What's the best structure? Episode 1 - Tax planning

Generally, a company or a trust is the best for tax planning. Here's why.

Tax Snap available from Resources tab.

Next episode: Episode 2 - Asset protection.

Date published: 1 September 2021

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TRANSCRIPT

Introduction

In practice for a small business, there are really four entity structures that you can use.

There are sole traders, yeah, partnerships. Yup. Companies and trusts. Yep. And, and they're the four structures that you're going to be looking at. Various pros and cons, various pros and cons. We will run through some of now.

What we've done is we've chosen the main factors that people generally will consider when changing entity structure or starting in business. So these are the types of things that you want to be considering. And these are the things that are going to tell you what structure is best for you. 

Tax planning 00:24

So let's start with tax planning, tax planning. Basically each entity structure differs in the way that you eventually paid tax on the income that you've earned. It does. It does. Some of them are better and worse, but generally it's all about flexibility. Yeah, that's right. 

Sole trader 00:50

So really basically a sole trader has income and expenses. You earn profit, you pay tax on that profit. There's no way around that. That's just how it is. Whatever the business makes in profit, adds to your income and you paid tax at your marginal tax rates. So if you make $20,000 of profit and you earn no other income during the year, you're not gonna pay any tax.

If you earn $200,000 profit, then you're gonna pay a lot of tax. That's right. So there's no pushing it back to later years. Yeah. There's no capping it at a lower tax rate. Yep. There's no retaining of earnings to use in reinvesting in your business. Generally there's no splitting of the income either. So, perhaps if you have a family member or spouse doing work for you, like your wife, you might be able to pay them a reasonable wage, but you're not going to be able to pay them $100,000 to do a little bit of admin work. Correct. The ATO is not going to be happy with that. That's right. 

Partnership 1:43

So so similarly very similar to that is a partnership. The only difference between a partnership and a sole trader is there's two or more of you, but the way you pay taxes exactly the same. So you have a predetermined split based on a partnership agreement, 50/50, 70/30. Whatever it is. Might be a bunch of you, but essentially the business makes a profit. You received the profit as your, whatever your percentage is, and you pay tax at that at your marginal rate. 

So in our previous example, if you had a business that had $20,000 of profit, and it was a 50 50 split, you'd pay tax on $10,000, which in this case would be nothing. If you earned $200,000 profit, your 50 50 split would be a hundred thousand dollars and you pay tax on a hundred thousand dollars.

Do need to be active though, correct. Investing a substantial amount into the partnership. Correct. So you can't just set up a 90, 10 split if you want 90% of the income to go to your grandma who might have no income. Yeah. Correct. That's right. Yeah. So they need to be active partners in this business. 

So yeah, it's setting up a business with you and you and your space, it's fine, as long as you're actually both working in that business. So that is a big tax saving. If you're in a situation where you don't want the complexity of business, you're both going to be working on it. You might not be earning any other income, automatically there, you can split the income between the two of you.

Yep. Yep. Well, you know, if you're both active in the business, you think you probably would be anyway, because exactly you'd just be paying your wages to one person or yeah. Taking, taking that split each. So yeah. What we've got next is the company that's right. 

Company 3:14

So in the company, in this instance it is a separate legal entity to you.

So it's its own, the best way to think about it. It's actually another person. By, by lodging, an ASIC form,.you birth the company. Yeah. It pays tax on its own right. Yep. at its own tax rate. So one thing that's beneficial about the company is that its tax rate is lower than the highest marginal tax rate for individuals. That's right. So especially, so if you're a small business, the company tax rate comes down even more. So traditionally it's been 30%. If you're a small business base rate entity that it's 27.5%. Yeah. So a lot of people think, well, of course, I'm going to be paying less tax in a company because it's tax at 27.5%. Whereas my highest marginal rate as an individual is 45%. 

Yeah, but that is kind of a fallacy. Yeah, it's a fallacy. And the reason being is because as an individual, it's a progressive tax rate. So it starts nothing up until $20,000. Then it goes to 19% and then it keeps going up, you know, 32.5%, whatever it is, 37%, 45%, whatever the, whatever the amounts are, it starts getting bigger the more you earn. 

So up until. $40,000 now you're actually paying much less tax as an individual, as you would as a company. Yes. Every dollar above that point. However, it starts to be per dollar you pay less in the company. So in an instance where let's, let's go back to our $200,000 example.

