures – sole trader, partnership, company or trust. Of course, there are also more sophisticated structures out there, but most possible structures are essentially hybrids of two or more of these basic ones. Which structure is best will depend on a few considerations that we can run through right now; and there are real advantages in getting this choice right from the outset to avoid the headaches and costs that would come with fixing up problems down the track – like they say, prevention is better than cure!
One tip that every new business owner should hear is this: Sit back, put your feet up, and answer yourself this question – where will your business be, and what will it look like, a few years from now?
The sorts of things you need to chew over are: Do you want to stay small and work from home? Will you need to employ staff? How long will you stay in business? Will you have a partner or partners? What is your market? Will you need to chase start-up capital?
But don’t sweat over your choice. You can always change business structure as your enterprise changes and grows. For many businesses, the growth plan may well include changing to a different structure at a key point in the future – for example, if you plan to expand overseas. Ultimately, the business should be in the structure that is most appropriate in each stage of its life cycle. The important thing is to have a robust and long-term plan right from take-off.
Although the choice is yours, it may help to know how each structure will affect the way your income is taxed, your operating costs, how you will be able to protect
your assets, and how clients and other businesses will deal with you.
To be a sole trader is the simplest business structure, and as the name implies you will be operating the business on your own, and will control and manage all aspects of your business. For tax purposes, your personal financial affairs and your business’s affairs are one and the same – there is no separation.
There are few legal formalities, but you will need an ABN (Australian business number), and the structure is inexpensive to set up. You receive the full benefit of any profits, and keep all after-tax gains when you sell- up. However you also personally bear the full brunt of any operating losses.
Also, access to finances is limited to your own resources, and you are legally responsible for everything the business does. You also put private assets at risk, such as your house or car, if the business goes into serious debt and these private assets are targeted in any debt collection efforts.
As a sole trader:
- you use your individual tax file number when lodging your tax return
- the income of the business is treated as your own income
- your business income is taxed at personal income tax rates along with your income from other sources
- depending on your turnover, the Tax Office may need you to pay PAYG instalments (pay-as-you- go) over the year towards the amount of tax that can be expected at the end of the financial year
- you may also have to register for GST (goods and services tax)
- you will also need to take care of superannuation arrangements, but may still be able to claim for personal contributions
- and if you decide to take on an employee, you’ll need to pay 9% of their ordinary time earnings into their super fund.
Amounts of money you take from your sole trader business are not ‘wages’ for tax purposes, even though you may consider this the case, so you can’t claim a deduction for money you ‘draw’ from the business.
This arrangement sees you carrying on business with one or more other people, and receiving income jointly. There are more shoulders to bear the burden, but also more people to share profits, losses and responsibilities.
Partnerships are still inexpensive to set up, and there will likely be greater financial resources than if you operated on your own as a sole trader. On the flip side however, you and your partners are responsible for any debts the partnership owes, even if you personally did not directly cause the debt.
And each partner’s private assets may still be fair game to settle serious partnership debt. This is known as ‘joint and several liability’ – the partners are jointly liable for each other’s debts entered into in the name of the business, but if any partners default on their share, then each individual partner may be severally held liable for the whole debt as well.
As a partnership:
- the business itself doesn’t pay income tax. Instead, you and your partners will each need to pay tax on your own share of the partnership income (after deductions and allowable costs)
- the business still needs to lodge a tax return to show total income earned and deductions claimed by the business. This will show each partner’s share of net partnership income, on which each is personally liable for tax
- if the business makes a loss for the year, the partners can offset their share of the partnership loss against their other income
- a partnership does not account for capital gains and losses at all; if the partnership sells a CGT asset, then each partner calculates their own capital gain or loss on their share of that asset
- the partnership business is not liable to pay PAYG instalments, but each partner may be, depending on the levels of their personal income
- as a partner you will need to take care of your super arrangements, as you are not an employee of the business
- personal contributions should still be deductible, and any eligible employees of the business will still need to be covered for the compulsory 9% super guarantee.
Money drawn from the business is not ‘wages’ for tax purposes. As with any business, you will need an ABN and will need to register for GST if the business’s annual turnover is more than $75,000 (before GST).
Operating your business as an incorporated company will transform your enterprise into a separate legal entity. This more complex business structure is usually more costly to set up and administer, and will also come under the regulations of the Australian Securities and Investments Commission (ASIC).
