- June 20, 2016
- Posted by: Michael Ouzounis
- Categories: Business, Income Tax, Structures, Tax Planning
This is one of the most common questions I receive from clients all the time. “I am looking at starting up a new business but I need to decide on how to structure it”. “Do I form a trust, or maybe a company or do I just set myself up as a sole trader?”
We will go through each of the structures available in more detail.
Starting a business as sole trader is the simplest of the various structures.
The main advantage of this structure is that there is less formalities to start your business and the associated professional costs are quite minimal.
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Any profits you make in the business are taxed at your marginal tax rate as though you were on a wage. From a tax point of view if it takes time to get your business going and there are losses in the first year or 2 of operating these losses will get carried forward and applied against future years of profits through your business in years to come. Note you cannot apply losses as a sole trader against other forms of income such as wage as an employee unless you satisfy 1 of the 4 ATO requirements. The most common requirement that is met is having income of at least $20,000 in the business year.
The availability of the 50% CGT (Capital Gains Tax) discount can also make this structure a desirable way to invest.
On the negative side of things once you start trading at a profit you will pay income tax at your marginal tax rate (which could up be to 49% for those earning more than $180,000 after 1 July 2016).
There is also no availability to split income between family members, which is often available where a trust is used as the business structure.
More importantly, structuring as a sole trader does not provide you with any form of asset protection from creditors of the business, so you the individual will bear the loss or liability or in the event of family break-ups. However, this kind of protection can be offered by the use of a discretionary trust.
A partnership is where 2 or more (people or entities) work together with a view to making a profit.
The costs to establish are quite low with all profits distributed between the partners.
An agreement should be drawn up before commencing, but keep in mind that one party can end up liable for the debts of the other party therefore personal assets are at risk with no asset protection under this structure.
With losses, the same rules apply as a sole trader where you cannot distribute losses from a partnership to the partners unless you satisfy 1 of the 4 ATO requirements. The most common requirement that is met is having income of at least $20,000 in the partnership business at any given year.
Discretionary (Family) Trusts
A Discretionary Trust is a tax structure where a trustee (a company or an individual) carries out the business on behalf of the members (beneficiaries) of the trust.
The main advantage of using a discretionary (family) trust to run your business is that you have the flexibility to decide who benefits from the income or capital of the trust. This will mean when you are trading profitably the trust (in conjunction with tax planning from your Accountant) you will be able to distribute its income and capital in the most tax effective way, typically to the beneficiaries with the lowest tax rates or with capital losses.
The other main advantage is asset protection where assets are held through a discretionary trust. This is because the beneficiaries of a trust are not the legal owners of the business, therefore creditors cannot easily access the assets of the business if a particular beneficiary encounters financial problems. This is in contrast with other structures such as companies (or owning the asset as an individual/sole trader) where creditors have easy access to business assets held.
It is a common practice to have a company as trustee for trusts for asset protection. Generally, company trustees are corporations with no assets. The trustee is personally liable for the trust’s liabilities. It is common for trusts to have corporate trustees to limit the trustees’ liabilities to the assets of the corporation, and often this business structure is more tax effective. Alternatively if you had an individual(s) as a trustee this would expose the trustee(s) to the same levels of business risk as a sole trader.
Discretionary (Family) Trusts also allow for succession planning and the transfer of wealth to future generations without immediate tax consequences.
The biggest downside of investing through a trust is that the tax losses will be trapped in the trust as a trust cannot distribute losses to beneficiaries.
Unit (Fixed) Trusts
Unit Trusts are recommended when more than 1 group (unrelated parties) or family is involved in the business operation. As the name suggests the unit holders have a fixed interest (units) in the business which is similar to shares in a company. The unit holders will receive a distribution in accordance with their respective holdings in the trust.
Advantages include fixed interest providing protection where more than 1 group or family are involved in the business. Asset protection where a company is used as a trustee. There is also the ability to raise capital by issuing additional units.
Some of the disadvantages can be Unit Trusts are not as flexible as Discretionary Trusts, sale of the units can be caught but Capital Gains Tax (CGT) event and attract stamp duty. If an individual is used as a trustee they can be personally liable for some of the debts of the trust.
The other scenario is to set up your business through a company. Shareholders own the company while a director(s) run the company.
A company will pay tax at the corporate rate of 27.5% (provided the company turnover is less than $10m), which is significantly lower that the top marginal rate for both individuals and trusts (which sits at 49% including medicare levy). You can not personally use the profits unless paid out to you as wages or dividends. A company can pay dividends where the shareholders can claim franking credits which the company subsequently pays out of taxed profits, at the rate of 30%.
The benefit of choosing a company structure is that it provides limited liability to the shareholders, meaning 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 assets of the shareholders.
Being a director of a company comes with many responsibilities and you may be personally liable for the company’s debts and losses where a company becomes insolvent or you have breached your duties as a director and caused harm to the company.
Losses in the company are trapped and can be extremely tricky to make use of any losses where there are changes in ownership of the company or where the nature of the business changes over time.
Companies cannot access the 50% capital gains discounts compared to the other structures.
Additionally, the cost of setting up and maintaining a company is also more expensive with greater compliance obligations imposed by regulators such as ASIC.
From my experience many businesses start out as a sole trader and then as they become more profitable and successful, they look at restructuring to trading as a company or rolling the business into a trust. Each structure has its benefits and disadvantages, however depending on personal circumstances what may work for you may not work for someone else.
From 1 July 2016, small businesses will be able to change the legal structure of their business without incurring any income tax liability when active assets are transferred by one entity to another. This rollover applies to active assets that are CGT assets, trading stock, revenue assets and depreciating assets used, or held ready for use, in the course of carrying on a business.
If you are looking at setting up a business or even changing your business structure, contact Moss Financial Solutions for advice on how best to do it for your personal situation.