Business Structures and Their Tax

Total taxation revenue collected in Australia in 2019-20 was $552.0 billion which made up of 27.8% of total Australian GDP. 

Of that taxation revenue, almost 60% was made up of taxation on individuals and taxation on enterprises. The rules on taxation are very complex and the amount paid by an individual depends on many different factors and circumstances.

At Company123 you can have unlimited legal and tax consultations for $150 a month. Our two experts have a combined 50 years of experience and will assist you in making the best decision regarding your tax.  

Each business structure is taxed in a different manner and the amount of income you generate under each structure will have an effect on the rate of taxation. Each company structure has its own benefits and obligations and have great purpose depending on the circumstance.

Different factors will influence the decision as to what business structure to create such as the reporting requirements to ATO or ASIC, the amount of legal liability you intend of having and how much power you have over your business.

Sole trader

When most people think of a small business owner, a sole trader comes to mind. A sole trader is a business structure which applies to individuals. It means that you and your business are not separate legal entities. As such, you are legally responsible for all aspects of the business and are accountable for any losses the business may make. However, creating a sole tradership is inexpensive and does not require very extensive reporting requirement to the relevant authorities. 

All you need to do to be a sole trader is to have an Australian Business Number (ABN). You can apply for an ABN through the Australian Business Registry (ABR) or you can apply through our website. If you would like to operate a business under a commercial name that is not your legal name, you will have to apply for a Business Name. You can apply for a Business Name on our website. This business name will be owned by your individual ABN. You can apply for more than one business name per ABN.

Under this structure you will pay tax according to the income the business makes. This income is essentially your own personal income given that the business operates under your ABN and is not a separate legal entity.

For Australian residents, the taxation brackets for individuals are as follows:

It is important to note that you will need to register your business for Goods and Services Tax (GST) if your annual turnover is expected to be more than $75,000. 

Benefits of sole trader:

• Simple to set up and operate.

• You retain complete control of your assets and business decisions.

• Fewer reporting requirements.

• Any losses incurred by your business activities may be offset against other income, such as your investment income or wages (subject to certain conditions).

• Allows you to use your individual tax file number (TFN) to lodge tax returns.

• You are not considered an employee of your own business and therefore don’t pay payroll tax, superannuation or workers’ compensation on income you draw from the business.

• Relatively easy to change business structure if your business grows or if you wish to wind things up.

Disadvantages of being a sole trader:

• Unlimited liability which means all your personal assets are at risk if things go wrong.

• Little opportunity for tax planning – you can’t split business profits or losses with family members and you are personally liable to pay tax on all the income from the business.

• You cannot employ yourself.

For tax time, it is important that you put aside money to pay you income tax at the end of the financial year. Usually, you will do this by paying quarterly Pay As You Go (PAYG) instalments.

If you are a sole trader, you don’t have to make super contributions to a super fund for yourself. However, you may want to consider super as a way of saving for your retirement. You can also create a Self-Managed Super Fund (SMSF) through our website. By contributing to your super, you may be able to claim a tax deduction. 

Partnership

A partnership is a business structure made up of 2 or more people who distribute income or losses between themselves. It is common for Law firms, financial companies and many small businesses to operate under a partnership. Similar to a sole trader, the partners are not separated from the business are liable for any losses and debts the business makes. However, the amount liable depends on the type of partnership created.

A partnership is a contractual legal relationship between the partners with a view to bring profit to the business. As such, creating a partnership is vital to have all terms and intricacies of the relationship defined. It is important to have a good relationship with your partner and be in the same mind about how the business will be run. If a partner leaves or a partner joins there will need to be a variation to this agreement.

A partnership agreement will have terms regarding:

• The roles of each partner

• How the partnership will run

• The way profits and assets will be distributed

• What happens if a new partner joins

• What happens when a partner leaves

• How the partnership will be disbanded

There are 3 main types of partnerships:

• General Partnership is where all partners are equally responsible for the management of the business, and each had unlimited liability for the debts and obligations in may incur.

• Limited Partnership is made up of general partners whose liability is limited to the amount of money they have contributed to the partnership. Limited partners are usually passive investors who don’t play any role in the day-to-day management of the business. Different states have different rules on how to register limited partnerships.

• Incorporated Limited Partnership is where partners can have limited liability for the debts of the business. However, under this partnership there must be at least one general partner with unlimited liability. If the business cannot meet its obligations, the general partners become personally liable for the losses.

