17 Jan 2012 | Small Business
When people seek professional advice on how to best own and operate a business they often end up with a company. This choice of business entity, although providing some protection for the owner’s personal assets in the event of the business being sued, does come at a major capital gains cost.
For income tax and legal purposes a company is treated as an entity and pays tax on profits at the 30 per cent company tax rate. For other business structures, such as a partnership, unit trust, or discretionary family trust, it is the partners, unit holders, or beneficiaries that pay tax on profits made. This can result in tax being paid at the top marginal tax rate of 46.5 per cent.
This is why business owners often choose to own and operate a business through a company in the mistaken belief they receive a major tax benefit. The reality is, although profits earned by a company are taxed at 30 per cent, when shareholders want to use those profits tax is paid at their applicable marginal tax right. This means companies only delay paying tax.
The limited liability benefits of operating through a company are available where a unit trust or discretionary family trust is used by having a company act as trustee. This leaves the only benefit of using a company is the delaying of paying tax.
Because of the way capital gains tax is calculated this benefit is far outweighed by the capital gains tax cost when a business is sold. This is because a company doesn’t benefit from the 50 per cent general discount, and the benefits of the small business capital gains tax active asset discount are not received.
When the capital gains tax regime was first introduced tax was only paid on the profit after taking into account the effect of inflation. The catch was the CPI discount only applied to capital gains made by individuals but not companies. When the CPI discount was replaced with the 50 per cent general discount companies were again excluded.
Because companies are treated as an entity for income tax purposes, and shareholders pay tax on profits distributed to them by a company, the 50 per cent small business active assets discount is not received by the shareholders. This is because once the 50 per cent active asset discount is distributed to shareholders they will pay tax on all of it.
For example if a company made a $100,000 profit on selling the goodwill of a business, and the small business active asset discount was claimed, the company would pay tax at 30 per cent on $50,000. In addition the shareholders pay tax on the $50,000 they receive at their applicable marginal tax rate.
If that same business had been owned and operated by a discretionary family trust the 50 per cent general discount would have applied, and after claiming the 50 per cent active asset discount, the beneficiaries of the trust only pay tax on $25,000.