There are over two million small businesses in Australia. If you’re thinking of adding your brand-new business concept to the already crowded market, what do you need to consider for tax purposes before you start the business and in the early days?
Choosing a structure
So, you’re setting up a new business and you need to know the tax implications. The first question you’ll need to consider is what structure to use. Do you form a company, do you operate through a trust or do you simply set yourself up as a sole trader?
It helps to know the difference between each business structure, so this section outlines your options:
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. When you run a business as a sole trader, you simply record the business’s income and expenses in your personal tax return.
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 be applied at the individual level against all your other forms of assessable income, including salary and wages and income from other business activities.
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 45% for those earning more than $180,000). 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 protection in the event of family break-ups.
A trust is a business 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 can 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.
Each beneficiary records their share of the income of the trust in their personal tax return and pays the tax themselves. The trust usually only pays tax if it doesn’t distribute all the profits which arise in the business.
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.
The other possible scenario is to set up your business through a company.
Shareholders own the company while directors run it. With many small businesses, the company directors are also the 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 company is a separate legal entity to the people who run it. That means that the company lodges its own tax return and pays tax on its profits at the company tax rate – currently 25% (provided the company is trading and it’s aggregate turnover is less than $50m). The company can then distribute profits to shareholders in the form of franked dividends. These dividends are taxable to the shareholders less a credit for the tax already paid by the company.
In some cases, companies don’t pay out profits to shareholders; they retain them, possibly for future investment in the business. In that sense, companies can be regarded as tax shelters since the rate of tax payable by the company (25%) is significantly lower than the higher rates of personal taxation. That is only part of the story of course; ultimately the cash in the company needs to be extracted and at that point tax will need to be paid, so the tax is deferred rather than avoided.
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.
On the downside, 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.
Alternatively, they run the business through a trust, which has a company as either sole trustee or one of a number of trustees. The trust can then stream profits to the corporate trustee, which is taxed at the corporate rate, rather than the higher personal rates.
Incurring costs before the business starts
It’s quite common to incur costs relating to a proposed business even before you start trading. Certain costs that you incur can be claimed even before the business starts.
These can be claimed by whoever incurs them, even if the business ends up in a different entity (you incur a cost personally but end up running the business through a company).
Examples of what could be claimable include:
- Payments to accountants and lawyers for structuring advice, setting up entities, due diligence and business plans (deductible even if the business doesn’t go ahead)
- Government fees and charges relating to setting up an entity (eg stamp duty)
What registrations do I need?
Tax File Number
If you’re operating as a sole trader, you will simply use your own TFN.
If you’re creating another entity, such as a trust, partnership or company, that entity will need its own TFN. The procedure for applying for a business TFN is different to applying for an individual one. You can get one via the Australian Business Register (ABR) website (www.abr.gov.au).
TIP: The ABR is the central registry of Australian business information so as well as getting a TFN, you can also get an ABN, register for GST, apply for pay-as-you-go (PAYG) withholding and register your business name.
Australian Business Number
An ABN is essential for any Australian business since it is used in numerous other business interactions, with customers, suppliers and other government agencies. You’ll need an ABN for instance before you can register for GST. If you don’t have an ABN, other businesses must withhold 49% tax on any payments they make to you for goods or services.
You can get an ABN through the ABR website (see above).
Australian Company Number
You’ll only need this if you are planning to run your business through a company. If so, you’ll need to get this before you apply for an ABN. You can apply for one through the Australian Securities and Investments Commission website (asic.gov.au).
Pay As You Go Withholding (PAYG)
You’ll need to register for PAYG withholding if you intend to employ people who will be paid wages or salary. You’ll need to deduct tax from each wage or salary payment and pay it to the ATO through the PAYG system.
You can register through the ABR website (see above). If you already have an ABN, you can register for PAYG through the business portal of the ATO website.
Goods and Services Tax
Your business will need to register for GST once your annual turnover is $75,000 or more.
Once you’ve passed the annual turnover threshold, you have 21 days to register so it’s worthwhile checking your turnover each month to see if you’re close to exceeding it. Registration is voluntary before that point.
If you’ve just started a new business and expect it to reach the GST turnover threshold or more in its first year of operation, you should register for GST even if you haven’t yet reached the $75,000 threshold.
You can register for GST online via the ABR website (see above). You can also register for GST via the Business Portal on the ATO website.
TIP: You only register once for GST, even if you operate more than one business. So, if you run a pastry shop and a clothing shop, you only need the one registration unless one of the businesses is operated through a different entity, such as a company.
Mark Chapman is director of tax communications at H&R Block.