Yes. You might want to earn a wage that you need to live on of let's say $70,000. So you pay yourself a wage of $70,000. You're going to pay much less tax on that $$70,000, but you know, you're going to start, end up paying more per dollar back at $45, 000. Yeah. So it makes more sense to pay yourself a wage and then retain those earnings in the company. And for every dollar above that pay less tax. So you could live on family $40,000, you could, you could do it much better, but I was just picking a number that more realistic.

Correct? Yeah. So what this is is flexibility, and this is what you don't have in sole traders and partnerships. So what Dan is talking about there is if you don't need the cash, then you could pay less tax as a whole group, you individually, and the company by paying yourself a wage up to a point where the tax rate is lower than a company, and then paying the rest of it at the next lowest available tax rate, which is in the company. 

And then companies are also really good because you can do some planning with dividends and franking credits tax. Tax that's paid by a company isn't just lost. It's actually still, even labor tried to change it, but liberal got voted cause like we tried to change it too much, but yeah, they you can still get refunds from franking credits attached to dividends. Yeah. So so essentially that is also a really handy tool when it comes to flexibility of tax planning. So a company just gives you that much more ability to plan where your income is going to sit and what tax rates are going to pay then compared to a sole trader and a partnership.

And you know, eventually if you are paying yourself a dividend, you are paying the same marginal tax rates on that income. But the difference is in those years, you might be able to reduce your wage and just pay dividends. Or your business might be winding up and you just paying out dividends for a few years instead of earning a wage, well then what you've effectively done is. Yeah, saved a lot of tax. It's about timing. It's about timing, timing. As we're seeing now the tax rates are coming down for individuals. So the longer you can be paying tax as a company right now, the less tax you're going to pay as an individual in the future.

Yeah. Now it's between $40,000 and $45,000 and $120,000, a company pays tax from that $45,000 point onwards. Yeah. So you could probably survive if there's two of you, husband and wife working, earning $45,000 from a company, you probably could survive on that almost. Yeah. You're going to be paying very minimal tax. So that's a good one. 

Trust 6:57

So the next one up is a trust and now there's different types of trusts. Very quickly there's a discretionary trust, which means that the way a profit is distribution is up to the discretion of the trustee. Which means basically towards the end of the financial year, you make a declaration of who is going to get the profit. 

Or a unit trust, which is more like a company. You have a fixed ownership in a business. And the profit is distributed at that fixed percentage, similar to a partnership. So let's just assume that the unit trust acts the same way as the partnership in terms of tax savings. Disregard that one. 

However, the discretionary trust in this tax planning way is very flexible. It's the most flexible. It is. It is, it legally allows you to split income to people who aren't participating in your business. So you could send income to whoever you like, as long as they're willing to receive it. And include it in their tax return. Yeah. And it's, and it's, it is limited to specific people. There's certain tiers or family members who are allowed to, so you can't tell them. They have to be a named beneficiary or within like two or three tiers of relatives. You can name specific people. Yeah. You can name specific people. So yeah. This is the thing with discretionary trust. The flexibility sometimes is a hindrance.

Yeah. But the thing that you lose a little bit of flexibility on compared to a company is a trust pay tax on the profit in the trust. So essentially a company, you can choose where you're going to pay the tax. If it's going to be as an individual or as a company. Under a trust you actually have to distribute the income from the trust to beneficiaries. Yeah. So there's no retaining of profits to pay a lower tax rate. That's right. Yeah. So the trust doesn't pay tax in its own right. And if it does, it pays it at the highest marginal rate. Not like the company that pays it at 27.5% or 30%. Yeah. It'll pay it at 45%. So you have to get it out to individuals, which means that if you are earning high income from day dot in your business, potentially a company could be better. It could give you more flexibility to push tax back. Yeah. 

And we'll go into the specific circumstances of why a trust might be beneficial for you, but it also depends on like yeah if you're, you know, separate people, not related going into a business together that can end up being a problem. If you're trying to retain amounts, there's all sorts of things that go into a, but we'll get there in a second, but tax planning, it's the most flexible, but you lose some flexibility with retaining profits.

Conclusion 9:20

Yup. There is more complicated structures you can set up. But we won't go into those, but essentially yet for tax planning purposes, the most flexible in terms of where it goes, but yeah, you can't pay it at the lower tax rate. That's right. So we've got clear standouts for tax planning purposes at the company and the discretionary trust.