This article is an overview of the most common business structures for small to medium-sized businesses in Australia.
In choosing an appropriate business structure, there are several essential factors to consider:
- Asset protection
- Tax minimisation
- Growth of business
- Relationships among key stakeholders
There is no perfect structure as such, and trade-offs need to be made between the above factors. The above factors may vary in importance depending on the particular business.
The most common business structures are:
- Sole trader
IN THIS ARTICLE
Partnership; advantages and disadvantages
Company; on taxes; advantages and disadvantages
Trust; on taxes; advantages and disadvantages
Combination of entities
A Sole Trader is a business conducted in the name of an individual.
Being a sole trader is the simplest way to do business. Essentially, you simply obtain an Australian Business Number (“ABN”) and commence business.
You are required to lodge an annual income tax return and report your business income & expenses.
If your annual business income exceeds $75,000 you are required to register for GST (Goods and Services Tax) and lodge Business Activity Statements (“BAS”), usually every quarter.
The main disadvantage of being a Sole Trader is a risk. If your business is sued, any assets you personally and/or jointly hold with others (such as a house) are at risk.
You could take out business insurance to protect against this risk. However, insurance may not protect you in every situation.
Another way of lessening this risk might be to hold valuable assets in another entity such as a Trust, SMSF (Self Managed Superannuation Fund), or even another individual such as a spouse or close relative.
Being a Sole Trader is the most useful structure in the early stages of a small business. Cost and simplicity are usually the primary issues when starting a new small business. A Sole Trader is very cheap and simple to get started and also to maintain.
As a Sole Trader is an individual, he or she will be taxed on the net business income at individual marginal tax rates.
A Sole Trader small business can usually qualify for one or more of the small business CGT concessions, as well as the general 50% CGT discount. Qualifying for these concessions is very important when minimising tax on the sale of a small business. As making a profit on the eventual sale of a business should be a key consideration when starting a business, these concessions should play an important if not central role in small business tax planning.
A Partnership is usually when two or more individuals carry on business together. A partnership can also include non-individuals such as companies or trusts, however, for simplicity, only a partnership of individuals will be discussed in this section.
A Partnership is not a legal entity in itself, unlike a company or trust. It is essentially an informal or formal agreement between two or more parties to carry on business.
A Partnership is a simple way to do business. The partners can simply obtain an ABN in the name of the Partnership and commence business.
Depending on the relationship between the partners, it may be useful to document important issues in a partnership agreement. For example, profit share, capital contributions, ownership of assets, division of work and responsibility, etc. A partnership agreement will be less applicable the closer the relationship is between the partners e.g. between spouses. There is legislation in each state which governs basic partnership rights and obligations in the absence of a partnership agreement.
The partnership is required to lodge an annual partnership income tax return and report business income & expenses. The net income of the partnership is distributed to the partners according to agreed percentages and then taxed at the partner’s marginal tax rates.
To determine the amount on which each partner will pay tax, the net income or loss of the partnership is first determined and lodged on a separate return as if the partnership was a taxpayer. Each of the partners receives a share of this income or loss which is disclosed in their personal returns and subjected to tax according to their individual circumstances.
The partner’s share of a partnership loss can be offset against other income subject to the non-commercial loss rules.
The ATO does not require a partnership to lodge a partnership tax return where the only income derived is:
- rent from a jointly owned investment property
- interest from a jointly held account, and/or
- dividends from jointly held shares
In these instances, each partner shows their share of the income and expenses at the appropriate items on their own individual tax return.
The net income of the partnership is assessable income less allowable deductions calculated as if the partnership was a resident taxpayer.
Assessable income does not include capital gains. These are returned at the partners’ level.
Allowable deductions do not include:
- prior year losses (as losses are distributed to the partners and not carried forward)
- salaries to partners
- interest paid on capital
- personal superannuation contributions
Any tax offsets (e.g. imputation credits) are claimed at the partners’ level.
Note however that for GST purposes, it is the partnership (and not the partners) that is regarded as carrying on the enterprise. Therefore, it is the partnership that must register for GST and lodge the necessary details on the business activity statement where turnover is more than $75,000.
