Taxes are an important consideration in deciding how to structure your business. A company structure is very common and has its various advantages and disadvantages. Companies pay tax differently to individuals. If you are looking to set up a company, or if you have already incorporated, it is imperative that you understand how to manage your company’s tax liability. If you are a shareholder of a company, you will also need to be aware of the relevant tax consequences resulting from your share ownership. This article sets out:
- what it means to operate your business through a company; and
- the relevant taxes your company needs to pay.
What is a Company?
A company is a separate legal entity you set up to hold assets and earn income in its own capacity. This means that a company is considered separate from the individuals who own and operate it. Therefore, the company is itself liable to pay its own debts. That liability is not ordinarily the responsibility of the individual participants in the company.
Who Are the Participants in a Company?
Firstly, the main participants in a company are directors and shareholders.
Directors manage the day to day operations of the company. They also have an obligation to manage the company in the best interests of the shareholders. In contrast, the shareholders are the owners of the company and are the capital contributors of the company.
A company owns assets and incurs debts in its own name, meaning that shareholders and directors are not liable for the debts of the company.
However, directors may incur some personal liability if they breach their director’s duties, such as having the company trade while it is insolvent or failing to pay PAYG or superannuation in certain circumstances. Shareholders are also liable to pay any unpaid amounts on partly paid shares they hold.
How Are Companies Governed?
Companies are governed by general law as well being significantly regulated by the Corporations Act 2001.
Additionally, the operation and management of a company will be affected by its company constitution and shareholders agreement, should the company choose to implement one.
How Will My Company Pay Tax?
Taxation of a Company’s Income
A company is its own entity. A flat company tax rate applies to income generated by the company.
The company income tax rates are a two-tier system:
- “base rate” entities (i.e. companies which carry on a business and have an aggregated turnover of less than $50 million) pay 27.5% in tax; and
- all other companies pay 30% in tax.
A flat rate can be attractive for growth because the tax rate will not increase as the company’s revenue increases.
However, unlike sole traders or partnerships where tax losses can be offset against an individual participant’s other income, tax losses are ‘trapped’ within the company because a company is its own entity.
Tax Liability of the Shareholders
Companies can choose to distribute profits to shareholders in the form of dividends. Dividends form part of the income that a shareholder earns during the year and so will affect their tax liability.
The company imputation system is a crucial part of company taxation and importantly works to prevent double taxation at the corporate and shareholder levels.
The imputation system results in companies generating ‘franking credits’ when they pay tax. When the company pays fully franked dividends to shareholders, those shareholders will receive franking credits for tax already paid by the company. As a result, shareholders do not need to pay tax on what would have been the whole amount of the dividend.
If a shareholder’s personal tax rate is below the company’s tax rate, they will receive a refund of the difference from the Australian Taxation Office (ATO). However, if the shareholder’s personal tax rate is higher than the company’s tax rate, the shareholder will be liable for the difference.
For example, Lauren receives fully franked dividends of $700 and a franking credit of $300 (after the company paid tax at a rate of 30%). Assuming that Lauren is on the 19% marginal tax rate, the tax consequences would be as follows:
|Tax at 19%||$190|
|Tax liability on dividend||$0|
|Refund of excess franking credits||$110|
Assuming that Lauren is on the 37% marginal tax rate, the tax consequences would be as follows:
|Tax at 37%||$370|
|Tax liability on dividend (“top up tax”)||$70|
There are circumstances when companies must pay unfranked dividends. For example, the company doesn’t have franking credits because it hasn’t paid any tax.
Additionally, there are tax considerations if you structure your business with more than one company, for example a dual company structure with a holding and operating company.
You may want to establish as a tax consolidated group. This means that, for tax purposes, your group companies are one entity. Therefore, you only need to fill out one tax return.
Similarly, you can also establish as a goods and services tax (GST) group, where only one member of the group needs to complete activity statements and accounts for GST purposes.
Tax consolidation or GST grouping can make managing a group of companies less administratively burdensome. Consolidation will also not affect the different companies being considered separate entities for legal purposes. That is, from an ordinary commercial liability perspective, each group entity remains a separate legal entity.
Capital Gains Tax
In addition to income tax, it is also important to bear in mind that capital gains tax (CGT) is payable on gains relating to capital assets. For the company, capital assets could include the equipment and machinery of the business. However, these are generally dealt with under the depreciation rules (which apply in priority to the CGT rules) and goodwill.
Shareholders will also need to be aware of the CGT consequences for themselves personally. For example, gains or losses from the sale of their shares.
Is My Company Eligible for the 50% CGT Discount?
Subject to meeting certain conditions, certain taxpayers can halve their capital gain before including it in their income. That is, they can take the first half of the gain completely tax-free and only pay tax on the remaining half. However, companies are not eligible for the 50% CGT discount (whereas individuals and trusts are).
This may be a significant disadvantage, depending on what your commercial goals are. Each structure has advantages and disadvantages. Accordingly, it is important to weigh these alongside your goals and most likely scenarios in deciding how to structure your business.
What Small Business CGT Concessions Apply to my Company?
A small business entity is either a company:
- that carries on a business with an aggregated turnover of less than $2 million; or
- where the total net value of the CGT assets does not exceed $6 million, owned by:
- the company (in the event of an asset sale); or
- the shareholder(s) (in the event of a share sale).
If your company is a small business entity, the relevant taxpayer may be able to access the small business CGT concessions.
The small business CGT concessions allow you to disregard or defer some or all of the capital gains made from an ‘active’ asset (i.e. an asset used in the course of carrying on a business or an asset inherently connected with the business), in certain circumstances:
- where you sell an active asset, it was continuously owned for 15 years, you’re aged 55 or over and are retiring or permanently incapacitated:
- you can reduce the capital gain on that asset by 50% (in addition to the 50% CGT discount discussed above);
- you can use the small business retirement exemption to shelter up to $500,000 from tax (although, if you’re under 55, you must contribute the sheltered amount to a complying superannuation fund); and/or
- you can defer all or part of the capital gain for two years or longer if you acquire a replacement active asset or incur expenditure on making capital improvements on that active asset.
Companies have unique tax rules which apply both at the company level and shareholder level. There is a two-tier corporate tax rate which applies to company income. Additionally, the imputation system applies to dividends paid to shareholders. Importantly, the 50% CGT discount does not apply to companies.
Therefore, if you need assistance in setting up a company or understanding the legal and tax considerations of a company structure, get in touch with LegalVision’s taxation lawyers on 1300 544 755 or fill out the form on this page.
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