Benefits of a partnership:

• Cheap to set up

• Relatively easy to change the structure

• More capital available relative to sole trader

• Have more people to create ideas

Disadvantages of a partnership:

• Partners’ liability is potentially unlimited

• You are liable for the decisions of fellow partners

• Difficult circumstances arise when a new partner joins or a partner leaves

For tax time, the profits and losses of the businesses are split amongst the partners as per the partnership agreement. The partnership doesn’t pay income tax on the profit, rather each partner reports their share of the partnership income in their own tax return as per the tax brackets above. However, the partnership has its own TFN and ABN and must lodge an annual partnership return showing all income and deductions of the business.

Please refer to the Partnership Act 1963 and the Corporations Act 2001 for more information regarding the formation of partnerships.

Companies

Unlike sole traders and partnerships, a company is a separate legal entity to those running the business. As such the largest difference between these structures is how it is taxed. A company is run by its directors and owned by its shareholders. As it is a separate legal entity, it is able to act in its own regard as a ‘natural person’ and enter into agreements in its own name. 

There are two types of companies: a private and public company. A proprietary (private) company cannot raise money through the general public. Other requirements are that it must have at least one shareholder, one director and not more than 50 shareholders that are not also employees.

There are also public companies. These companies are allowed to allocate shares to the public as a means of raising capital. These shareholders own small fractions of the company. A public company must have at least one shareholder, one secretary and at least three directors. There are also much more strict reporting requirements for these larger public companies.

Benefits of a company

• As it is a separate legal entity, shareholders have limited liability and as such have their personal assets protected. If the company is in debt, only company assets can be used to pay liabilities.

• Tax rate capped at 30%

• Company can continue beyond the life of its shareholders

• A range of Government grants and incentives available for companies

Disadvantages of a company

• Control of your company is diluted with the more shareholders you have

• High cost of setting up the company due to ASIC fees

• Higher reporting standards 

• More complex structure will require higher level of business understanding

• Companies cannot access 50% capital gains tax discount

The Corporations Act 2001 applies very strictly to companies and have to regularly correspond to the Australian Securities and Investments Commission (ASIC) in the form of an annual review. You will also need to keep records that show your compliance with the Act where you will need to have a registered officer, a principal place of business, regular company meetings, a written records of meetings and resolutions. ASIC will have to be notified of any changes to these business details within 28 days. All financial records must record and explain transactions and financial positions and performance where they will need to be audited.

Control of your company will be diluted depending on the way shares are allocated to shareholders. Directors govern the internal management of the company and have obligations to act in good faith, act in the best interests of the company, exercise care and diligence, prevent the company trading while insolvent and assist the liquidator in the winding up of the business.

Companies need to acquire an ACN (Australian Company Number) though the Australian Securities and Investments Commission (ASIC). Company123 can help you get your ACN through our website. This number is separate to an ABN that one may have as a sole trader. However, if your company is running a business, it will require both an ABN and an ACN. An ACN is an identifier of your company registration where it must be present on company documents such as invoices, orders, receipts and other legal documents, its acts as a way that ASIC can monitor the activities of your company. An ABN is used more so for taxation purposes where it is needed to register for Goods and Services Tax and payroll tax as well as the TFN. If neither an ABN or ACN is present, you could face a fine from the ATO or ASIC, respectively.

Companies are taxed depending on its size. 

For companies that had less than $25 million turnover for the 2017-18 income year and less than $50 million for the 2018-2019 income year, the tax rate is 25% for 2021-2022. This taxation rate will likely continue in future years. Another requirement for the base rate entity company tax rate is that 80% or less of the company’s income comes from passive income. This is because the company must be carrying on a business. Passive income includes income such as: corporate distributions, royalties and rent, interest revenue and capital gains. 

The full company tax rate for companies that do not meet the above requirements is 30%. Examples of companies that may have to pay the full tax rate includes trustees of corporate unit trusts, public trading trusts or corporate limited partnerships.

However, this rate is taxed from the first dollar earned as companies do not have a tax-free threshold.

A company tax return will need to be lodged each year with a company structure. This is separate to your individual tax return you may have as a sole trader. Directors of the company will likely assist with the lodging of the company tax return but will need to submit their own personal one as well on top of that. Money can be allocated to directors as a form of wages and as a salary but cannot be considered as drawings. Companies are taxed on the taxable income. This is the profit of the business less the deductions which can be claimed. This then will be taxed at the company rate as discussed above.

