Companies are a common way for businesses to operate. Companies are separate legal persons, and in Australia companies are registered by the Australian Securities and Investments Commission (ASIC). There are a number of advantages, and some disadvantages, to operating a business via a company. These are discussed below.
Who is Who in a Company
There are two main people, or groups of people, involved in a company. These people are directors and shareholders.
ASIC describes a company director as “… a person who is responsible for managing the company’s business activities.” All companies require at least one director who is resident in Australia.
A director must be a natural person (that is, a human).
A shareholder, or ‘member’ of a company, must be a legal person. This means that companies can own shares in other companies. The shareholders own the company.
Directors may be shareholders of the company. A company cannot own shares in itself, but there is some authority that some other entity can hold shares in a company on trust for that company.
Advantages of Using a Company
The main advantage of a company is that it is a separate legal person and enjoys limited legal liability.
This means that the liability of people involved in a company is limited. Shareholders’ liability is limited to any unpaid amount on shares owned by the shareholder. Directors are not liable for a company’s debts, although action can be taken against them if they have not exercised due care in managing the company, and especially if they have knowingly allowed a company to trade when it is insolvent.
The advantage here is obvious: the owner of a company is not personally liable for the debts of the company, provided that that person has not breached any director’s duties they may owe to the company.
This is in contrast to a sole trader, who is personally responsible for the debts of the business.
In some situations, directors may be asked to guarantee loans made to companies. If that is the case, the director does take on a liability – but they do so in their capacity as a guarantor, rather than merely because they are directors.
A company is able to borrow to finance its activities, in the same way that a sole trader can do. However, a company can also issue new ownership shares to buyers as a means of raising money. These shares will ‘dilute’ the ownership interests of the existing shareholders (although they may, of course, be issued to the existing shareholders).
Companies pay tax at a flat rate of either 28.5% (for small businesses with turnover less than $2 million) or 30%. Australia utilises a dividend imputation scheme such that company profits are not double taxed when they are paid out as dividends. Basically, the shareholder who receives a dividend out of taxed dividends receives a franking credit for the amount of tax that was paid on the dividend before it was paid. For example, if a company earned $100 in profit and paid $28.50 in tax, then the shareholder who receives the net (or franked) dividend of $71.50 will pay tax as if they received $100 – but will receive a credit for the $28.50 already paid. In this way, if the shareholder’s marginal tax rate is actually less than 28.5%, they will receive a refund from the tax office.
Unlike sole traders or trusts, companies do not have to pay dividends each year. Combined with the franking system, this allows them to ‘time’ the payment of dividends to a financial year in which the shareholders marginal tax rate are less than 28.5%. 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 $24,947. The ability to retain profits to be distributed as dividends in low-profit years reduced the overall tax liability.
It is relatively easy to transfer ownership of a company, simply by transferring the shares in the company to some other person. In small businesses, this typically occurs in conjunction with a change in directorship. For example, a family business might have mum and dad as both directors and shareholders. As the children turn 18, or at some later time, they may also be appointed as directors of the company and thereby start taking a role in its management. Mum and dad may or may not remain as directors also. The adult children can also either have additional shares issued to them or acquire shares from their parents.
It should be noted that, while this does not trigger a CGT event for the company, Mum and Dad as individual shareholders may experience a CGT event if and when they dispose of their shares.
Creation of an Employer
One of the key advantages of a company that is often overlooked is that the company creates an employer-employee relationship with the people working within the business. A director is deemed to be an employee of the company for most purposes. So, if a business is operated as a sole trader, the individual is not an employee. But if the business is operated as a company, the individual is an employee.
This allows, for example, a business to provide multiple company cars to its operator. It also makes superannuation contributions for the operator of the business somewhat simpler, and can make accessing things such as travel allowances when travelling on business easier to achieve as well.
Disadvantages of Using a Company
Companies do face additional costs that do not apply to sole traders. These include establishment costs and ongoing annual fees. Most of these costs are payable to ASIC as the corporate regulator.
That said, the additional costs of operating a business through a company are not especially high and certainly will not outweigh the advantages of doing so.
Companies do not obtain the 50% CGT exemption on assets owned for greater than 12 months.
In addition, any negative gearing or other form of tax loss that a company incurs is confined within the company and can only be of benefit if taxable income can legitimately be passed in to the company.
Lack of Flexibility
There can also be an element of inflexibility in using a company to run a business. It is difficult, for example, to exercise discretion as to who receives the profits of the business. Such discretion is often the best way to manage the tax liability of something such as a family business.
The Dover Way
This last disadvantage of a company (that is, the lack of flexibility) is a big one and gives rise to Dover’s typical recommendation for small businesses: that they be run under a trust structure with a company as the trustee such that all of the advantages of the company (with the exception of retaining profits) are available, as are the flexibility advantages of the trust arrangements (which typically obviate the need to retain profits). Most of the advantages of operating a business as a sole trader or via a company 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.
For further information about the pros and cons of operating a business as a company trader, please read this article by the folks at the Quinn Group.