As for a Sole Trader, the main disadvantage of a Partnership is risk. The partners are jointly and severally (individually) liable for the debts of a partnership. If the partnership business is sued, any assets held personally and/or jointly hold with others are at risk.
Again, as for a Sole Trader, the partners in a partnership can usually qualify for one or more of the CGT small business concessions, as well as the general 50% CGT discount.
A company is a legal entity created and governed under the Corporations Act 2001. The most useful benefit of a company is that its liability is limited. Most companies used for private business are abbreviated Pty Ltd (Proprietary Limited) as opposed to a public company Ltd (Limited). Limited liability means that if a business operated by a company is sued, the shareholders (owners) of the company are not liable for any debt or loss.
If a company is a private company, it is subject to special rules concerning loans and certain payments to shareholders and their associates in Division 7A and section 109 of the Tax Act. Division 7A deems distributions of profits by private companies to shareholders and/or their associates to be taxable unfranked dividends unless they fall within one of the specified exceptions.
A private company is defined in section 103A(1) as a company that is not a public company in the year of income.
A company will be a public company if it satisfies one of many tests, the most common being ordinary shares in the company listed on a stock exchange in Australia or overseas on the last day of income.
The director(s) is responsible for managing the company. In contrast to a shareholder, a director can be personally responsible for debts caused by the company e.g. unpaid employee wages or superannuation, or insolvent trading. Due to the limited liability of a company, banks often require a personal guarantee by a director for company loans. In most circumstances, however, a director is not liable for company losses or debts incurred.
The Australian Securities & Investments Commission (“ASIC”) charges a registration fee to set up a company, and an annual supervisory levy is also payable.
A company is required to lodge an annual income tax return and report business income & expenses. Financial statements should also be prepared. As a company is a separate legal entity from its shareholders (unlike a Sole Trader or Partnership), there are more rules that need to be complied with. The most significant one is in relation to loans from the company to directors or shareholders.
ON COMPANY TAX
Company tax rate
A company is a taxpayer in its own right for income tax purposes.
Resident and non-resident companies pay tax at a flat rate on their taxable income and have no tax-free threshold and do not pay the Medicare levy.
A flat tax rate of 30% applies unless the company is a base rate entity, which has a tax rate of 26% for the 2021 financial year and 25% for the 2022 financial year and onwards.
A base rate entity is a company that both:
- has an aggregated turnover less than the aggregated turnover threshold of $50 million
- 80% or less of their assessable income is base rate entity passive income
Base rate passive income includes most dividends, interest, royalties, rent and net capital gains.
Company Taxable Income
Taxable income is the assessable income of the company less all allowable deductions.
Special rules apply for the deductibility of losses and in respect of the receipt of dividends. Losses must be carried forward and cannot be distributed to shareholders.
The capital gains tax provisions apply to companies. A net capital gain for the year will be included in the company’s assessable income (note capital gains are not included when determining PAYG instalments through the year).
A net capital loss is carried forward and offset against capital gains in future years. Unlike trusts, companies do not qualify for the 50% discount on the disposal of assets that have been held for more than 12 months.
Companies are required to self-assess their final tax liability for a year of income and lodge a return specifying their taxable income and the amount of tax payable on that income. Returns generally must be lodged by the date on which the company is required to pay its final tax liability.
Companies pay quarterly PAYG instalments or pay one annual instalment. These instalments are credited against the annual liability.
Clubs, societies and associations
Clubs, societies and associations required to pay income tax are generally treated as companies for income tax purposes. Their taxable income is calculated in the same way as for companies apart from a special rule with respect to mutual income. This provides that receipts derived from mutual dealings with members are not assessable income.
Non-profit clubs, societies and associations that are treated as companies (referred to as non-profit companies) have the benefit of special rates of tax.
If the non-profit body is a charity, it is income tax exempt. Even if non-profit bodies are exempt from income tax, they may still have PAYG withholding, FBT, the superannuation guarantee and GST obligations.
The imputation system provides for shareholders to receive an offset for tax paid by the company against their own tax liability on distributions received from the company. Where the offset exceeds tax payable by the shareholder, a refund of excess offset is usually available.
Companies impute the tax they have paid to distributions by attaching “franking” credits to distributions they make. The amount of the franking credit is then added to the assessable income of the shareholder and an offset is allowed for the franking credit.
