A sole proprietorship, a partnership, a trust, or a Pty Ltd company are all business structures.
Which business structure in Australia is best for you? This could be one of your most crucial business decisions; therefore, it’s important to get it right.
One of the most common tax mistakes made by small business owners is mixing funds, which is the practice of using a single checking account for both business and personal purposes.
The reason: “It’s all my money, and I can resist the temptation to mix business and personal transactions, so why bother with a separate business account and complicate things further?”
This question has a simple three-letter answer: Tax.
Whether you’re a first-time entrepreneur or a seasoned business owner, deciding on the best structure for your company can be difficult. There are numerous options, each with its advantages and disadvantages.
Dynamic Business interviewed Mark Chapman, H&R Block’s Director of Tax Communications, about the many business structures and the tax implications of each so you can make the best possible decision.
Factors to consider
According to Mark, the most important criteria to consider are:
- Asset protection
- Registrations – what tax and other registrations, such as TFN, ABN, and ASIC registrations, are required?
- Structure complexity
- Compliance costs – sole traders are very inexpensive, but companies have high compliance costs.
- Profit extraction for the owner and family
Let’s take a look at each one separately.
Company – Pty Ltd, or Proprietary Limited
The name of a company must indicate its legal status. If the company is proprietary, the word ‘Proprietary’ or the abbreviation ‘Pty’ must appear in the name. If the company’s liability is limited, the word ‘Limited’ or the abbreviation ‘Ltd’ must appear at the end of its name.
- Pty Ltd is the most common type of business structure in Australia. It is limited to 50 non-employee shareholders.
- There is no tax-free threshold for companies – owners pay tax on every dollar the company earns.
- It is limited by shares, which means that it is created with a share capital at the time of formation by each initial member.
- If the company is liquidated, its personal assets are not at risk.
- As a separate legal entity, the company must lodge its own tax return and pay tax on income.
Mark says that the first possible scenario is to set up your business through a company.
“Shareholders own the company while directors run it. In many small businesses, the company directors are also the shareholders. To become a company, an entity must:
- be incorporated under the Corporations Act 2001 (Commonwealth Act); and
- be registered with the Australian Securities and Investment Commission
“The company is a separate legal entity from the people who run it. That means that the company lodges its tax return and pays tax on its profits at the company tax rate – currently 25% (provided its aggregate turnover is less than $50m).
“The company can then distribute profits to shareholders in franked dividends. These dividends are taxable to the shareholders, less a credit for the tax already paid by the company.
“In some cases, companies don’t pay out profits to shareholders; they retain them, possibly for future investment in the business. In that sense, companies can be regarded as tax shelters since the rate of tax payable by the company (25%) is significantly lower than the higher rates of personal taxation.
“That is only part of the story; ultimately, the cash in the company needs to be extracted, and at that point, the tax will need to be paid, so the tax is deferred rather than avoided.”
Why pick this structure?
“The most common reason people choose a corporate structure is that it provides limited liability to the shareholders.
“In other words, the extent to which shareholders are liable for the company’s debts is limited to the amount they’ve invested as share capital. There are also asset protection benefits because creditors of the company cannot access the shareholders’ assets.”
“On the downside, companies cannot access the 50 per cent capital gains tax discount. Setting up and maintaining a company is also more expensive than the alternatives, with greater compliance obligations imposed by regulators like ASIC.”
A Sole Trader is the first thing most people think of when they think of a small business owner. This structure protects your right to make all business decisions while blurring the distinction between personal and business assets.
Business owners need to keep their financial records- external sites, including tax returns, for five years like sole traders. They also need to notify government agencies of any business changes within 28 days.
Why pick it?
Mark says that the main advantage of this structure is its simplicity.
“There’s less red tape to negotiate to start your business, and the associated legal and professional costs are minimal. When you run a business as a sole trader, you record the business’s income and expenses in your personal tax return.
“From a tax point of view, the main advantage is that if it takes time to get your business going, any tax losses can usually be applied at the individual level against all your other forms of assessable income, including salary and wages and income from other business activities.
“On the downside, once you start trading at a profit, you’ll pay income tax at your applicable marginal tax rate (which could be up to 45% for those earning more than $180,000). The potential to split income between family members, often available where a trust is used as the business vehicle, does not exist.
“In addition, setting up as a sole trader does not provide you with any form of asset protection from creditors or protection in the event of family break-ups.”
Point to note: While Sole businesses are not required to register with ASIC, they must have and display an Australian Business Number (ABN). These can be found on the ABN Lookup website of the Australian Taxation Office.
If you have a business partner you trust and want to work with, forming a partnership may be a good option. This strategy has proven to be effective for many Australian business owners.
The costs of forming a Partnership are low, as are the annual administrative costs of a Pty Ltd Company. A Partnership also offers more financial reporting confidentiality than a Pty Ltd or Public company.
Why pick it?
“A partnership is essentially treated as a group of sole traders. The partnership itself isn’t a legal entity, but it does have to lodge its tax return for information purposes only (the partnership itself doesn’t pay tax),” Mark notes.
“Each partner pays tax on their share of net partnership income. As with sole traders, any losses from the partnership business will be available to the partner to reduce their other income.
“Capital Gains Tax assets of the partnership are owned by each of the individual partners, meaning that capital gains flow through to the partners. Partners can access the 50% CGT discounts as they hold an interest in each partnership asset as an individual.
“Partnerships are relatively simple and easy to run, but they have a couple of disadvantages; there is no asset protection for the partners, and there is no limited liability, meaning that partners are open to legal action (which can be particularly severe in the case of a partnership as the partners are “jointly and severally liable”, meaning if any of the partners do not have enough money or assets to pay their share of a debt, the other partners may be personally liable).
“Partnerships cannot claim a deduction for ‘drawn’ from the business by the partners. Amounts taken regularly from partnership business, and regarded by some as their ‘wages’, are not wages for tax purposes and are not tax-deductible.”
Mark Chapman is a tax professional with over 25 years of experience in the UK and Australia, specialising in tax for individuals and SMEs. He is a member of the Chartered Institute of Taxation and a fellow of the Institute of Chartered Accountants in England and Wales.
Disclaimer: Dynamic Business does not provide tax, legal or accounting advice. This article has been prepared for informational purposes only and should not be relied on solely for tax, legal, or accounting purposes. You are strongly encouraged to consult your advisors to determine how the information may relate to you or the specifics of your business.
All information is sourced from business.gov.au.
Learn how to change from a sole trader to a company.
Understand the key tax differences between sole traders and companies.
Keep up to date with our stories on LinkedIn, Twitter, Facebook and Instagram.