Which business structure should you use?
When you start a business it can be daunting, especially when you consider the different things you need to consider. There are the obvious things such as what tools you need, vehicles, premises and staff. But then you get to the administration side of things and two of the big things to look at are insurance and how you structure your business.
In this article I look at the different business structures and the pros and cons of each.
Sole trader and partnerships
The easiest way for you to set up is as a sole trader or a simple partnership. There are minimal costs and you have complete control of how it operates. Often these are a good way to start. However, be aware that any profits you make are treated as your personal income and are taxed at your marginal tax rate. You are also personally liable for any losses.
The next step along the ladder, and the most common in Australia is a company. A company is owned by its shareholders and run by the directors. The shareholders and directors do not need to be the same people. Companies can be large public companies such as Coles or Woolworths, or they can be private companies. For this article, we will focus on private companies.
Companies are more costly to set up compared to setting up as a sole trader. They also don’t allow you to benefit from certain capital gains tax concessions. This could be significant if you are looking to sell your business or accumulate assets within it.
One of the big benefits of a company is that shareholders are not liable for the company debts. However, directors may be, so consider carefully who the directors and shareholders are. The second benefit is the tax rate for businesses is less than the tax rate for most individuals. This is offset if you pay yourself a salary and/or dividend.
Discretionary or unit trust
The final way of running a business is through either a discretionary or unit trust. A trust involves a trustee (either an individual or a company) holding the trust assets in their own name for the benefit of the trust’s beneficiaries.
Trusts can be complex, are more expensive to administer, can be limited in the type of work they do and cannot retain profits. However, they allow more flexibility with splitting income between beneficiaries. They also allow you to take advantage of capital gains tax concessions.
Let’s look at the tax effectiveness of each structure by considering three business owners, Chris, Fiona and Emma. They are all married with two kids going to university and not working. They have already paid themselves and their spouse a salary of $95,000 each, but they have a further $100,000 in profits they wish to distribute.
Chris runs his business through a family trust, Emma runs hers through a company (with her and her husband as shareholders) and Fiona is in a partnership with her husband.
Chris “distributes” the $100,000 to his kids. They each pay $7,797 in tax meaning there will be $84,406 remaining.
Fiona pays an extra $50,000 to both herself and her husband. They will each pay an additional $18,500 in tax, meaning there will only be $63,000 remaining.
Emma and her husband pay themselves a dividend. Between the tax that Emma, her husband and their company pay, they will also end up with only $63,000.
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