Following on from our overview of how to turn your hobby into a business, let’s look at that third step in more depth: The million dollar question … How do you set up your business?
Have you thought about the structure that you will operate your business from?
There are four structures commonly used by small business; namely sole trader, partnership, trust and a company.
The above structures all have different implications on things like:
- initial set up costs
- ongoing business costs
- potential personal liability/asset protection
- responsibilities as a business owner
- ongoing compliance (paperwork and administration) requirements and the amount of tax you pay (i.e.) your tax liabilities
- the way you exit the business.
Generally, costs and complexity increase as you move from a sole trader to a partnership, company or trust.
The simplest business structure is a sole trader. That means there is no separate business entity – you personally trade as the business. You need to register an ABN, and if required – a business name. There is no other legal or tax formality. The business income, less any allowable deductions claimed, is included on your personal tax return together with any other income (for example, part time employment, interest, dividends etc) and reported on the individual return. If the business sells good or services (turnover) above $75,000, (the GST threshold for a profit based organisation), then you need to register for GST. As you are registered personally for tax, there is no separate Tax File Number (TFN) for the business.
A partnership is also relatively inexpensive to set up and operate (but more onerous than a sole trader). A partnership consists of between 2 and 20 people who carry on business with the intention of making a profit. A formal partnership agreement is important to document the arrangements between the partners, and I personally believe no-one in a partnership should be in business without one.
The main features of a partnership business structure are:
- income, losses and control of the business is shared among the partners
- the partnership has its own TFN and must lodge an annual partnership return showing all income and deductions of the business
- a partnership doesn’t pay income tax on the profit it earns – each partner pays tax on their individual share of profit they receive
- a partnership has its own ABN
- a partnership must be registered for GST if its annual turnover is $75,000 or more.
It should be noted, as a partner of a partnership you can’t claim deductions for money drawn from the business. Amounts you take from a partnership business are not wages for tax purposes.Partners are responsible for their own super arrangements; however, the partnership is required to pay super for any employees.
A company is a more complex business structure. The company is a separate legal entity of which you will be a shareholder. You will also likely be the director, company secretary and public officer all rolled into one. “ The ‘Jill’ of all trades”, right?!
Setting up a company has a set-up cost payable to a shelf company, and further fees payable to ASIC. There are annual administrative costs payable to ASIC, and the company is required to conduct annual compliance steps like completing a going concern and solvency review and signing a resolution to the effect that the company is liquid and solvent (basically this means that the company has bucks in the bank, and can settle debts as they become due and payable for the foreseeable future!). The income earned by the company belongs to the company. The company is required to have a separate bank account. The company needs to register for a separate TFN and lodge a separate annual company tax return. The company will usually pay PAYG Instalments (which is basically a pre-payment of tax).
If you wanted to get money out of the company:
- Repayment of any loan that you initially provided to set up the company. As this is usually funded with after tax money – the repayment of the loan is capital in nature, and not included on your tax return;
- The company registers as an employer and you earn a salary and wage from the company. If you earn no other income – it makes sense to pay yourself a minimum of $18,300, (the current tax free threshold), as the company gets a deduction of this amount, and you get the income tax free;
- The company retains the money, pays tax at 28.5% (current small business tax rate) and then declares a dividend to you, the shareholder with a fully franked dividend. You then declare the dividend into your individual tax return, and get the tax credit for the franking credit (tax already paid by the company).
Generally speaking, setting up a trust can be expensive, as a formal deed is required and there are formal yearly administrative tasks for the trustee to undertake. A trust deed is required for a trust, and this outlines how the trust will to operate. A trustee is legally responsible for the operation of the trust. The trustee can be an individual or a company. If you are running a business through your trust, it is highly recommended that you have a company as the trustee. The trust will need to distribute profits to beneficiaries, in the distribution percentages determined by the trustees.
A trust must have its own TFN for lodging its annual tax return and must show all income and deductions of the business, plus any distributions to its beneficiaries. A trust is also required to have its own ABN, and must be registered for GST if above the registration thresholds. Usually the trust has not tax obligation, provided the profits are distributed to adult resident beneficiaries. Where profits are distributed to minors and/or non-resident beneficiaries, the trust becomes liable for the taxation on that share of the income.
A trust is a great tax planning tool and offers asset protection, but it is complex in nature and often not the first choice of someone starting up a new business.
Click here to view or download a PDF table summary of the four structures most commonly used in Australia.
There are advantages and disadvantages to each structure, and it largely depends on personal circumstances and where you are in the business life cycle. Starting up – you may suit a sole trader, but you may soon evolve into needing a company.
The sole trader is easily able to convert to a company at a later stage. If you have personal assets that you want protecting from the start, consider starting a company immediately.
Whichever structure you decide on, ensure your business has been set up properly and legally. Some groundwork now will save you a whole lot of potential headaches in future.
Further, having a business structure means just that – you are in business, and serious about it.