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When should you move from being a sole trader to a company?

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Broadly speaking, a company tends to be the best structure for a business to operate within, but it’s important that the switch from sole trader to company is made at the right time and for the right reasons. Here are some of the common reasons for making the switch.

1. Tax purposes

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 28.5% (previously 30%) and a sole trader pays the standard individual marginal tax rates, which can go as high as 49%.

Where this line of thought falls over is 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 considered Personal Services Income (i.e. reward for your labour), in which 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, it’s likely you won’t be affected by this rule and you can retain excess profits in the company to be used for working capital and have it taxed at the company rate.

If this is the case for you then you’ll likely be interested to know that:

The magic number is currently around $117,000

The magic number is the amount of taxable income you can earn before you are paying more than an average rate of tax of 28.5%, 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 more than $117,000 as a sole trader before they consider a company structure.

What other tax benefits are there?

  • Travel allowances. A company can pay its employees tax-free travel allowances whereas a sole trader cannot pay allowances to themselves.
  • Research and development tax offset. Companies undertaking qualified R&D activity can receive a tax offset to help fund the activities. This is only available to companies and it’s not the only grant/offset to restrict access to companies only.
  • Selling your business. Sole traders who sell their business will be liable for the resulting tax completely, whereas if it’s a company structure you can enjoy some flexibility. Under a company structure it’s ultimately the shareholders paying the tax and, with some clever planning, this can be well managed.

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2. Commercial reasons

If you have big growth plans for your small business 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 customers 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 potential clients that you are a company and that it isn’t just little ‘ol you –  a company implies a certain scale and level of seriousness that a sole trader operated business simply can’t match.

In addition, having a large business can be inherently risky and for that reason alone it’s wise to operate out of a separate legal entity (i.e. not yourself), which leads into …

3. Legal reasons

Broadly speaking a company structure will 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.

Making the transition

If you think that a company is the best structure for your business you should compare the benefits you’ve identified with the associated costs. Some of these include:

  • Setup and registration
  • Shareholders agreements
  • Superannuation on your wages
  • Annual ASIC fee
  • Company tax work
  • Bookkeeping, payroll, BAS, etc.

If your sole trader business has any goodwill attached to it there may be capital gains tax consequences from 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. You might want to check out 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. Make sure you’re doing it for the right reasons and at the right time for you.

Written by Ben Fletcher, managing director at Generate. A version of this article was originally posted on their Better Business blog.

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