Choosing the right structure for your business is a consideration that is not only important from the start, but as your business grows and develops. Here we look at the basic differences between operating under the simplest of structures compared to the most complex business structure.
Parliament recently passed legislation that will reduce the risk and complexity for small businesses who wish to change their legal structure. Read more about the changes in our blog Tax relief for small business restructure.
So why was it important for the government to support small businesses to who want to restructure?
The business structure that you build your business on can determine:
- how much tax you pay
- your responsibility as a business owner
- your potential personal liability
- your asset protection, and
- ongoing costs and volume of paper work for your business.
Changing business structures may be one of your lower priorities, and it’s easy to stay with the status quo. But, depending on your circumstances, there may be benefits to changing your business structure.
The four most commonly used structures in Australia are sole trader, partnership, trust and company. Typically, costs and complexity increase as you move from a sole trader to a partnership, to a trust or company. This video from the ATO explains more: Choosing your business structure
From sole trader to company
Let’s look at the basic differences between operating as a sole trader (the simplest of structures) or a company (quite a complex business structure).
Key tax differences
One of the basic differences that any business owner migrating their enterprise from sole trader status to that of a company is that the money that drives your business along is no longer coming from, or going to, your own hip pocket. Money will still come in the door, but will not be your own personal funds anymore.
Also as a company you will be required to lodge two tax returns. One will be your own personal return, as you usually would, and the other a company tax return — as both you and the company will be liable for tax. The tax rates that apply however will likely be different.
Tax rates and other key taxation differences are summed up in the table below.
|What is the tax-free threshold?||$18,200 for sole traders (individuals) in the 2015-16 income year.||There is no tax-free threshold for companies.|
|What are the income tax rates?||Sole traders pay tax at their individual income rates.||This is 30%.However, from the 2015-16 income year onwards the company tax rate for small businesses with an aggregate turnover of less than $2 million is 28.5%.|
|What type of tax returns need to be lodged?||An individual tax return each year.Business income and expenses go in your individual tax return using a separate business schedule – you do not need to lodge a separate return for your business.||A separate company tax return needs to be lodged.You must also lodge your own personal return as an individual for income you earn via wages, shares, dividends or loans received from the company or any other sources of income.|
Key tax similarities
There are some similarities of course. Your business tax rates may change due to structure, but your obligations for tax and superannuation are not based on structure. Therefore you may still need to register for pay-as-you-go (PAYG) instalments, and if there are employees you’ll also have to pay the superannuation guarantee, withhold tax and issue PAYG withholding statements.
And whether your business is operated as a sole trader or company, you are required to register for GST if the business’s annual turnover is greater than $75,000. Payroll tax of course depends on whether there are employees, but the rates and thresholds are set by each state government.
As a sole trader you are personally liable for all aspects of your business, including debts. So if things go bad and you have to liquidate assets to cover losses, your own personal assets may be liquidated. That means the things you’ve worked hard for — the family home and car, for instance — are potentially vulnerable in a dire situation.
A company is a separate legal entity (it exists under the law in its own right) and therefore has a degree of asset protection as the company is responsible for the company’s liabilities. The company can enter into contracts, borrow money and buy and sell its own assets. So the business’s debts, for example, will be met by the company, not you personally.
But, very importantly, you as company director are charged under regulations with ensuring the company meets all of its legal obligations — including taking care of debts and other financial matters, regulatory and reporting issues, looking after tax and super obligations such as PAYG withholding and super guarantee.
Failure to do so will attract not only severe penalties but in the worst instances, jail time. And as company director, you will be held personally liable, so any personal asset protection can be compromised.
As a sole trader, you can take money out of the business bank account as personal drawings. Your money is the business’s money and vice versa. A separate bank account is not compulsory, although this could be a handy idea just to keep track of the business’s finances.
But with a company, money earned by the business belongs to the business and a separate bank account is mandatory. As a director, the company may pay you a salary or “director fees”, but you cannot simply put your hand in the till at random.
Sole traders cannot “retain profits”. In the hands of the sole trader, profits are income that is taxed at the sole trader’s personal marginal rate.
Generally however, a company can decide to retain profits rather than distribute them to shareholders. The company can then use the retained profits to grow the business. The retained profits are taxed as income of the company.
You can also receive dividends from shares in the company or a loan. An important consideration with taking one of these forms of payment will be what is known as “Division 7A”. This is basically an integrity measure to prevent the recipients from withdrawing funds from the company and avoiding tax.
Which business structure?
The question of which structure is best suited to your business at any point in time can only be answered by looking at the specific circumstances of your business.
It is important to remember that, while it is important to choose wisely in the first instance, you are not locked into the structure that you start with.
As your business changes or grows it may be worth exploring whether there are benefits to changing your structure.
If you are interested in transitioning, make sure you are aware of all that is involved. Ask our business advisers for help and advice.