With all the responsibilities small business owners have, it’s easy to overlook work deductions that…
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There are three main ways to structure a business, however, the first questions I ask when posed with the question about the right business structure is not about structure at all. I ask questions around what the enterprise does and what the primary motivations are for running the enterprise. Why – well the enterprise might not be a business at all – it might just be a hobby.
So, what is the difference? A hobby’s primary purpose is to provide enjoyment and fun. A business is primarily commercial in nature and the purpose is to make a profit. Another distinction is that a business is an activity that is planned, organised and carried out in a business-like manner. My mother knits and tats for enjoyment and sells some of what she makes at a local craft shop. This is a hobby as the primary purpose of doing the knitting and tatting is for enjoyment and selling the goods at the craft shop is merely a way to offload some of the final products and earn some cash to recover some of the costs.
The ATO also may ask the business if you’re running a hobby or a business especially if you are making losses. I worked with a farmer who had basically retired and was reporting losses to the ATO who in turn wanted to see the business plan to get the farm back into profit – they were questioning if in fact the farm was now a hobby and if so would not be entitled to the same deductions as a business.
After you determine that you are a business you then decide which structure you use. It will depend on several factors: What type of business will it be? How many people will be involved? How will the profits be shared? What will be your legal liability? How will the tax be paid? Where do you envisage the business in the future?
structure your business today for YOUR future situation
If you are in business by yourself and envisage the business to stay that way, then you will probably elect a sole trader structure for your business. If the business grows, you will generally need to move to a different structure.
As a sole trader:
- you benefit from all profits and capital (goodwill) growth
- you have low start-up costs
- there is no legal separation between the business and the owner, so potentially your liability is unlimited and extends to your personal assets
- profit (and losses) from the business are treated as part of the owner’s personal income. There is not a separate tax return for the owner and the business.
You choose the partnership structure when two or more people start a business. In lots of ways, it is like a sole trader structure in that a partnership is not a separate legal entity. The partners’ liability is unlimited and can extend to personal assets. The partnership does not pay tax, rather the partners pay tax on their share of the partnership income.
The partnership does need its own tax file number and must complete an annual tax return showing the allocation of income to each partner.
I recommend a partnership agreement be drawn up upon establishment of a partnership to avoid any disputes in the future, if this is the structure that you choose.
A proprietary limited company has shareholders who own the business and directors who run the company on their behalf. You only need one shareholder and one director and it can be the same person – it can also be you, the person who starts the business. A proprietary company is a scalable business structure and has the following features:
- Shareholders’ liability is limited to the amount invested in the company.
- It is a separate legal entity that pays tax on its profits at the company tax rate. The company has its own ABN and tax file number. Owners are either taxed on their income as employees or they pay tax on director’s fees or as dividends distributed.
- Compliance costs are higher, e.g. you will need to pay an annual ASIC company statement fee and pay for an accountant to prepare the company’s annual tax return.
Note that with a proprietary company, consultants and contractors are still subject to the ATO personal services rules. However, with a diversified client and revenue base this structure may allow business owners to build up capital in the business and also potentially lower their average tax rate (tax advice should be sought from a tax agent though).
One of my strongest recommendations if you structure your business as a proprietary limited liability company, and you have more than one shareholder, is to put in place a Shareholders Agreement at the same time. A Shareholders Agreement is a contract that the shareholders negotiate outside of the Corporations Act to govern their relationship and business arrangements.
It details their rights, responsibilities, obligations and liabilities, and protect their interests — with regard to their particular circumstances. Examples of such circumstances could be on transfer of ownership, dividend payments, what happens if a shareholder dies, gets married or divorced, who can be shareholders in the future, and dispute resolution methods. I have seen things get pretty messy for companies where there was no Shareholders Agreement, and also seen a start-up company that put in place a Shareholders Agreement before they started trading and it was the one key thing that was the difference between obtaining a permit to operate from a government department or not.
The last piece of advice is think down the track a bit – several years – think about how both your business will look and your own personal circumstances and then structure your business today for that future situation.