If you’re among the many Australians who have decided that this is the year you’re going to set up a new business, spend the time and money getting the ownership structure of your business right from the start.
I was recently asked by a family member to help out on the sale of part of his business to an incoming partner. One of the things I suggested to him was that now might be the time to incorporate — to have the business and its assets owned by a company of which he and his new partner were shareholders.
Unfortunately, as the business has been in existence for some time, the stamp duty costs were a deal killer. It would have cost thousands of dollars to make the switch. Plus it would have slowed down the deal they were ready to implement.
The lesson here is that the structure you start with is often the one you’re stuck with long term. Stamp duty can be a deal breaker where real property and other business assets are involved, but even things as simple as having to notify all your customers of new payment details or change business license details can put substantial hurdles in the way of making a switch once the business is up and running.
Many people start off as sole traders (owning the business in their individual name) because it’s the easiest. It’s much simpler than having to pay an accountant or adviser to review the options, advise you on the best approach and then implement the structure. However, in the long term this approach can be a false economy.
The first one to consider is running the business through a company, with you and your partner (if you have one) as shareholders and directors.
A key advantage of operating through a company is that it gives your business a legal life separate to that of you and your partner. It means if the business is sued by a disgruntled customer or competitor, it’s the assets of the company that are exposed to the financial claim, not yours (although directors can be liable in some circumstances).
The business also continues to operate unhindered (at least, in the legal sense) if one of the partners (shareholders) becomes bankrupt, found guilty of a crime, incapacitated, or passes away. It’s very simple to replace someone as a director, but much harder to switch partners or co-owners.
Companies can also provide more tax flexibility, as business income belongs to the company and is taxed at the corporate tax rate of 28.5 percent (if classified as a ‘small business’). The owners only need to pay tax at higher individual marginal tax rates if the company chooses to pay them a dividend. Note though that a company isn’t always better for tax, since it doesn’t get access to the same capital gains tax concessions as an individual.
Owning a business through a trust, with a company as trustee and the owners and their families as beneficiaries, can provide the best of both worlds. Set up correctly, a trust can provide the legal protection of a company while allowing maximum flexibility to minimise tax bills and also access capital gains tax concessions.
Unfortunately ‘best practice’ trust structures are often considerably more expensive to set up and operate than a single company. It’s not something you want to do if the potential benefit is marginal.
A company costs roughly $600 to $700 to establish (including ASIC fees of $463) and (based on current rates) annual ASIC costs of $246 plus the cost of your accounts and tax return. Remember you’ll need to do business accounts and a tax return even if you operate as a sole trader, so check with your accountant whether using a company makes any difference and if so, how much.
The cost of using a trust varies depending on how complex you make it. A simple trust structure might cost you another $500 to $1,000 upfront and add a similar amount to your annual accounting fees (note that a more complex structure could be substantially more).
While these costs may sound a lot, you need to consider the potential benefits and the cost of having to make a change in business structure down the track. If you need to change, you could easily be staring down tens of thousands of dollars in stamp duty and you could be paying thousands in legal fees to restructure loan agreements and contracts.
To give an example of how a sticky situation can develop, let’s say you’ve been operating for a while and you make a taxable profit of $180,000 in the year ended 30 June 2016. As a sole trader, you’d be liable for tax of $58,147, while a company paying its owner a salary of $80,000 would have a total tax burden (across both company and individual) of $47,647. In the right circumstances, a trust structure could make it a lot lower — a reduction of more than half isn’t out of the question.
While you could save over $10,000 in tax each year by switching structure, the switch itself might cost say $30,000 (largely stamp duty and legal costs) and require a substantial time commitment to put into place. It’s a tough choice to make and one that could have been avoided by paying a bit more to start with a company (or trust) in the first place.
If the worst happens and the business becomes exposed to a lawsuit, it will probably be too late to change. The business and all your personal assets could be on the line.
This isn’t to say that a company or trust is always the best option, especially if you’re starting a small business that’s intended to stay small. All things considered, running your business as a sole trader might be the best way to go.
The key point here is to make sure you talk to an accountant or adviser with experience in the sector in which you plan to operate, and consider the options and their pros and cons upfront. Don’t automatically go the cheap and simple route as a relatively small saving now might cost you a large amount of money, or everything, down the track.
Richard Livingston is a founder of Eviser (www.eviser.com.au). This article contains general investment advice only (under AFSL 469838).