When speaking with small business owners one of the common questions that comes up is “when should I move from being a sole trader to a company?” It can be a tricky area and as it comes up so often we thought we’d write this piece to explain what you need to consider when moving from being a sole trader to a company.
Broadly speaking, a company tends to be the best structure for most businesses when they are at the right stage and in our experience there are three main reasons for making the move. There are many other factors to consider, but in this article we’ll be focusing on these three main reasons as well as the costs of operating via a company structure.
1. TAX
People assume that by operating via a company structure they’ll pay less tax than continuing as a sole trader. This assumption comes about because the current small business company tax rate is 25% whereas a sole trader pays the standard individual marginal tax rates which can go as high as 47%. Where this line of thought falls over is that when you’re operating as a solo operator (or perhaps you have some helpers, but you deliver the primary work) it’s possible the income you’re earning will be considering Personal Services Income (PSI) (i.e. reward for your labour) and in that case the ATO will want to see all the profits from your business passed through as a wage to you. This means the net outcome is no different to when you were a sole trader, more or less.
However, if your business has multiple people carrying on the same work as you (i.e. billable work and not admin work), or you’re in the business of selling goods rather than services, then you may not be affected by the PSI rules and can retain excess profits in the company to be used for working capital and taxed at the company rate. If this is the case for you then you’ll likely be interested to know the magic number which is currently around $100,000. What is the magic number? It’s the amount of taxable income you can earn before you are paying more than an average rate of tax of 25%, i.e. the amount of wages you can be paid before it makes sense, from a tax perspective, to leave the rest of the money in the company. Some people find this number a useful benchmark for deciding when to start a company, meaning they need to be netting as a sole trader more than $100,000 before even considering a company.
What other tax benefits are there? The truth is that most of the tax deductions available to small companies are also available to sole traders. One of the core tax deduction differences we see day-to-day is the ability to pay yourself travel allowances (aka. per diems) from a company which you can’t do for yourself as a sole trader, but aside from that there isn’t a load of difference when it comes to deductions.
The big difference, from a tax perspective, comes when it is time to sell your business. Sole traders who sell their business will be liable for the resulting tax completely, whereas if it’s a company structure you may be able to access some flexibility.
Bottom line? There are some tax savings to be had, mostly by those building the business to be more than just themselves and mostly when it comes time to sell the business.
2. COMMERCIAL
If you are happy operating your small business as a sole trader then that’s great, nothing to worry about, but if you have big growth plans then operating as a sole trader simply won’t cut it in the long run. You won’t easily, if at all, be able to take on investors as they’ll want the security and flexibility of the company structure in place.
You may also find that some suppliers won’t engage with you or add you to their preferred supplier lists if you’re not operating as a company. This is typical of larger organisations that are worried about getting into trouble for not paying employee entitlements, such as superannuation, which can happen if you are a sole trader, but typically isn’t an issue if you operate the business via a company.
It can also help simply to be able to say to possible clients that you are a company and that it isn’t just little ‘ol you. Whilst this impression can sometimes be a little misguided, a company implies a certain scale and level of seriousness that a sole trader business simply can’t match.
In addition to this, having a large business can be inherently risky and for that reason alone you’ll likely want it to operate out of a separate legal entity (i.e. not yourself) which leads to me to reason number 3.
3. LEGAL
We can’t give you legal advice, that’s what you pay your lawyers for, but what we can say is that company structures generally provide some level of legal protection, a barrier, between yourself and third parties. This can be important if you employ people, ever have supplier issues, dramas with clients, etc. Definitely something worth thinking about and speaking with your lawyer about.
WHAT’S NEXT?
If you’ve read the above and think that a company is the way to go for you, nice one! It’s now a good idea to compare the benefits you’ve identified with the associated costs to ensure it makes strategic sense for your business to make the switch. Some of these include:
Superannuation – whilst you may not have needed to make superannuation contributions for yourself as a sole trader you will need to make them for yourself as an employee of your new company so be sure to factor this in.
Setup and registrations – you can skip professional advice and DIY for under $600, or you can engage a professional to handle everything for you including advice for which you can expect to pay $1,500+
Shareholders agreement – if you’ve got a business partner you should have a formal agreement. Expect to pay $1,500+
Annual ASIC fee – is currently around $300
Annual company tax work – this really varies and you get what you pay for, but expect it to start at $2,500.
Bookkeeping, payroll, BAS – you need to ensure your books are always up-to-date, payroll and superannuation obligations are looked after as well as the BAS being done on time each month/quarter. Prices vary a lot here and can depend on the size of your business, but expect to pay at least $300 a month for this service plus whatever costs are associated with your bookkeeping/payroll software (we recommend Xero and it starts at $32 a month)
If your sole trader business has any goodwill attached to it there may be Capital Gains Tax consequences of shifting the business from yourself personally into the company structure. There is generally relief available from having to pay tax here, but you should get advice to make sure there won’t be any tax bills associated with the move.
You’ll also want to be across the extra legal and compliance responsibilities that come with being a director of a company. We can’t advise on this but you might want to check out this page on the ASIC website for further guidance.
Setting up your own company to run your own business is a key strategic step for most successful businesses. What is key here is to ensure you’re doing it for the right reasons and at the right time for you.
Over the years we have setup companies and helped with ongoing tax compliance work for countless SME owners, so if you’d like some help in making the move yourself, let us know. We’d love to help.