Winding up the company can be a more difficult task than it would be to shut down the business of a sole trader or partnership. A sole trader is able to cancel their ABN within 28 days of ceasing trading. In a similar manner a company can deregister their ACN with ASIC. 

However, as a company holds assets separate to the way a sole trader would hold their own assets, the process of winding up the company will require extra work to sell assets and pay off any debts and liabilities. If your company has less than $1000 you can deregister your company through our website. If your company has more than $1000, a majority of directors need to make a declaration of solvency. This informs ASIC that you will be able to settle all debts to creditors within 12 months of the commencement of the winding up of the company. After which a resolution will need to be passed with a majority of 75% of members being in favour of the resolution. This resolution will appoint the liquidator that will settle the assets. They lodge with ASIC a list of receipts and payments from debtor sand creditors. IF the liquidator doesn’t believe the company is solvent and rather is insolvent, they will wind up the company in insolvency and must appoint a voluntary administrator. After this process the company will be deregistered with ASIC.

A company that is deregistered is still shown on ASIC registers, where the status of the company will show as ‘Deregistered’. Under the Corporations Act 20021, all records are property of ASIC after deregistration due to the fact that the directors of the company are no longer part of the company at this stage. They are however obligated to keep the company records for another three years. If the company is being liquidated, the liquidator must keep the company books and records for another five years after deregistration.

Trusts

A trust is a relationship between numerous parties where a trustee will hold assets for the benefit of the beneficiaries. Family businesses are often set up as a trust so that each family member can be made beneficiary without having any involvement in how the business is run. The trustees in discretionary trusts are able to distribute income in a manner that is most beneficial from a tax point of view. For example, capital gains can be distributed to those that have a capital loss within the trust structure as to minimise Capital Gains Tax. The way the income can be distributed is at the discretion of the trustee in a discretionary (family) trust.

You can set up a trust through our website and create yourself a trust deed expertly drafted by Company123.

We also can set up what is known as a unit/fixed trust where a unit trust operates in a similar manner as to what shares do. Profit is divided according to the terms set out in the trust and can only be amended by changing the deed.

A tax must have its own tax file number for lodging its annual tax return and GST if it has a turnover of $75000 or more.

If all trust income is distributed to adult Australian residents, the trust itself doesn’t pay tax but those allocated income will be paying tax according to their own marginal tax rate after the allocation of trust income. Further, if all or part of the net trust income is distributed to non-residents or minors, the trustee is assessed on the that share on behalf of the beneficiary – these beneficiaries may need to declare their share of the trust’s net income in their own income tax returns and can claim a credit for the tax paid on their behalf by the trustee. As such if a beneficiary qualifies for a franking credit offset, they are also required to include the amount in their assessable income Where the trust accumulates net trust income and does not distribute it to the beneficiaries of the trust, the trustee is taxed on the income at the highest marginal rate. 

It is worth noting that in a family dispute, the Family Law Courts of Australia will consider any assets owned by discretionary trusts to which a spouse is a beneficiary as a form of financial resource and can factor this into their judgements regarding the split of assets. In the case of bankruptcy, trusts may offer some protection provided the bankrupt person is not the appointor or trustee and provided the bankrupt person has not transferred wealth to the trust with the intention to defeat creditors.

A loss made by the trust cannot be distributed to beneficiary. However. It can be carried forward and used to reduce the trust’s net income in a later year.

Benefits of a trust

• Asset protection in the event of divorce or bankruptcy

• Trusts are eligible for a 50% capital gains discount

• Trusts do not have any contribution limits unlike Superannuation funds

Disadvantages of a trust

• Losses cannot be distributed

• Trusts have an expiry date of 80 years and may create a Capital Gains Tax event

• Any income earned that is not distributed is taxed at the maximal marginal tax rate

• There are some costs involved in establishing and maintaining the trust

Conclusion

Many different factors should be taken into account as to how to run your business and under what structure. You will need to take into consideration the different costs and benefits of each structure and ultimately what is right for you and your business. Indeed, while you are able to change your structure over time and expand your business, it is beneficial to make the right decisions earlier on to save time and headache. 

Speak with our business consultants at 03 9832 0660 for more information.