It’s an exciting time, but it’s also a time when you need to make decisions that could prove vitally important down the track: under what structure to run your business, and how you will pay yourself - whether you take a salary, drawings from income, or loans from the company.
“Getting it right from the outset can save you both headaches and money”
These may be less exciting decisions than your website, your marketing plan and establishing your new premises – but they’re absolutely critical decisions. Getting it right from the outset can save you both headaches and money.
Small business structures
There are four main structures to choose from: sole trader status, a partnership, a proprietary limited company, and a proprietary limited company as trustee for a trust (whether a discretionary trust or a unit trust).
Sole trader status – or multiple sole traders operating in partnership – is easiest to set up: all that you need is an Australian Business Number (ABN). You are taxed on the company’s net profit at your individual tax rate, and end-of-year accounting is simple: all you need to do is produce a business profit and loss (P&L) statement, and prepare a personal tax return based on the net profit.
A proprietary limited company requires a company name, Australian Company Number (ACN) and ABN. You are creating a legal entity, which has the privileges of limited liability in the case of litigation or bankruptcy, and the company tax rate, but it has obligations in terms of documentation, record-keeping and registration with the Australian Securities & Investments Commission (ASIC). The establishment and annual tax and compliance costs are higher than for sole trader status.
A proprietary limited company as trustee for a trust has the added layer – of both responsibility and cost – of establishing the trust and maintaining its accounts. At the end of each financial year, the trust is required to distribute all of the trust’s profits - they cannot be kept in the trust.
Asset protection is critical
The proprietary limited company-plus-trust structure is the least common, but the best, says business coach and mentor Dr. David Dugan, of Elite Enterprises. “Entrepreneurs not only want to succeed, they should also be thinking of protecting their business and their personal assets. But too many people stuff it up by not getting the structure right and the appropriate insurances in place from the start.”
“Too many people stuff it up by not getting the structure right and the appropriate insurances in place from the start”
Dugan says the company-plus-trust structure gives business proprietors the most flexibility and the most complete asset protection. “The downside of this structure, which is why people sometimes don’t want to do it, is that at the end of the year you have to distribute all of the profits in the trust, whereas in a company you can hold the profits in there.
Your company as part of your overall wealth
“Also, it costs a little bit more to get a company and a trust set up. But it gives you much more tax-effectiveness and flexibility in terms of your overall wealth creation strategy, which may have investments outside your business,” says Dugan.
“Not enough small business owners are thinking at the outset about protecting themselves and their assets, but they should be. That aspect alone makes sole trader status or a partnership a recipe for disaster,” he says.
How will you pay yourself?
Once you have decided on the structure you want, you then have to think about how you will be paid. The options here are salary, drawings from the business or loans from the business depending upon the business structure.
“The structure and payment plan must be in place from the very start”
Within these parameters can lie a great deal of complexity, which is why the structure and payment plan must be in place from the very start, says Garry Godfrey, principal of business advisory company Australian Business Clinic.
Unlimited liability for sole traders and partnerships
A lot of people are focused on costs at the outset, and want to do it as sole trader or in partnership,” says Godfrey. “That’s fine if they’re prepared to be taxed at their marginal tax rate, and to accept unlimited liability. Too many people don’t think about this, but sole traders and partnerships are liable for everything – accidents, debts and liabilities.
If you're a tree lopper, and you drop a big branch on a house, you could be sued for your personal assets. The proprietary limited company structure has that essential layer of asset protection,” he says.
Salary the safest
In most cases, Godfrey recommends a proprietary limited company with the owner drawing a salary. “Ideally you would be an employee of your own business, being paid regularly, the pay-as-you-go (PAYG) tax being taken out and remitted to the Australian Taxation Office (ATO) with a group certificate and director’s tax return at the end of the year, as well as the company tax return.”
Where company owners can get in trouble, says Godfrey, is if they have “a sole trader mentality,” and pay themselves by taking money out of the business along the way. “Drawings do not work in a company. That could be treated as a director’s loan, what the ATO calls a Division 7A loan.
Are loans a liability?
Unless there is a formal loan agreement in place setting out the interest and repayment schedule, that income could be deemed personal income, and taxed at the business owner’s personal tax rate,” he says.
Regardless of what structure is established, Dugan says it’s a good idea to take a regular salary. “It’s simply bad strategy to start off not being paid. If the business is going to sell product or services and make money, from day one, every time money comes in there should be a certain proportion of that going off to the tax account, to the owner – even if it’s a small amount – and to build up the business’ financial buffer.
“Regardless of what structure is established, it’s a good idea to take a regular salary”
If that’s not happening, the business owner has to think long and hard about the business model and the pricing,” says Dugan.
It’s important to get it clear in your mind before you start a business what structure will suit you best, and also, how you plan to pay yourself. Getting this right from the outset can save you money – and help you sleep better – down the track.
Your accountant, insurance broker or business adviser should be able to help you with advice. Before you seek tailored advice, here’s a handy site to go over the alternatives: https://www.business.gov.au/info/plan-and-start/start-your-business/business-structure.
This video also has the lowdown on the business structures you can use, and how tax may apply to each.
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