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First, let’s consider the simplest of the various 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. 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 some anti-avoidance rules) be applied at the individual level against all your other forms of assessable income, including income such as 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% Capital Gains Tax discount can also make this a desirable way to invest.
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 49% for those earning more than $180,000 after 1 July 2014). 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 in the event of family break-ups. That kind of protection can be offered by the use of discretionary trusts, which I’ll consider next.
A trust is a 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.
In addition, any capital gains incurred by the trust 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 held. 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 the company. In many cases company directors are also shareholders.
To become a company, an entity must:
- be incorporated under the Corporations Act 2001 (Commonwealth Act); and
- be registered with the Australian Securities and Investment Commission
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.
Finally, there’s the advantage that the company will pay tax at the corporate rate of 28.5% (provided the company’s turnover is less than $2m), which is significantly lower than the top marginal rate for either individuals or trusts (which currently sits at 49% including the Medicare levy and the debt levy). The shareholders can then claim franking credits on any dividends which the company subsequently pays out of taxed profits, at the full corporate rate of 30%. On the downside, it can be tricky to make use of 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% capital gains tax 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.
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 capital gains tax on the transfer of the assets. From 1 July 2015, that relief has now been broadened so that most changes of business structure are exempt from capital gains tax.