Small business tax – understanding the difference between sole trader vs company
Posted by Northadvisory on August 27, 2020
Should you be a sole trader or set up a company? Structuring your business effectively from the get-go could give you the best tax outcome and save you plenty of hassle come tax time. But a lot of new small business owners don’t always get it right. It’s important to understand the differences in tax obligations and reporting as a sole trader or as a company.
Before you dive head-first into setting up a new business, it’s worth considering what business structure works best for you: one that can deliver you real tax benefits at the end of the financial year.
Set up a tax effective business structure
Sole trader. Company. Trust. Partnership.
It’s important to know the responsibilities of each business structure, because it may affect the tax you are liable to pay, asset protection and costs. And picking the right option for your situation could help you reap in the benefits at tax time.
For most new small business owners, they will be looking at the sole trader vs company business structure.
A sole trader is an individual running a business. It’s the simplest and cheapest way to set up your business. They report their earnings from the business through their individual tax file number and are liable for any tax debt, based on the standard marginal tax rates.
On the other hand, a company is a separate legal entity. Company earnings are reported independently, and all income is subject to a single company tax rate.
But these distinct differences are just the start. There are plenty of other considerations to take into account before making the decision.
Structuring your business effectively for tax purposes will give you real peace of mind knowing you can maximise the advantages and minimise the stress.
Key differences in tax obligations and reporting
Sole traders and companies have similar tax and reporting obligations, with a few notable exceptions.
Being aware of these key differences can help you to make the most out of your personal situation. Here are some most important differences you should take into account:
A sole trader will be able to claim the tax-free threshold of $18,200 in the 2020-21 financial year. They will then start to pay tax as an individual. For a company there is no tax-free threshold. You will pay tax on every dollar the company earns.
Sole traders pay tax at the individual income rate. The marginal tax rate ranges from 19% through to 45%, whereas a small business entity pays 26% income tax as of 2021 on its taxable profit. Another thing to keep in mind is that if the income the company derives is from a personal service you the owner provide, all the profit derived from that personal service is taxable in the individual’s name and does not get the benefit of the reduced company tax rate.
Lodging tax returns
How you lodge your tax returns varies. For sole traders, you will do this with an individual tax return annually. As a company, you will need to lodge a company tax return annually. Within this, you will need to report on income, deductions and income tax the company is liable to pay.
Capital gains tax
The way capital gains tax is handled varies depending on the business structure.
For a sole trader, you may be able to reduce capital gains through the discount method, indexation method or through CGT concessions available for small business.
Generally, the discount method does not apply to companies when calculating capital gains. If your company meets the conditions of the indexation method for calculating your capital gain, you must use this method.
Small business entity concessions
As a small business you can claim specific tax concessions. Regardless of your business structure type, you can claim small business tax concessions as long as you meet the eligibility criteria.
For tax purposes, you are a small business entity if you operate a business for all or part of the income year and have less than $10 million aggregated turnover.
The concessions available include income tax concessions, goods and services tax (GST) and excise concessions, pay as you go (PAYG) instalments concessions and fringe benefits tax (FBT) concessions.
Taxes and superannuation
Your business activities determine which taxes and superannuation you may need to pay and report on.
You need to register for goods and services tax (GST) if you have an annual turnover of $75,000 or more ($150,000 for a non-profit body). You may also need to pay your income tax through pay as you go (PAYG) instalments.
If you have employees, you will also need to collect PAYG withholding amounts from payments you make to them, and give and report on the withheld amounts to the ATO. Plus, you will need to pay superannuation contributions for your eligible employees.
If your employees receive a fringe benefit, you may also need to pay fringe benefits tax.
Both sole traders and companies can employ people. If you do, you may have a payroll tax obligation. As an employer, you are required to pay tax on the wages of your employees. This tax is managed by the territory and state governments.
When to consider personal services income
You should consider claiming your income under personal services income (PSI) in the event that the income is from your skills or efforts as an individual and you earn more than 50% of the income from a contract for your skills, knowledge and efforts.
The PSI rules are designed to ensure that people who earn income from personal services where the arrangement is in substance an employment-type arrangement are taxed in the same way as an employee would be.
PSI rules can apply to almost any industry, trade or profession. However, there are common examples such as financial professionals, IT consultants, engineers and medical practitioners.
To help you understand whether PSI applies to you, find more information on the Australian Taxation Office’s website.
Talk with the small business specialists
Seek professional advice from a tax accountant to achieve a better tax outcome.
With all the latest up-to-date information on tax obligations and reporting, a tax professional can run through all the options, keeping in mind your personal situation. And they can recommend the best way to set up a tax effective business structure.
The team at North Advisory is here to explain the importance of business structure on your tax obligations and reporting requirements. If you’d like to find out more about how we can assist, please contact us today.