When deciding how to structure your business, it is crucial to think about the tax implications.
You may be thinking about running your business:
- as a sole trader;
- through a trust;
- as a partnership; or
- as a company.
Each business structure has different tax obligations and is taxed in different ways. This article will discuss the various tax obligations of each business structure. Note that this article will not consider capital gains tax.
A sole trader is an individual who owns and manages their business with their own ABN. It is the simplest and cheapest business structure. However, as a sole trader you are personally responsible for all of the business’ debts and liabilities.
Sole traders pay the same tax as individuals, at personal income tax rates. You must report all business income in your individual tax return using your Tax File Number (TFN). You pay income tax on your combined business and personal income with PAYG (Pay As You Go) instalments. If you have employees, you are also responsible for withholding income tax from their wages. In addition, if your annual business turnover is over $75,000, you must pay GST.
A major tax advantage of being a sole trader is that you are eligible for the general 50% capital gains tax (CGT) discount. This means that any gains you make from selling the business or capital business assets are taxed at half your income tax rate. Capital business assets include assets like goodwill and trademarks.
For example, Matthew works part-time as a mechanic on an annual salary of $38,000. He also owns a business selling car parts which he operates as a sole trader. The business has an annual income of $28,000. Therefore, Matthew’s total taxable personal income is $64,000, which, at the current Australian income tax rate results in a $12,437 income tax bill.
A partnership is a group of people carrying on a business together and sharing the business’ income and losses. Like sole traders, partnerships are cheap and simple to set up. They also need their own TFN and ABN. You can form a partnership with a verbal agreement or a written partnership agreement. However, it is recommended that you have a written partnership agreement in place.
Like sole traders, partners are also liable for the business’ debts and liabilities. They are also legally responsible for the actions and debts of the other partners.
A partnership does not pay tax on its business income. Instead, the partners share the business income. The partners are taxed for their share of the business income plus other personal income at their personal (marginal) income tax rates. The partnership is also responsible for withholding income tax from the wages of any employees.
For example, a partnership business of three equal partners makes $120,000 in a financial year. $40,000 is distributed to each partner. Each partner is then taxed on their total personal income for the financial year at their marginal income tax rates, inclusive of the $40,000 partnership income.
Like sole traders, partnerships are also eligible for the 50% capital gains tax discount upon selling the business or certain assets. If the partnership’s annual business turnover is over $75,000, it must also register and pay for GST on applicable sales of goods and services.
A company is a separate legal entity. Shareholders own shares in the company and directors make the management decisions.
A company itself owns the business’ income. You cannot take the business’s income unless you receive it as wages (as an employee) or as dividends (as a shareholder). If you are an Australian resident, the company tax already paid on the company profits can be ‘imputed’ to you. This is usually done by attaching a franking credit to the dividend. This results in a franked dividend. This is a dividend which has already incurred company tax. The franking credit represents the amount of tax paid on the dividend.
You can then reduce the amount of personal income tax you pay on dividend income by the amount of franking credits. If your personal income tax rate is higher than the company tax rate paid by the company, you will be taxed for the difference between the two. This system prevents company profits from being taxed twice.
Company profits are taxed at the company tax rate. The company tax rate is 30% for larger companies and 27.5% for companies with a turnover of less than $25 million. As the company tax rate is lower than personal income tax rates, there are significant tax advantages if you plan to reinvest company profits into the business. Like a partnership, a company is also responsible for withholding income tax from employees’ wages and paying them through PAYG instalments.
A trust is a relationship between a trustee and beneficiaries. The trustee legally owns assets for the benefit of beneficiaries. Trustees and beneficiaries can be either people or companies. Many businesses operate through discretionary (family) trusts. The trustee manages the business and distributes business profits to the beneficiaries through the trust.
An example of this is a family business where the father is the trustee of the trust and manages the family business. He distributes the business income as trust income to himself, his wife and his children, who are beneficiaries of the trust.
Although a trust is not a separate legal entity (unlike companies), trusts are treated as separate entities for tax purposes. A trust must have a registered TFN and, if it carries on a business, an ABN. The trustee must manage the trust’s tax obligations.
When a trustee distributes trust income to a beneficiary, the beneficiary pays tax on their share of the trust income. This is at their personal income tax rate if they are a person or at the company tax rate if they are a company. The benefit of running your business through a family trust is that the trustee can choose to distribute the trust income to beneficiaries with lower personal income tax rates.
For example, they can distribute trust income to a spouse or adult children who have lower personal income tax rates.
The trustee must pay tax on behalf of any beneficiaries who are under 18 or who are not Australian residents. Any undistributed trust income is taxed at the highest marginal tax rate. As a result, trust income is taxed at a significantly higher rate than company profits. Trusts may be advantageous from a tax perspective if you plan to take all of the business income as personal income.
When choosing a business structure, you should consider the tax implications of the structure you choose. Different structures are taxed in different ways, with some structures having more tax benefits over others. Sole traders and partnerships are taxed at personal income tax rates. Company profits are taxed at company tax rates. The different parties to a trust are subject to varying tax rates.
ServoPro members can access our free Legal Helpdesk for specialised help and advice tailored to your specific business. For more information call Dan Armes on 0490 415 063 or email [email protected]