One of the most common enquires that we get from clients, whether they are current or new, is about what business structure they should use if setting up a business. It’s important to get it right from the start because of potential consequences that can arise in future, so it’s an enquiry that we are grateful to receive. The wrong structure can cost you more in tax and compliance costs that would have been unnecessary.
A sole trader is an individual carrying on their own business. A sole trader is the cheapest business structure and there are few legal and tax formalities – you need an Australian Business Number (ABN) as a minimum. The tax reporting requirements are a business schedule in the individual’s income tax return. There is no separation between the individual and the business, meaning that there is unlimited legal liability for a sole trader and no asset protection.
The profit of a sole trading business is included as taxable income to that individual and taxed at marginal income rates. Losses can offset against other taxable income, unless it is a non-commercial loss.
A partnership is an association of people who carry on a business together. There are few legal and tax requirements – an ABN is required, as well as a Tax File Number (TFN) and the partnership lodges its own tax return. The breakdown of a partnership can be rough, and partnership agreements are generally a good idea, but can be expensive – more so than the cost of setting up a trust or company.
There is no separation between the individuals in partnership and the business, meaning that there is unlimited legal liability and no asset protection. Making this structure even riskier is the fact that all partners are bound by the commitments made by any one partner for the business.
So if John and Jane are in partnership and John takes out a loan from the bank in the name of the partnership and disappears with the money, the bank can pursue the assets of Jane to recover what they are owed. It would then be up to Jane to take legal action against John to recover anything that she could.
The profit of a partnership is shared equally, or as per the partnership agreement, and is included as taxable income to each individual and taxed at marginal income rates. Partnership losses can be offset against other taxable income, unless it is a non-commercial loss.
A trust is an obligation imposed on a person or company to hold property and/or assets for the benefit of others. A trust can be discretionary, where there is no fixed entitlement of income or capital for beneficiaries because it is distributed according to the wishes of the trustee. Or it can be a unit trust, where income and capital are distributed to unitholders in proportion to the number of units held (in some regards, units in a unit trust are effectively what shares are to a company).
A trust can generally protect the assets being held for beneficiaries. There is some cost to set up a trust because a formal trust deed is required to be written up by a legal professional. The trust deed rules how the trustee must operate the trust. The trustee can be an individual or a company, which will provide even greater asset protection. Formal, yearly administrative and compliance tasks are required, incurring further costs.
The profit of a discretionary trust is distributed to beneficiaries at the discretion of the trustee. For a unit trust, profits are distributed among unitholders in proportion to the number of units held. Losses remain in the trust to be carried forward and offset against future profits.
A company is an incorporated, distinct legal entity. This structure has the highest costs to set up in comparison to those discussed above, as well as annual filing fees and the greatest administrative and compliance requirements. The legal liability of a company is limited to the assets held by that company. The assets of shareholders cannot be pursued.
A company can distribute profit by paying a dividend to shareholders, or it can retain the profit for its own use. The tax rate for a company is generally 30%. However, it is 28.5% for small companies carrying on a business, which is lower than the marginal tax rate for individuals with a taxable income of less than $87,000. Dividends paid to individual shareholders are taxed at individual rates.
Some other key points to know include:
- a sole trader, partnership or trust is entitled to the 50% discount of capital gains. A company is not;
- a discretionary trust can generally make the best use of lower income tax brackets;
- unit-holders of a unit trust and shareholders of a company are entitled to claim a deduction if they finance the purchase of their units or shares, as they have a fixed entitlement to income.
- beneficiaries of a discretionary trust do not have a fixed entitlement to income so they are not entitled to claim a deduction for finance;
- fully franked dividends can fund the tax payable on taxable income;
- individuals not earning a salary will be responsible for their own PAYG Instalments and superannuation;
- banks will generally protect themselves by securing guarantees from directors;
- even greater benefits can be achieved when combining entities, for example:
- a corporate trustee provides greater asset protection than an individual trustee;
- a discretionary trust can be sole shareholder of a company. This would provide the asset protection and legal liability benefits of a company and access to the most tax effective distribution of income provided by a discretionary trust;
- a company can be the beneficiary of a trust, resulting in tax savings, in comparison to individuals earning over $37,000.
If you are interested in setting up any sort of structure for your business or investments you will require advice tailored to your needs. Please call Optima Partners to make an appointment so we can plan to achieve the best possible outcomes for you.
DANIEL CAUSERANO – SNR ACCOUNTANT