- Why would you consider using a company structure rather than being a sole trader?
- When might working as a sole trader work for you?
- 1. Sole Traders carry unlimited personal liability.
- 2. Sole Traders can face high personal tax rates
- 3. Sole Traders can be seen as a liability to work with
- Why are some companies cautious of contracting a sole trader?
- Are you an Independent Contractor or really just a De Facto Employee?
- When do the PSI rules apply?
- A practical example
- What to do if you are still a Sole Trader?
Perhaps the biggest decision at the beginning of your business journey is deciding which business structure you'll choose to trade under; sole trader or a company structure?
There are a number of different structures available, but for most 'Tradies' and start up service businesses, the choice will be between operating as a sole trader or establishing a company.
- Working as a sole trader is the simplest form of business structure and is relatively easy and inexpensive to set up.
- Working through a company structure is more expensive and has additional layers of complexity and advantages.
And if you're making this choice based simply on cost alone and choosing the sole trader path, the question you need to answer is ‘What could possibly go wrong?’
Why would you consider using a company structure rather than being a sole trader?
- When you cause damage or injury as a result of your business activities, you're liable for all costs that the other party suffers as a result.
- Using the analogy of a fire door, a company structure separates you and your family from many of the business risks you'll face and unlimited personal liability.
When might working as a sole trader work for you?
It's hard to imaging a modern business today that safely trades under the sole trader path, but here goes...
If you're in a business that probably will never get sued, if you don't drive a vehicle, don't provide expert opinion, and if you don't create, repair or deliver a product, don't build something, install something (or help someone who does) that could possibly someday fail or hurt somebody, if you would never have a customer who later turned out to be desperate, demanding or litigious (or at worst a predator), or if you never go onto a person's private property, you don't go onto public property or have a business partner or apprentice who does - maybe, just maybe a sole trader structure could be right for you, … sometimes.
For the rest of us, conducting business as a sole trader today is an unacceptable business risk that you need to understand and take action to avoid.
Here are three high-stakes reasons to get some better business advice.
1. Sole Traders carry unlimited personal liability.
A sole trader is responsible for all the liabilities of their business.
- As a sole trader you have unlimited personal liability.
This means if you are sued your personal liability is unlimited and puts at risk all your personal assets, including any assets jointly-owned with another person, such as a house.
This is because a sole trader and their business are seen as one-and-the-same entity; there is no separation between the two and because of this there is no separation between personal responsibility and personal liability.
- Unlimited liability is an enormous risk to you and your family.
How to spot a sole trader?
The easiest way to tell the difference between a sole trader and a company structure is by their trading name.
A sole trader’s legal name will typically look like this:
- John Smith trading as John Smith's Electrical Services
Whilst a company's legal name will typically look like this:
John’s Electrical Services Pty. Ltd.
Unlimited liability puts you and your family at a significant and usually an unacceptable risk.
- Any debt the business incurs is your personal responsibility.
- All your personal assets are exposed to litigation as you are personally responsible for all your business interactions, losses, accidents or litigation.
- If you're unable to pay your creditors they may be able to sue you personally for unpaid liabilities, damages and penalties.
- Any employee or contractor who sues your business is suing you personally and your personal assets may be exposed and sold to pay damages
Simply put, when trading as a sole trader there is no fire door between you and your business risks; you and your family are personally exposed and you can loose your home.
Pro Tip: Many accountants will not take on sole trader Tradie clients because of the increased liability risks they face and the unacceptably high prospect of their losing their homes due to a business liability.
2. Sole Traders can face high personal tax rates
A sole trader is treated as an individual for tax purposes and their business activity is simply part of that personal tax return.
- Sole traders and their business are seen as a single entity which means you share a single TFN and ABN.
- A company on the other hand is seen as a separate entity with its own TFN and ABM.
As a sole trader, all profits go straight to you and once business profit is added you pay tax at marginal rates.
- Marginal tax rates start at 0% and increase to 49%.
- The top company tax rate is about 28%.
Add to this there is no ability to split income through a trust among other family members which could help reduce your tax bill.
3. Sole Traders can be seen as a liability to work with
An issue for a sole trader to consider is how your customers and suppliers see you, as they search around for stable suppliers of business services.
Businesses want to work with businesses that have a solid reputation and history.
The harsh reality is some businesses (often medium to larger) rely upon supply chain stability and will require any prospective supplier to first provide a capacity statement and may simply not have confidence in a sole traders’ ability to consistency deliver the outcome or safely manage the normal risks of business.
Having a company structure in place helps formalise your business arrangements and provides a more stable and established look for your clients.
Pro Tip: Many people face the reality that a Pty. Ltd. abbreviation after their business name can be the difference between them securing the deal or not.
Why are some companies cautious of contracting a sole trader?
If you’re selling your specific skill set, knowledge and your time (as opposed to a physical product), then depending on your circumstances, you may be earning PSI.
- Personal services income (PSI) is defined by the Australian Taxation Office (ATO) as income that's mainly a reward for your personal efforts or skills (not selling physical products).
If you have received PSI you then need to work out if the PSI rules apply to that income.
Are you an Independent Contractor or really just a De Facto Employee?
This is an important distinction to understand because it can also affect whether you’re classified as a defacto employee of a business customer, even if you think you are an independent contractor, because you earn more than 80% of your income from one source.
When do the PSI rules apply?
The PSI rules apply when 50% of the income you receive for a contract was for your labour, skills or expertise.
If more than half the income received for a contract was for your labour, skills or expertise, then all income from that contract is classified as PSI.
A practical example
If you're working for company A as a sole trader, company A may choose to restrict the amount of work you do for them because they don't want you to be seen by the ATO as their de facto employee.
- This could result in them having additional risks and additional potential costs - such as paying you superannuation, issues around workers compensations and additional ATO reporting responsibilities - and a whole lotta extra mess.
Learn more about PSI here.
You see how a business customer might feel its just easier to work with someone using a company structure?
What to do if you are still a Sole Trader?
Make a note to ask your accountant to explain the high-stakes risks you face as as a Sole Trader.
- How you structure your business is more than just the way your name appears in print.
- It's also a public statement about how you see your business.
In a competitive world of business and an increasingly litigious society there are many business risks that need to be managed and keeping you and your family safe from them is one of the most important things you can do.
If you're a sole trader today, make sure you (and your partner) clearly understand the reason behind that choice and the unlimited liability risks you are personally liable for.