If you're ready to start up a new small business, choosing the right structure for your business should be one of the first items on your to-do list.
A simple small business structure contains two moving parts.
The first part is the operating entity.
The operating entity is the entity that carries on the business. It would make sales and collect payments from customers, own the assets used in the business and employ the staff working in the business.
The second part is the holding structure.
The holding structure comprises the entities that sit in between you (being the individual controller of the business) and the operating entity.
Choosing the right operating entity and holding structure involves striking a fine balance between several factors including asset protection, tax minimisation, control, setup cost, compliance costs, access to capital, employee ownership, suitability for offshore expansion and loss preservation.
An individual starting up their first small business may require only a single operating entity to begin with, while an experienced entrepreneur with significant assets at stake may require multiple operating entities and a multi-tiered holding structure.
However, of these factors, there is one that almost all small business owners consider to be of significant importance when choosing a business structure.
Fortunately, when it comes to income tax minimisation (and income tax minimisation alone), it is possible to develop a ‘model’ structure that could be adopted by a typical Australian small business looking to operate tax effectively.
The key to this structure is one number.
Write it down. We’ll come back to it later.
Components of a business structure
- Sole trader (individual)
- Trust (discretionary or fixed)
- Partnership (any combination of the above as partners)*
While partnerships are considered an operating structure, they are not a ‘separate legal entity’ from their constituent partners and do not have any tax or legal characteristics of their own.
The remainder of this post assumes you have a basic understanding of how these entities function. If you need to familiarise yourself, I suggest the following resources:
Intermediate: Clayton Utz – Doing business in Australia
How to minimise income taxes
The objective of our model structure is to allow both business income and capital gains relating to the business to be taxed at the lowest rate allowable under Australia’s income tax laws. This means:
- business income should be taxed at or below the company tax rate; and
- capital gains should be eligible for reduction using both the general 50% CGT discount and the small business CGT concessions (where relevant).
There are two taxpaying entities in Australia – individuals and companies.
Individuals are taxed at marginal rates of between 0% and 49%, depending on their taxable income.
Companies are taxed at a flat rate of either 28.5% or 30%, regardless of how much taxable income they earn.
Note: to qualify for the lower 28.5% rate, the company must be a ‘small business entity’ (“SBE”). To qualify as an SBE, the company must carry on a business and have an actual or estimated aggregated turnover of less than $2m.
Consider a business with a profit of $18,000.
Now consider a profit of $175,000.
In summary, where your business generates a small profit, it is likely that an individual would pay less tax than a company on that income. However, as business profits increase, the higher the likelihood that a company would pay less tax overall.
What about trusts and partnerships?
Unlike individuals and companies, trusts and partnerships are typically not taxpayers. Rather, the income they earn is distributed to companies or individuals that then pay tax on the income.
For example, a discretionary trust that derives Australian business income of $100, can distribute that $100 to either an individual, who would pay tax on the income at their marginal rate of up to 49%, or a company, that would pay tax at 28.5% – 30%.
The key differentiator when it comes to capital gains, is that individuals are eligible to claim the general 50% CGT discount, while companies are not.
For this reason, it is preferable for capital gains to be taxed to individuals rather than companies.
While capital gains would not be a day to day concern for most small businesses, it is important to plan for a potentially significant capital gain upon sale of your business. Putting the right structure in place from the outset could result in a considerably better CGT outcome upon the eventual sale of your business.
Typically, the sale of a small business occurs in one of two ways:
- share sale - sale of shares in an operating company (or units in a unit trust); or
- asset sale - sale of assets used in the business.
Share sale vs asset sale
Where your business is operated through a company, the sale could be structured as either a share sale or an asset sale.
Under a share sale, shares in the company operating your business would be sold to the purchaser. This would generally give rise to a better tax outcome where it results in one or more individuals being taxed on any capital gain on the shares. These individuals could access the CGT discount, resulting in an effective tax rate of 24.5% (assuming the individual were on the top marginal tax rate of 49%).
Under an asset sale, the operating company itself would sell the assets used in the business to the purchaser. This would result in any capital gain on the sale being taxed to the company at the company tax rate of 28.5% or 30%.
Comparing the two, there is a potential tax saving of approximately 4% - 5.5% where the sale is structured as a share sale versus an asset sale.
Where your business is operated by an individual (i.e. sole trader), partnership or discretionary trust, the sale could only be structured as an asset sale.
Since individuals (and trusts that distribute to individuals) are eligible for the CGT discount, the maximum effective tax rate on any capital gain would be 24.5%.
Under both a share sale and an asset sale, the small business CGT concessions may be accessed to reduce the capital gain further.
The model structure
This number represents an inflection point for our model structure.
Where business profits are less than $127,314, it would be more tax effective for an individual to pay tax on them at marginal rates.
Where business profits exceed $127,314, it would be more tax effective for a SBE company to pay tax on them.
