I love companies. Of all the structures available to businesses in Australia, companies are by far and away my favourite. Today I’m going to try and make you love them as much as I do.

So what is a company? To understand what a company or a “corporate form” is means understanding 2 key concepts.  Firstly that it is it’s own separate legal entity.  As it’s own separate legal entity it is given many of the rights ordinarily afforded to individuals.  It can enter contracts, take out loans, be sued, sue someone, own assets, pay taxes and so on. It can live forever without being closed down.  It is usually created by one or a group of individuals who exchange funds (usually cash) for an agreed ownership percentage in the company: a shareholding.  Shareholders are usually limited in terms of their liability to the extent of the amount they have invested, this is a concept known as limited liability and I will go into a little bit more detail about this in a minute.

The second concept really understand is how the corporate form as we understand it came into being.  This involves a brief history lesson.  A company, or a corporate form can trace it’s roots for centuries however, they really began to take hold in the shipping industry in the 1600’s as a way of managing both the money contributed by investors and the risk of shipping around the world. Probably one of the most famous companies cropping up in many a pirate movie is the East India Trading Company which relied on the corporate form to manage the risk of moving it’s ships and cargo around the world.

Fast forward several hundred years and the corporate form has become one of the most popular forms of structure for a business due in large part to the concept of limited liability. This concept too has been around for generations and has it’s roots in Italy again, as part of the merchant shipping fraternity. It came about as a result of an economic arrangement whereby a passive partner would provide the funding for a managing partner to sail a merchant vessel. At the completion of the voyage, the partners would divide the profit between themselves based on a pre-arranged agreement.  This allowed the passive partner to limit their liability to only what they put in while the managing partner assumed the risk of the voyage and cargo.  As time went on the number of people grew.

When it comes to the modern day this concept of limited liability is an integral part of how companies function.  Indeed, it is one of their key advantages.  Imagine you are a mining company or a company undertaking research into a new product, limited liability becomes attractive to investors as it allows them to quantify any potential loss they may have as a result of the failure of the corporate venture.  In most cases it protects their other assets so they can relax knowing they will never lose the family home. In-turn means they are likely to invest more into the venture.

In Australia companies are governed by the Australian Securities and Investment Commission, better known as “ASIC”.  ASIC administer and apply the Corporations Act which is for lack of a better analogy, the law which governs the way a company can behave.  Failure to adhere to the law can result in punishment, the worst being the forced closure of the company and it’s dissolution (there are penalties for the directors as well, but that’s beyond the scope of today). 

Now with us all understanding the 2 key concepts of what a company is we can have a look at their pros and cons.  For me personally, the two concepts of separate legal entity and limited liability are massive pros.  This is because mentally I find it easy to imagine the company as person and treat it as such.  It makes running my business easier as some of the more complex things I need to be understanding are made easier simply by thinking of it as a separate human being (albeit it one without physical form).  I find when explaining to clients that their business is not an extension of themselves, having them as a company makes it a lot easier.  Here in Australia when you set-up a company you are given a file with all the key documents in it needed for the company to run.  If you liken this to the brain of the company suddenly everything begins to fall into place and the documentation requirements begin to make sense as well. 

Limited liability is also a massive bonus because as a small business owner it means you can protect your personal assets such that your family is unlikely to be left homeless in the event your business venture doesn’t work out.  Although I should mention here there are a couple of actions which director shareholders can take which will render limited liability useless, but provided you don’t do these things, then everything should be fine.  The key one being the company taking out a loan and the director shareholder standing as guarantor.

This concept of limited liability is a massive bonus over other structures such as partnerships.  Many professional practices especially those in the medical, legal, accounting and veterinary spaces are set up as partnerships because of their profit-sharing abilities. However, in the event one partner acts inappropriately, all other partners are jointly and severally liable both in a professional and personal capacity to make good on the cleaning up the mess.  A company however provides a level of protection for the shareholders such that the liability remains within the company and is not expected to be cleaned up by the joint shareholders. 

Imagine this, you and a select group of doctors set up a partnership together.  Things run smoothly for several years and whilst you personally have a few gripes about not being able to manage your tax effectively because of the way the partnership distributes profits and you can’t own any assets in your own name, you are mostly happy.  Then something goes wrong and one of your partners is accused of doing something they shouldn’t have been doing.  Guilty or not, they are no longer able to be a part of the business and so you exit them from the partnership however, here’s the sting in the tail.  He’s not the only one who pays financially for the accused wrong-doing, you all have to.  And for you, this means selling your home and downsizing.  If the business had been structured as a company then the liability would have most likely been limited to him alone leaving the rest of you to carry on with your lives uninhibited.

Shareholders in companies don’t need to be individuals, they can be trusts, other companies, partnerships, super funds, pretty much any other business structure can own shares in a company.  From a wealth-management perspective, this can make them extremely attractive as it gives shareholders the ability to manage their income and wealth split.

Let’s go back to our doctors in practice together.  Once the partner has left they seek advice and start again as a company.  Because you haven’t been able to manage your wealth properly you set-up a trust and your trust owns your share of the company.  Each year when the dividends are paid, they are paid to your trust and from their, your trust can “decide” who receives what in terms of income.  As a busy career man, you have been the breadwinner in the household and your wife has earned significantly less than you.  The trust is able to weight the distribution in her favour so as to better control the amount of income distributed to beneficiaries and therefore the amount of tax you all pay.

