If you are ready to grow your sole trader business – limit your personal liabilities, take on more employees, perhaps involve a third party who is willing to inject funds into your business – it may be time to consider changing your business structure to a company.
Many small businesses in Australia start out as sole traders, as it is a simple and cost-effective business structure.
As a sole trader, you have full control over the business. However, when operating under this structure, you are personally liable for all aspects of your business, including debts. This means personal assets such as your home or car may be used to pay business debts.
Clearly, moving from one structure to another will affect how you run your business and your legal obligations.
It is important to ensure you understand the differences when deciding whether operating your business as a company will meet your individual and ongoing objectives.
I’ve summarised some of the key differences below:
Control over the business
Essentially, sole traders have full control over their business operations: they make all the decisions.
In a company, shareholders appoint directors to make those key decisions. If there is more than one director, all directors have a say in how the business is run and the company and its directors are subject to the rules in the Corporations Act 2001.
Major decisions may require the approval of shareholders, who are usually entitled to vote in accordance with their shareholding.
In private family companies, the directors and shareholders may be the same or associated persons, so a degree of control is still maintained.
Income from a sole trading business is treated as your individual income. This means you have full access to draw on all funds in any business account you operate. A separate bank account for the business is not compulsory but is recommended.
You are able to claim a tax deduction for any costs incurred in running your sole trader business, provided you keep complete and accurate records.
On the other hand, any income earned by a company belongs to the company and setting up a separate bank account is mandatory when operating in this type of structure.
The directors of a company may be paid wages or a fee for services they perform, but they cannot simply withdraw money from the company’s bank account as drawings. Shareholders in a company receive income in the form of dividends.
Sole traders are taxed as individuals and the amount and rate of tax varies depending on their level of income.
Currently, marginal tax rates range from 19 per cent (once taxable income exceeds $18,200) through to 47 per cent on income over $180,000. No separate income tax return is required for a business carried on as a sole trader; all income and expenses are included in the individual return.
Unlike individuals, there is no tax-free threshold for companies – they pay tax on each dollar of taxable income.
Companies that qualify as small business entities are currently taxed at a rate of 27.5 per cent and all others at 30 per cent. Recent changes will see this rate progressively reduced to 25 per cent over the next 10 years.
Companies are required to prepare financial statements and lodge a separate income tax return each year. In addition, any benefits received by directors and/or their associates may be subject to fringe benefits tax (FBT), which is paid by the company.
Regardless of your operating structure, your business must register for goods and services tax (GST) if its annual turnover is $75,000 or more.
Liability for debts
As mentioned previously, as a sole trader you are personally liable for all aspects of running the business, including financial and tax debts.
Your liability is not limited in any way. This means that all your business assets, together with your personal assets (even is you own them jointly with your spouse), may be used to settle business debts.
One major advantage of a company is that there is limited liability. A company is treated as a legal entity, separated from its shareholders. Generally, a company’s liability is limited to the extent of its assets.
The shareholders' liability is also limited, and they are not responsible for debts incurred by the company except for any unpaid capital on shares issued to them.
Directors also enjoy a degree of limited liability, unless they’ve signed any personal guarantees. Directors are generally only personally liable in circumstances where they act negligently or fraudulently, or breach their duties as directors by allowing the company to trade while insolvent.
Directors are also personally liable for certain tax debts incurred during the period of their directorship, and this liability continues even if they cease to be a director of the company.
Both sole traders and companies can employ staff members. Both business structures are required to have workers’ compensation insurance, meet tax and super obligations and fulfil employee entitlements.
Directors are personally liable for any unpaid or unreported pay as you go (PAYG) withholding or any amount on the superannuation guarantee charge (SGC). Therefore, companies need to ensure they are lodging and paying on time so that directors are not penalised.
A sole trader cannot offer another party a share in the business. If they want to expand their business operations but need to raise capital, they must approach a bank or other institution for finance, which must be repaid (with interest) out of funds generated by the business.
Companies are able to attract other investors who are willing to inject cash into the business in exchange for shares in the company. They effectively become part-owners of the business, but this may be an effective way to raise much-needed capital to fund business expansion.
What would happen to your business if you were to pass away? Although it is probably something you don’t want to think about, you should.
As a sole trader, your business would simply cease upon your death and any assets (and liabilities) would be dealt with in accordance with your will, assuming you have one. This may not provide the security you want for your loved ones.
Companies enjoy what is called ‘perpetual succession’. This means the company continues to operate even after directors and shareholders pass away. Shares in a company may form part of a will.
Other things to consider
There are costs involved to both form and run a company. Companies are more regulated than a basic sole trader structure, and this requires a higher level of record-keeping and periodic bookkeeping/accounting to ensure records are maintained appropriately.
The Australian Securities and Investments Commission (ASIC) also levies an annual fee on all registered companies.
Although these costs are certainly more than you would incur maintaining a business in a sole trader structure, they should be weighed up against the ongoing benefits a company structure could produce.
The above points cover some of the major differences between operating a business as a sole trader and as a company.
There are many other factors to consider and you need to think carefully about where you want your business to be not only right now, but in five and even 10 years’ time.
Veronica Southern is the director of McKinley Plowman.