A distribution statement is issued for each distribution to indicate to the shareholder the amount of franking credit (if any) allocated to that distribution.
Companies are required to maintain franking accounts to record tax paid by them, credits received from other companies and credits allocated to distributions, along with some other transactions that increase or decrease the franking account balance.
The company tax rate is often lower than a shareholder’s marginal tax rate, but a lower comparative tax rate is only usually as useful for tax planning purposes as long as profits are retained in the company. Company profits on which company tax has been paid can be paid to shareholders as franked dividends. The franked dividend is taxable to the shareholder but he or she receives a credit for the company tax paid. So, company profits are ultimately taxed at the shareholder’s marginal tax rate.
A company is not eligible for the general 50% CGT discount. This is a significant tax disadvantage when holding assets that appreciate in value. Although a shareholder may sell their shares and access the 50% CGT discount, purchasers usually prefer to buy the assets of a company rather than the shares.
It is not uncommon for new businesses to incur net losses. In the early stages of a business, a disadvantage of a company can be that losses cannot be distributed to shareholders and used to reduce any other taxable income they might have. Losses can usually be carried forward indefinitely however and used to offset against taxable income in future years.
Generally, it is, therefore, better to use other structures such as trusts to hold appreciating assets and use a company to carry on the actual business. Separating valuable assets from a business is also prudent asset protection – it is not wise to unnecessarily expose valuable assets to the risk of litigation.
ADVANTAGES OF COMPANY
- limited liability for shareholders (apart from personal guarantees);
- perpetual succession;
- easy to retain profits tax effectively for future expansion;
- lower tax rate;
- dividend imputation is available;
- salary packaging benefits are available.
DISADVANTAGES OF COMPANY
- the distribution of profits in a tax-free manner is difficult;
- Division 7A and 109 may operate to deem dividends in undesirable situations;
- 50% CGT discount not available;
- the costs of incorporation;
- the formality of the structure;
- administration may be cumbersome;
- losses are trapped;
- tests to claim deductions for carry forward losses.
Trusts evolved in England in response to representations for a Court of Chancery. This Court brought in a new doctrine of fairness called equity and established the concept of property being held on behalf of or on trust for someone (e.g. a child) until they could properly take possession of it themselves.
The Court recognised that the ‘legal owner’ of an asset may have an obligation to hold and administer the asset for the benefit of another person – the ‘beneficiary’ or ‘equitable owner’.
For there to be a validly enforceable trust, there are 4 essential elements:
- a trustee who holds the trust property
- clearly identifiable property capable of being held in trust
- certainty of beneficiaries
- a personal obligation on the trustee to deal with the trust property for the benefit of the beneficiaries
In Australia, trusts are recognised for tax purposes and Division 6 of the Income Tax Assessment Act (the Tax Act) deals with the taxation of trusts.
The main types of trusts for tax purposes are:
- Fixed trusts: the class of beneficiaries to whom the income or capital of the trust is to be paid is fixed, and the share of the income or capital to be received by each beneficiary is fixed.
- Unit trusts: these are a common form of fixed trust. The beneficial entitlement to income of the trust is divided into units and the trust income is paid to whoever holds the units at the specified distribution date in proportion to their entitlement.
- Discretionary trusts: the trustee has the discretion to choose which beneficiaries (from a class of beneficiaries specified in the trust deed) should receive the income or capital of the trusts and/or what amount is to be paid to each beneficiary.
- Hybrid trusts: these are trusts where there are both fixed entitlements and some discretionary elements; and deceased estates.
A discretionary trust is the most common type of trust and is also referred to as a “family” trust (mainly because discretionary trusts are popular structures for family investments and businesses).
A trust is essentially an obligation of a trustee to own and manage assets on behalf of beneficiaries. Legislation in each state governs the basic rights and obligations of the trustee and beneficiaries, however, the trust deed (a document that establishes the trust) is more important and specifies in greater detail the rights and obligations of the trustee and beneficiaries.
