Chapter 02 – Sole Trader

A ‘sole trader’ is a person operating their business without any legal entity such as a company or a trust. The business may be in the individual’s own name, or they may use a registered business name. But the individual does not use any form of business structure: they run the business themselves.

 As a result, a sole trader situation is often seen as the simplest. And it is true that there are times when a sole trader situation makes good sense. That said, there are also a number of disadvantages that may apply to sole traders. We will examine each of the advantages and the disadvantages in turn.

Advantages

The advantages of a sole trader situation include the following:

Ease and Speed of establishment

To run a business as a sole trader, a person typically needs nothing more than an ABN before they can commence operations. The business is not subject to the Corporations Act (although it is, of course, subject to all rules on fair trading, etc.).

In addition, sole traders do not have to pay to establish or run legal entities such as companies.

Control

A sole trader typically has sole control over his or her business. This is not the case, for example, if a business is operated by a company (either in its own right or as the trustee of a trust) with multiple directors, where the directors must agree on decisions regarding the business. (A business run by a company with a single director does not suffer this disadvantage).

Taxation

Sole trader situations can confer some tax advantages in particular situations. These include where the business is likely to make a loss. If a business is operated via a trust or some other form of legal structure, and the business makes a loss, the tax benefit of that loss may not be available. Businesses losses are typically ‘quarantined’ within legal structures such as family trusts. This means that the tax benefit of a loss can only be utilised by a trust if there is other income that can legitimately be passed through a trust.

Losses incurred as a sole trader can be offset against any other taxable income earned or received by that trader. If, for example, a business owner is a full-time employee who is also running their business on a part time basis, then any losses in the business can be offset against salary or wage income.

It is for this reason that it can make sense for a business owner with a high income earning spouse to run the business in the name of that spouse. For example, a client who is a medical doctor and whose husband is establishing a small business with a high chance of making a loss may choose to own the business in her own name, such that any losses can be offset against her medical income.

Disadvantages

The disadvantages of a sole trader situation include the following:

Unlimited Liability

The main disadvantage of the sole trader situation is that the business owner has unlimited liability for the conduct and debts of the business. For professional people, this can raise the prospect of there being a case for negligence or similar taken against the trader. (This can be somewhat mitigated by professional indemnity insurance).

The inability to limit liability in a sole trader situation can leave the sole trader’s assets at risk. For example, a sole trader may organise an unsecured loan to finance their business. If the trader defaults on this loan, then any other assets of the trader, such as his or her family home, may be at risk.

Limited capacity to transfer ownership

When a business is conducted as a sole trader, there is limited capacity to transfer some or all of the ownership of the business without triggering a CGT event. For example, if a business owner wishes to transfer her business to her sons, then the transfer will be seen as a disposal in her hands.

Were the same business being conducted via a family trust with a corporate trustee, for example, then the business owner would need simply to change the directorship of the trustee company to her sons. The company as trustee could exercise discretion to send profits to the sons with or without a change in directorship.

Limited ability to raise finance

In a similar way, the inability of a sole trader to issue units or shares in the business restricts the range of finance sources to lenders. A company, by contrast, may also use debt finance, but can also raise revenue by issuing shares to other people.

Taxation

Sole traders typically cannot retain profits to be paid out in future years. This is in contrast to a company, which will pay company tax at the rate of either 28.5% or 30% for larger entities. Once this tax is paid, the company can then retain the profit to be paid out as a dividend in some future year, when the shareholder or beneficiary has a lower personal income tax rate and can thereby make use of franking credits to reduce the effective rate of tax paid on the profit. Consider an example:

John uses a company, called John Pty Ltd, to run his business. He employs three staff and thus the business generates business income (as against personal services income). The business earns $100,000 profit in 2014/2015. The company pays tax of $28,500 on this income. John takes a dividend of $35,750 (franked, thereby accounting for $50,000 of the pre-tax profit) and leaves the remaining profit in the company.

With the franking credit, John’s taxable income is $50,000 and the tax payable is $7,797. He therefore receives a rebate from the ATO of $6,453 (being the actual tax paid of $14,250 minus the tax payable of $7,797). In this way, he receives an actual after-tax income of $42,203, being $50,000 minus the $7,797 tax liability. The $42,203 is received $35,750 from the company and $6,453 from the ATO.

In 2015/2016, the business does not make a profit. It breaks even. John pays himself a further dividend (out of retained profits) of $35,750. Once again, he receives a franking credit for $14,250, bringing his taxable income up to $50,000. The tax liability of this amount is again $7,797, so once again John receives a tax refund of $6,453.

In total, John has received $100,000 of taxable income. The company’s ability to retain profits allowed John to ‘spread this income’ over two years, reducing the overall tax liability to $15,594.

Had John not used a company, but instead operated the business as a sole trader, he would have paid tax on $100,000 income in 2014/2015. The tax on this income is $24,947. He would then have paid no tax in 2015/2016, meaning the overall tax paid on the $100,000 is higher because John could not retain profits to be distributed as dividends in low-profit years.

The Dover Way

Most of the advantages of operating a business as a sole trader can also be achieved when a business is operated via a trust. Because of this, our starting point for a financial planner selecting the appropriate practice structure is typically a practice trust, whether it is a PSI (personal services income – income that cannot be attributed to someone or something else for the purposes of income tax) practice trust or a traditional family trust. Such a structure combines the benefits of being a sole trader with the benefits of being a company, while allowing the practice to avoid almost all of the negatives associated with practicing either as a sole trader or as a company. Trusts provide ‘the best of both worlds’ with few of the negatives of either. 

You can read more about trusts in the following sections.

Further Information

For further information about the pros and cons of operating a business as a sole trader, please read this article by the folks at Findlaw. The Quinn Group also provide a good analysis of the advantages and disadvantages of operating as a sole trader.

The Dover Group