So what are dividends?  Dividends are a distribution of the profit made by the company and are entirely optional that is, they don’t have to be paid every year if the company either does not have the cash surplus or it wants to use the money for other things.  They are paid to shareholders equally in respect of their shareholding so for example, you might have 100 shares owned by four different people (or entities) each holding 25%.  The profit would be split such that each entity would receive 25% of the amount to be paid.  Dividends can be either franked or unfranked that is have be paid with franking credits, depending on the business and how it has been performing.  A franking credit is the portion of tax that has already been paid on the profit which is being distributed. 

So this concept of paying franking credits is unique to Australia.  It is a recognition in the tax law of the fact that the profit has already been taxed once at the corporate level and to tax it again as a dividend received by the shareholder is in effect, taxing the same profit twice.  So the dividend is paid together with the tax already paid on it.  As a shareholder, both amounts have to be included in your tax return with any top-up tax being paid by you.

How much tax is paid by a company.  Well this is another area I love because it creates certainty.  At present in Australia if you are a company with a top-line turnover (that is gross income) of $10 million or less, you will pay 25% in tax.  If your company is either earning over $10 million or is a passive investment company (like a bucket company – a topic for another day), the tax rate is 30%.  Profits are tax once in the year in which they are derived.  If you elect not to pay a dividend, that profit is not taxed again in a later year because the tax is calculated on the actual profit of the business and not the cash balances.

The company as with every business pays salaries.  If you are a working owner of the business this affords us an opportunity to manage your cashflow quite effectively and lessen the need for those pesky quarterly PAYG instalments.  The company can pay you a salary.  The company then manages the tax needed to be paid on that salary just as it does for every other employee or indeed, if you were an employee yourself.  It will also pay your superannuation for you.  Because of this, your income becomes more regular meaning your household budget is easier to manage and maintain, but also, you don’t need to be finding the cash to pay quarterly instalments to the ATO because your company is managing it for you.  At the end of the year, you can always pay yourself a bonus or take a franked dividend to reward yourself for the blood sweat and tears you have shed over the course of the year.

This can be great as the business grows because it means you don’t have to draw the cash from the business (and pay high marginal tax rates), you can leave it in their to fund expansion and growth.  As a company grows it can remain privately held which as the wording suggests, means the company doesn’t have to report publicly what it earns, what it’s doing or adhere to a number of other requirements, or it can choose to list on the Australian Stock Exchange or “ASX”.  Generally speaking, companies choosing to list on the ASX do so because they are looking for a high-degree of investment in order to undertake some kind of activity.  But, and here’s the great thing about a company, a company choosing to list on the ASX doesn’t fundamentally have to change it’s core structure, it can grow from being a privately held company to a publicly held one relatively easily and without having to close it down and start again.

But there are some cons to having a company and one of the biggies is the inability to access any of the capital gains tax or “CGT” discounts.  So for individuals and trusts, the application of the CGT legislation is much the same with them both being able to access concessions such as the 50% discount.  Companies on the other hand are unable to do this and mush pay tax on the entire capital gain.  Whilst this is a negative against having a company it does open up opportunities in terms of structure and can force owners to think more in terms of risk mitigation than simply having all eggs in one basket.  For example, imagine you run a business as a company and you own the building you operate from.  Due to unforeseen circumstances the business fails and is forced to wind-up with creditors selling off all the companies assets in order to pay off it’s debts.  The building being an asset of the company is sold, used to pay debts and you as the shareholder walk away with nothing.  Had the building been owned separately by a trust for a example, the creditors would have been unable to force it’s sale leaving you as the owner with an asset to start again.

Whilst the ability to distribute dividends is fabulous, what can be particularly tiresome is the requirement to pay dividends equally to all shareholders of a particular class.  Going back to our example of 4 equal shareholders each owning 25%, this would mean they each have to receive the same dollar amount for each share that they hold.  As a professional services firm, you may have shareholders who have more experience and risk than others, liken this to equity partners versus salaried partners.  Having all shareholders as the same class of shareholder would mean “equity partners” would be receiving the same profit distribution as “salaried” ones.

All is not lost and there are ways around this.  Issuing a new class of shares to new shareholders or those to be considered as “salaried partners” is a way of ensuring that one dividend amount can be paid to one class, and another to the other class.  In time as the model changes, shareholdings can be exchanged to recognise the promotion of shareholders from the “salaried partner” stage to the “equity partner” stage.

And lastly, the reporting requirements for a company can be considered to be quite onerous.  Although it must be said, the reporting requirements for privately held companies is infinitely inferior to those required of their listed counterparts.  Annual reporting is required, together with all the usual annual compliance reporting requirements.  Minutes are required of meetings and to document any major decisions or changes to the entity.  Documentation is required to be maintained regarding shareholders and directors, and ASIC is required to be advised of any changes.  An annual general meeting is required where all key members of the business and shareholders meet to go through the performance of the company over the last year and discuss what is to happen going forwards.  A good accountant should make all of this as easy as possible for you.

I personally don’t consider the cons to be big enough issues to outweigh the positives which come with owning a company and running your business through a corporate structure.  Accountants like myself who love playing with business structures are able to make companies work so effectively you’ll wonder why you hadn’t switched to one earlier.  What do you think?

On that note, thankyou for watching, I will leave you with this video to watch next and I will catch you in the next one.

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