Sole trader or company? How to choose

Most Australian businesses start as a sole trader because it is quick and cheap. The question comes later, usually when profits grow, a contract asks for a company, or someone points out that your house is exposed. Choosing between the two is not only a tax decision. It affects your personal risk, your paperwork and how easily you can bring in partners or sell one day.

How a sole trader works

As a sole trader, you and the business are the same legal person. You trade under your own ABN, the profit is added to your other income and taxed at your personal marginal rates, and you report it in your individual tax return.

The advantages are real:

• Low cost and simplicity. No company to register, no separate tax return, no ASIC annual review fee.
• Losses can offset other income, subject to the non-commercial loss rules, which matters in a start-up year.
• The 50% CGT discount is available to you as an individual on assets held for at least 12 months, along with the small business CGT concessions if you qualify.
• Easy to wind up. You simply stop trading and cancel the registrations you no longer need.

The drawbacks are just as real. You are personally liable for every debt and claim of the business, without limit. Profits are taxed at your marginal rate whether you need the money or not, and at higher incomes that rate is well above the company rate. You also cannot easily share ownership, which makes bringing in a partner or selling part of the business awkward.

How a company works

A company is a separate legal entity. It owns the business, signs the contracts, employs the staff and pays tax on its own profit. You are a shareholder and, usually, a director.

A company that is a base rate entity pays tax at 25%; other companies pay 30%. Whether your company qualifies depends on its turnover and the kind of income it earns, so confirm this with your adviser rather than assuming. Profit left in the company is taxed only at the company rate until it is paid out to shareholders as a dividend, which can carry franking credits for the tax already paid.

The main advantages:

• Limited liability. Shareholders are generally not liable for the company's debts beyond what they have put in.
• Control over when profit is taxed personally. Profits can be retained and paid out in years when your personal income is lower.
• Easy to share and sell. Ownership is divided into shares, which can be issued to partners, investors or a buyer.
• Credibility. Some customers, lenders and government buyers prefer or require a company.

The trade-offs:

• Higher cost. Registration, an annual ASIC fee, a separate tax return and more bookkeeping.
• Directors' duties. You take on legal obligations as a director, including not trading while insolvent.
• The money is not yours. Taking cash out other than as wages, dividends or a properly documented loan creates Division 7A problems. See Division 7A: taking money out of your company the right way.
• No CGT discount for the company itself on assets it sells.
• Losses are trapped in the company and cannot be used against your personal income.

Limited liability has limits

Many owners move to a company for protection and are surprised by how much exposure remains. Banks and landlords commonly ask directors for personal guarantees. Directors can be personally liable for certain unpaid tax and superannuation under the director penalty regime, and for debts incurred while the company was insolvent. Your own professional negligence can also follow you personally.

A company protects you from many business risks, but not from personal guarantees, director penalties or your own conduct. Plan for that, rather than assuming the structure covers everything.

Comparing the tax: an illustration

Take a business making $200,000 profit a year. As a sole trader, all $200,000 is taxed at personal rates, with the top portion at the highest marginal rate plus the Medicare levy, whether you spend it or not.

If the same business is run through a base rate entity company and the owner draws a reasonable salary and leaves the balance in the company, the retained profit is taxed at 25% for now. That is a deferral, not a permanent saving. When the retained profit is eventually paid out as a dividend, the shareholder pays top-up tax at their marginal rate, less the franking credit. The real benefit comes from reinvesting in the business, smoothing income across years, or paying dividends to a shareholder on a lower rate, which is often where a family trust becomes relevant (see Discretionary (family) trusts explained).

These numbers are illustrative only. The right answer depends on your total income, how much you need to live on, and your plans for the business.

Signs it may be time to move

• Profit consistently exceeds what you need to live on, and the surplus is being taxed at your top rate.
• You are signing contracts, leases or employing staff that expose you to larger claims.
• You want to bring in a partner, an investor or a key employee as an owner.
• You are thinking about selling within a few years.
• A major customer or tender requires a company.

Signs it may be too early

• Profit is modest and you need all of it to live on.
• The business is likely to make losses in its first year or two that could offset other income.
• The work is personal services income, where the tax benefit of a company is largely switched off by the personal services income rules.
• The extra compliance cost would outweigh any saving.

Making the switch

Moving an existing sole trader business into a company is a restructure, not just a new registration. Goodwill and other assets are transferred, which can trigger CGT and, in some states, duty. Contracts, leases, licences, insurance, bank accounts and employee arrangements need to move across. Rollovers and concessions may reduce or defer the tax cost for eligible small businesses, but they have conditions. Read Restructuring an existing business before you act, and have a lawyer prepare the company constitution and transfer documents.

How we can help

We help business owners compare structures using their own numbers, not rules of thumb, and plan the move when the time is right. If you are weighing up a sole trader or company structure, contact us or read more about our business structuring work.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.