Below is an excerpt from the Life and Taxes: A Look at Life Through Tax book by Mark Chapman, available now on the CCH Bookshop.
There are about two million small businesses in Australia, employing nearly five million Australians. For many, starting a small business is a dream, a step away from the salaried rat race towards a future of economic independence.
So, if you’re one of the thousands of Australians every year who make the leap into starting their own enterprise, what do you need to consider for tax purposes before you start the business, and in the business’s early days?
Choosing a Structure
So, you’re setting up a new business and you need to know the tax implications. The first question you’ll need to consider is what structure to use. Do you form a company, do you operate through a trust or do you simply set yourself up as a sole trader?
It helps to know the difference between each business structure, so this section outlines your options.
First, let’s consider the simplest of the various business structures; starting a business as a sole trader or as part of a partnership (which is treated for tax purposes as basically a collection of individuals).
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 simply 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 (subject to the non-commercial loss rules — see ¶6-090) be applied at the individual level against all your other forms of assessable income, including salary and wages and income from other business activities.
Alternatively, if there is no other source of current year income, the losses can be carried forward and applied against income from future years.
Therefore, for those with relatively simple tax affairs, the easy access to loss relief can make operating as a sole trader very attractive. In addition, the availability of the 50% CGT discount can also make this a desirable way to invest since you can dispose of the business, or any assets in the business, after 12 months at half your tax rate.
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 47% (for 2017/18) for those earning more than $180,000). The potential to split income between family members, which is 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. That kind of protection can be offered in discretionary trusts, which we consider next.
A trust is a business structure where a trustee (an individual or company) carries out the business on behalf of the members (or beneficiaries) of the trust.
Family businesses are often set up as a trust so that each family member can be made a beneficiary without having any involvement in how the business is run.
The major advantage of using a discretionary trust to run your business is that you are able to decide who benefits from the income of the trust. So, when you start trading profitably, the trust will be able to distribute its income in the most tax effective way permitted by the trust deed, typically to the beneficiaries with the lowest marginal tax rates.
Each beneficiary records their share of the income of the trust in their personal tax return and pays the tax themselves. The trust usually only pays tax if it doesn’t distribute all the profits which arise in the business.
There’s a more detailed look at the way trusts are taxed in Chapter 17.
In addition, any capital gains the trust incurs can be streamed to those beneficiaries who, for example, have capital losses. The trust can also stream gains to those entities which are able to use the 50% discount (typically individuals) rather than those who can’t (companies, for instance).
There are also asset protection advantages in holding assets through a discretionary trust. Because the beneficiaries of the trust are not the legal owners of the business, creditors cannot easily access the assets of the business if a particular beneficiary encounters financial problems. This contrasts with other ownership structures such as companies (or owning the asset as an individual) where creditors have easy access to business assets.
The downside of investing through a trust is that tax losses will be trapped in the trust as the trust cannot distribute losses to beneficiaries. This will usually mean — subject to some complex anti-avoidance rules — that losses can only be rolled up and used against future income within the trust.
The other possible scenario is to set up your business through a company.
Shareholders own the company while directors run it. With many small businesses, the company directors are also the shareholders. To become a company, an entity
- be incorporated under the Corporations Act 2001 (a Commonwealth Act), and
- be registered with the Australian Securities and Investment Commission
A company is a separate legal entity to the people who run it. This means that the company lodges its own tax return and pays tax on its profits at the company tax rate (27.5% provided the company’s aggregate turnover is less than $10m). The company can then distribute profits to shareholders in the form of franked dividends. These dividends are taxable to the shareholders less a credit for the tax already paid by the company (see Chapter 10 at ¶10-030 for a more detailed overview of how company dividends are taxed).
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 (27.5%) is significantly lower than the higher rates of personal taxation (up to 49% in 2016/17; 47% in 2017/18, including the Medicare levy). That is only part of the story of course; ultimately the cash in the company needs to be extracted and at that point tax will need to be paid, so the tax is deferred rather than avoided.
The most common reason why 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 debts of the company 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 assets of the shareholders.
On the downside, it can be tricky to use any losses which might arise in the company, particularly where there are changes in the ownership of the company or where the nature of its business changes over time.
In addition, companies cannot access the 50% CGT discount. Setting up and maintaining a company is also more expensive than the alternatives, with greater compliance obligations imposed by regulators like ASIC.
Many people opt for a mixed structure, often running their trade through a company, which is then owned by a discretionary trust. This provides both the asset protection and lower tax rate advantages of a company combined with the ability to stream income (in the form of dividends) to beneficiaries of the trust.
Alternatively, they run the business through a trust, which has a company as either sole trustee or one of a number of trustees. The trust can then stream profits to the corporate trustee, which is taxed at the corporate rate, rather than the higher personal rates.
And what if you want to change? Many businesses evolve. Commonly, businesses start out as sole traderships and then, as they become bigger and more successful, they look to incorporate or to roll the business into a trust.
It has always been possible for a sole trader to transfer their business to a company without being hit by CGT on the transfer of the assets. From 1 July 2015, that relief was broadened so that most changes of business structure are exempt from CGT (see ¶9-010 for more details).
This chapter from Life and Taxes: A Look at Life Through Tax also covers:
- What registrations do I need?
- Do I need to register for GST?
- How does the GST work?
- Am I in business part 1: business or hobby?
- Tax incentives when you start a new business
- What tax deductions can a business claim?
- Taking on employees
- Making a loss in the early years
- Tax and the sharing economy
- Tax guide for Uber drivers
- Keeping records
- Am I in business part 2: employee or contractor?
- Are you affected by the personal services income (PSI) rules?