Note: if the company is not an SBE and therefore taxed at the general corporate rate of 30%, this inflection point would increase from $127,314 to $148,533.
It follows that our model structure must be flexible enough to accommodate the following:
- individual to be taxed on the first $127,314 of business profits;
- company to be taxed on any business profits exceeding $127,314; and
- individual to be taxed on any capital gains.
To achieve these outcomes, we can build the structure in two stages.
Stage one involves setting up a discretionary trust (the Old Time Trust) that will operate your proposed business.
All of the net income derived by the Old Time Trust could be distributed to an individual, who would be taxed on that income at marginal rates.
This structure could remain in place until the business’ profit (and consequently the trust’s net income) exceeds the magic number of $127,314.
Note: where there are a number of individuals over the age of 18 who are eligible beneficiaries of the trust, it may be possible for the trust to distribute $127,314 of income to each of these individuals.
There are two variations on stage 2 of the structure.
The first variation involves transferring the business from the Old Time Trust into a newly incorporated company (New Beginning Pty Ltd) that is owned by the Old Time Trust. It should be possible to complete this transfer without incurring any tax liability through accessing various CGT and income tax rollovers.
Note: care should be taken to consider the potential application of stamp duty to asset transfers from the Old Time Trust to New Beginnings Pty Ltd.
Once business has commenced through New Beginning Pty Ltd, you could take an annual salary or consulting fee, or the company could declare annual franked dividend to ensure that the first $127,314 of business profit is taxed to an individual rather than the company.
In the event that the shares in New Beginning Pty Ltd are sold, the Old Time Trust could access both the general 50% CGT discount as well as potentially the small business CGT concessions to reduce the gain.
Caveats to implementing stage 2 of the structure in this way include:
- small business unincorporated tax discount of up to $1,000 would be forfeited; and
- Where there is an asset sale, any resulting capital gain would be taxed to the operating company at corporate rates and ineligible for the general 50% CGT discount.
The second variation involves using New Beginning Pty Ltd as a corporate beneficiary of the Old Time Trust. In this case, the Old Time Trust would continue to operate the primary business.
This structure provides flexibility to determine how much income and capital gains to distribute to each beneficiary on an annual basis and consequently, who would bear the tax.
From an income perspective, individuals could be distributed up to $127,314 income each, with the remainder going to a company.
Note: For the company receiving the distribution to be taxed at the SBE rate of 28.5%, it would need to carry on a business (separate to that of the trust’s business).
From a capital gains perspective, distributions could be made to individuals who would be eligible to claim the CGT discount and potentially also the small business CGT concessions.
Caveats to implementing stage 2 of the structure in this way include:
New Beginning Pty Ltd would need to carry on a business to be considered a SBE and eligible for the 28.5% SBE tax rate (along with meeting the $2m aggregated turnover requirement); and
where the Old Time Trust does not generate sufficient cash to pay out trust distributions to New Beginning Pty Ltd, the deemed dividend rules in Division 7A could apply to treat the unpaid distribution as a deemed dividend.
To help determine whether it is tax effective for you to restructure your business structure from an individual or trust to a company (or vice versa), you could use this calculator.
The calculator provides both a recommendation of the most tax effective entity to operate your small business, as well as an estimate of the dollar value tax savings you could expect to achieve by changing entities.
Some parting thoughts
Company tax is not a final tax.
A company’s after tax retained earnings are eventually taxed to individuals when they are paid out in the form of franked dividends.
Therefore, the only benefit of paying tax at the company level is a deferral of ‘top up tax’, being the difference between individual marginal tax rates (up to 49%) and the company tax rate (28.5% or 30%).
The small business unincorporated tax discount trumps the company tax cut.
The small business tax offset applies to business profits taxed to an individual from either operating as a sole trader, receiving trust distributions or receiving partnership distributions. The offset is capped at $1,000, but represents a final reduction to the tax on business profits.
Contrast this with the company tax rate – although it may be lower than an individual’s tax rate, paying tax in a company provides for a deferral only. No offset is available to reduce the taxable amount of dividends paid from a SBE company.
Salaries can be used as an equaliser.
Salaries can be used as an equaliser when business profits fluctuate over time. If your business is operated through a company and is generating small profits, you could pay a salary or consulting fee to yourself instead of retaining the profits in the company. This would reduce profits in the company and increase the income taxable to you personally at marginal rates.
Note however, potential disadvantages of paying a salary are the compulsory on-costs to the business including superannuation, work cover insurance and potentially payroll tax.
Be prepared to fail.
ABS statistics indicate that 38% of Australian businesses fail within four years. Protecting your assets and preserving any carry forward losses are just as important as minimising income tax on profits!
All figures included in this post are for illustrative purposes and are based on tax rates current at the time of posting.
It is important to remember that everyone’s situation is different. The information contained in this post is general in nature and should not be relied upon as specific professional advice. Please contact us to obtain specific advice in relation to your particular situation.
Please leave your questions and comments below and we will do our best to get back to you.