In Short
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The tax treatment of your business depends on its legal structure.
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Sole traders are taxed at personal income tax rates, while partnerships distribute income to partners who pay tax individually.
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Companies are taxed separately from their owners and must pay corporate tax on profits.
Tips for Businesses
Choosing the right business structure is crucial for tax and legal reasons. Seek advice from a tax professional to understand the implications for your business, especially if your turnover exceeds $75,000. Keep detailed records and be aware of your obligations, including GST registration and payroll taxes, if applicable.
Table of Contents
When deciding on the structure of your business, it is important to consider the tax consequences and obligations of each option. You might be considering operating as a sole trader or through a trust, partnership or company. Each of these business structures comes with its own unique tax responsibilities and methods of taxation. This article will explore the various tax obligations associated with each type of business structure.
Sole Trader
A sole trader is an individual who owns and manages their business with their own ABN. It is the simplest and cheapest business structure to set up. However, as a sole trader, you are personally responsible for all of the business’ debts and liabilities.
Sole traders are taxed in the same way as individuals, at the sole trader’s personal income tax rates. You must report all business income in your individual tax return using your Tax File Number (TFN). You pay income tax on your combined business and personal income at the end of the financial year.
If you have employees, you are also responsible for:
- withholding tax from their wages under the PAYG withholding system;
- paying their superannuation contributions to their nominated superannuation funds; and
- if you are over the payroll tax threshold in the relevant jurisdiction, including payments to those employees in your taxable wages for payroll tax purposes.
In addition, if your annual goods and services tax (GST) turnover is over $75,000, you must be registered for GST and charge for applicable goods and services that you supply.
A major tax advantage of being a sole trader is that you are eligible for the general 50% capital gains tax (CGT) discount. This means that any capital gain you make from selling the business or capital business assets can be reduced by 50% if you have held those assets for at least 12 months. Capital business assets include assets like goodwill and land.
Partnerships
A partnership is a group of people carrying on a business together and sharing the business’ income and losses. Like sole traders, partnerships are cheap and simple to set up. They also need their own TFN and ABN.
You can form a partnership with a verbal agreement or a written partnership agreement. It is recommended that you have a written partnership agreement in place to clearly define the roles, responsibilities and rights of each partner, including:
- how decisions are made;
- how profits and losses are shared; and
- the process for handling changes or dissolution.
Like sole traders, partners are also liable for the business’ debts and liabilities. This liability is known as “joint and several liability”, being that each partner is legally responsible for the actions and debts of the other partners.
A partnership is not a separate legal entity, which means the partnership itself does not pay tax on its business income. Instead, the partners share the business income. The partners are taxed for their share of the business income plus other personal income at their personal income tax rates. The partnership is also responsible for:
- withholding income tax from the wages of any employees under the PAYG withholding system;
- paying superannuation;
- paying payroll tax; and
- if annual business turnover is over $75,000, registering for and charging GST on applicable sales of goods and services.
Capital gains made by a partnership are not included in a partnership’s business income. If the partnership sells a capital asset or experiences another CGT event, generally, the partners themselves will be the taxpayers assessed on any capital gain. Whether the individual partner is eligible for the 50% CGT discount will depend on that partner’s own facts and circumstances.
This guide will help you to understand your corporate governance responsibilities, including the decision-making processes.
Private Companies
A company is a separate legal entity, and thus, the income that the business generates is owned by the company. This means that, unlike sole traders and partnerships, the tax liability from generating income will be with the company. There is a clear separation between the company’s finances and the personal finances of its shareholders and directors, as you cannot take the business’ income unless you receive it as:
- wages, if you are an employee; or
- dividends, if you are a shareholder.
If the company has already paid income tax on its profits, the company can pass on the benefit of any tax it has paid to its shareholders. This is usually done by attaching a franking credit to the dividend, with that franking credit representing an amount of tax the company has already paid on the dividend. This means that, in practice, the shareholder will only pay the difference between the company’s tax rate, which is a flat rate of either 25% or 30%, and the shareholder’s individual marginal rate. This system was designed to prevent the double taxation of company profits.
As the flat company tax rate is lower than personal income tax rates, there can be significant tax advantages, especially if you plan to reinvest company profits into the business. However, a taxpayer should be mindful of the personal services income rules, which can affect who actually pays tax on a company’s profits.
Like a partnership and sole trader, superannuation contributions, payroll tax and the PAYG withholding system also apply to companies. Further, once the company’s GST turnover reaches at least $75,000 in a 12-month period, it will have to register for and charge GST on its goods and services.
Trusts
A trust is a legal relationship where a trustee holds and manages assets for the benefit of beneficiaries, which can include individuals or companies. Trusts are usually established through a legal document known as a ‘trust deed’. The trust deed outlines the terms of the trust, including:
- the roles and responsibilities of the trustee;
- the rights of the beneficiaries;
- the type of trust (unit or discretionary);
- how the trust’s assets and income should be managed and distributed; and
- any conditions or restrictions on distributions.
In many cases, businesses, particularly family operations, use discretionary trusts. Here, the trustee oversees the business and allocates profits to the beneficiaries according to the terms of the trust.
Trust Income
When a trustee distributes trust income to a beneficiary, the beneficiary pays tax on their share of the trust income. This is at their personal income tax rate if they are a person or at the company tax rate if they are a company. The benefit of running your business through a family trust is that the trustee can choose, for each financial year, to distribute the trust income to beneficiaries with lower personal income tax rates.
The trustee must pay tax on behalf of any beneficiaries who are:
- aged under 18; or
- not Australian residents.
This is at the highest marginal tax rate. Any undistributed trust income is also taxed at the highest marginal tax rate in the hands of the trustee. Therefore, trust income is taxed under the trust at a significantly higher rate than company profits.
Trusts may be advantageous from a tax perspective if you plan to take all of the business income as personal income or if there are certain asset protection or family succession plans. However, trusts can be disadvantageous if you wish to retain profits to reinvest in the business, as these retained earnings will be taxed at the highest marginal rate.
Key Takeaways
When choosing a business structure, you should consider the tax implications of the structure you choose. Different structures are taxed in different ways, with some structures having more tax benefits than others. Sole traders and partnerships are taxed at personal income tax rates. Company profits are taxed at company tax rates. The different parties to a trust are subject to varying tax rates.
If you are starting your own business, our experienced taxation lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
Sole traders pay tax at personal income tax rates and must report all business income in their individual tax return. If the business turnover exceeds $75,000 annually, the sole trader is also required to pay GST. Additionally, sole traders are eligible for a 50% capital gains tax discount on certain business assets.
Partnerships do not pay tax on business income directly. Instead, the income is distributed to partners, who are taxed on their share at personal income tax rates. If the partnership’s turnover exceeds $75,000, it must also register and pay GST. Partners are also responsible for withholding income tax from employees’ wages.
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