A trust provides a form of limited liability for beneficiaries. Beneficiaries are not normally liable for debts of the trust. A trustee is liable for debts incurred on behalf of the trust, as a business is actually carried on in the name of the trustee, but the trustee has a right of reimbursement from the assets of the trust, provided the trustee is acting validly according to the powers allocated to it by the trust deed and/or legislation. Asset protection can be further enhanced by using a company as a trustee of the trust.
The main benefit of a discretionary trust for tax purposes is the flexibility of income distribution. Each year the trustee must allocate the net income of the trust to one or more beneficiaries, otherwise, the trustee is assessed on the undistributed income at the highest marginal tax rate. The flexibility of income distribution is usually only useful however if one or more beneficiaries have low marginal tax rates. Sometimes a company is useful as a beneficiary, to cap the tax at the company rate of 28.5%.
Because beneficiaries have no rights to income unless the trustee makes a distribution in their favour, a discretionary trust is usually an unsuitable structure for unrelated parties undertaking business or investment.
Unlike a company with shareholders, a small business discretionary trust can “pass through” the 50% CGT discount to beneficiaries, who can then take advantage of the discount if they are eligible.
A disadvantage of trusts is that, similar to companies, losses cannot be distributed to beneficiaries and used to reduce any other taxable income they might have. Losses can usually be carried forward indefinitely however and used to offset against taxable income in future years.
FIXED OR UNIT TRUST
The main distinction between a fixed trust and a discretionary trust is that beneficiaries in a fixed trust have fixed entitlements (for tax purposes) to income, as opposed to a right to income being determined by the discretion of a trustee each year.
A fixed trust is always a unit trust, but a unit trust is not always a fixed trust. Most unit trusts are not actually fixed trusts for tax purposes. The reason why is that although beneficiaries may be allocated units, and appear to have fixed entitlements to income, the trustee often has one or more powers (under the trust deed) to influence the distribution of income. Or the trust deed may itself alter income distribution on the happening of a particular event.
Unit trusts that are not fixed trusts are generally treated as discretionary trusts for tax purposes.
Unitholders in a fixed trust are assessed on their share of the net income of the trust each year.
In contrast to discretionary trusts, fixed trusts are usually suitable for unrelated parties to conduct business or investment as there are clearly distinguishable rights to income and capital.
ON TRUST TAX
The trust is not a taxpayer and does not pay tax. The tax is paid by either the beneficiaries or the trustee.
The key section (section 97 of the Tax Act) provides:
“…where a beneficiary of a trust estate who is not under any legal disability is presently entitled to a share of the income of the trust estate, the assessable income of the beneficiary shall include so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary is resident…”
‘Income of the trust estate’
This is generally determined by the trust deed. It is also referred to as the ‘distributable income’ or ‘trust income’.
‘Net income of the trust estate’
This is the total assessable income of the trust estate determined as if the trust were a resident taxpayer less all allowable deductions. It is also referred to as the taxable income or the section 95 income. Special rules govern the use of losses. A trust is entitled to the 50% discount on the disposal of assets held for more than 12 months.
- entitled to immediate payment of a share in the trust: FCT v Whiting (1943) 68 CLR 99.
- a right to demand payment from the trustee or require that the trustee properly reinvest, accumulate or capitalise those funds in the trust: FCT v Whiting.
- the enjoyment of a right to demand and receive payment: Harmer v FCT 89 ATC 5180.
The following people are under a ‘legal disability’:
ADVANTAGES OF TRUST
- Flexibility of distributions
- CGT 50% discount
- Asset protection
- Salary packaging for employees
- Income splitting
DISADVANTAGES OF TRUST
- Profits retained in a trust are taxed at a penal rate
- Losses are trapped as unlike partnerships, they cannot be distributed to beneficiaries
- Complex rules govern the carry forward of losses
COMBINATION OF ENTITIES
Entities may be combined in a structure e.g. a partnership of companies or trusts, a company as a beneficiary of a trust, trust as a shareholder of a company. There may be multiple levels of entities within the one overall business structure.
It is preferable, however, to keep a business structure as simple as possible, especially for a small business. Complex structures are more costly to administer in terms of accounting fees and general administration and do not in themselves add value if there is not a good reason for their use. In addition, if a structure is not understood by the business owner(s), financial mistakes can be made which may have adverse tax and asset protection consequences.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.