A company will have far greater access to capital, shareholders are not liable for the debts of the business beyond the amount of capital they contributed, there will be greater asset protection because creditors can’t go after the shareholders’ personal assets, only the company’s own assets, and it will pay its own tax on its own profits. But tax reporting requirements are more onerous, and minority shareholders have little say in the running of the business unless they are in senior management.
For a company:
- it will need its own bank account, and its own tax file number
- it needs to lodge an annual income tax return, as money earned by the business belongs to the company
- the tax return will need to show the company’s income, deductions and tax it is liable for
- PAYG instalments will need to be paid, which are credited against the end-of-year income tax
- it will pay tax on its assessable income (profits) at the company tax rate of 30%, and there is no tax-free threshold
- GST will need to be taken care of if annual turnover is more than $75,000 (for not-for- profits, it’s $150,000)
- compulsory superannuation payments have to be made where required by law in respect of the company’s employees (including yourself, if you are a director of the company)
- if you receive wages or director’s fees, this needs to be shown on your individual income tax return.
If you are a shareholder in the company then you are entitled to receive dividends on which you will pay tax. Just be aware that if the company makes loans or payments to you, or if you take company assets for yourself, the law may treat these transactions as unfranked dividends, and they’ll be taxable to you as such, unless they are formally converted into interest- bearing loans.
Another way to describe a trust is as an obligation or a promise – where a person or a company agrees to hold income-earning assets or property for the benefit of others. A trust formalises this obligation. The one who legally holds the assets is the trustee. Those who benefit from the income are the beneficiaries.
So one basic function of a trust is to separate legal ownership and control (which the trustee has) from beneficial ownership (which the beneficiaries have). A natural result from this is increased asset protection, as the beneficiaries’ personal finances are not put at risk by the business, since the business assets are legally owned by the trustee and not by the beneficiaries.
The most common variety is a discretionary or family trust. Setting up a trust can be more expensive, and administrative paperwork potentially more complicated, but there can be tax advantages, as:
- tax is usually paid by the beneficiaries at their personal tax rates, which may be well below the top marginal rate, not by the trust, which would be taxed at the top marginal rate of 46.5%
- as trustee, you can use your discretion each year to decide which beneficiaries receive income, and how much – as long as the outcomes are within the rules contained in the trust deed, which is the document governing how the trust operates
- the trust’s beneficiaries, via their individual returns, pay tax on their share of the trust’s net ‘distributed’ income
- if all income is distributed, the trust itself would generally not be liable for any tax except in limited circumstances, when the trustee would pay tax on behalf of certain beneficiaries
- a trust will need its own tax file number, and the above ABN and GST obligations apply
- a trust is not liable for PAYG instalments, but trustees and beneficiaries may be’
- the same superannuation obligations also apply
- obligations also apply if the trust hires employees for its business.
If a beneficiary is not over 18 years of age or is not an Australian tax resident, the trustee will pay tax on the distribution on behalf of the beneficiary. The beneficiary has to declare the income anyway, but can claim a credit for tax paid on their behalf.
If the trust holds on to income, you as trustee will be assessed on that income at the highest individual marginal rate. If the trust carries on a business, all income earned and claims for expense deductions must be shown on a trust tax return, which will also show the amount of income distributed to beneficiaries.
Trust reform delayed another year
The government’s broad reform of the taxation of trust income has been delayed yet again, from July 1, 2013, with a likely commencement date of July 1, 2014, which would coincide with the intended commencement date for a new tax system for managed investment trusts.
A landmark High Court case highlighted the legality or otherwise of the streaming of trust income, and the fact that amounts on which a beneficiary is assessed for tax may not always match the amounts they are entitled to under trust law. The mismatch led to unfair outcomes and opportunities for tax manipulation, according to the Tax Office, so amending legislation was put in place to allow for capital gains and franked distributions to be streamed to beneficiaries (where permitted by a trust deed) by making them ‘specifically entitled’.
Other key issues at stake in trust law reform are fixed trusts and managed investment trusts (and the ability or not to admit further unit holders, and at what value) and the entitlements of beneficiaries under the general trust laws, including where there is no beneficiary presently entitled, disability trusts and child maintenance trusts.
While extending the deadline for proper trust law reform could be viewed as prolonging a good measure of uncertainty for many trustees, it is also appropriate, given the importance and complexity of trusts, that informed consultation and more considered solutions are adopted, which will hopefully result in better outcomes. We will advise of further developments as they occur.
Welcome to the InterActive Tax Consultants’ news – part of our personal and easy to understand approach to taxation. We are committed to working with you to achieve the best results for your business. If you have any question or would like more information on any of the articles please contact us.