Business basics: how do companies pay tax?

This article is part of The Conversation’s “Business Basics” series where we ask leading experts to discuss key concepts in business, economics and finance.

A company is a business that is established as a separate legal entity to its founders – like a person, it can be sued and incur debt. Importantly, not all businesses are companies – they can also be sole traders, partnerships or trusts.

But incorporating – becoming a company – isn’t cheap or easy, attracting a host of new fees and obligations^[1] for a business.

Yet, in Australia, companies remain the most common^[2] type of business. So why is becoming a company so popular, even for many small businesses?

You might think tax is the answer. The 25% corporate tax rate paid by small companies is much lower than the highest marginal tax rate for individuals of 45%.

If it were as simple as that, we might all go out and incorporate ourselves to pay less tax. But the picture is more complicated, and the trade-offs differ significantly between businesses.

So, how is a company taxed differently to an individual, sole trader or partnership? And if companies are “people” too – why is it any different from the rest of us?

Read more: Suddenly, there's talk about Labor reforming company tax. What did minister Ed Husic say, and what might actually work?^[3]

A business that’s also a “person”

In the eyes of the law, companies are treated as a separate legal entity (assuming directors have acted appropriately). This means that a company’s owners are not personally liable for the company’s debt, allowing them to take bolder business risks without fear of personal financial ruin.

This distinction flows to the tax system, where a company is treated as a separate taxpayer. But instead of marginal rates of tax that increase as taxable income increases (as with individuals), companies pay a flat rate of tax on all their taxable income.

Currently, the Australian company tax rate^[4] is either the default rate of 30%, or a reduced rate of 25% for companies with revenue less than A$50 million.

Companies calculate taxable income in much the same way as individuals do. Subtracting allowable deductions from assessable income over a year gives you a company’s taxable income.

They also make “pay-as-you-go” instalments of tax throughout the year (based on the previous year’s tax return), either monthly or quarterly. Typically, when a company lodges its tax return each year, most of its tax has already been paid.

In contrast, running a business as a “sole trader” means you and your business are effectively the same legal entity – your business’s income is your income.

The other structure options, partnerships and trusts, are also not separate legal entities. In these arrangements, parties have agreed to create legal relationships to conduct certain business activities together.

A partnership or trust must report its net income to the tax office, but it is the individual partners or beneficiaries of a trust who pay tax on their share of partnership or trust income. The main tax benefit of these models is the ability to split income between a number of partners or beneficiaries.

Do companies actually pay less tax?

Here’s a simple example comparing tax payable by a business operating as a sole trader, compared to the same business structured as a company.

Under 2024 rates, if you owned a small business as a sole trader and had a taxable income of $200,000, you would pay total tax as an individual of $64,667 (including the Medicare levy).

But if that same business was structured as a company, the tax payable by the company would be $50,000 (at the 25% reduced tax rate). Put simply, incorporation into a company structure would seem to save this small business $14,667 in tax every year.

But wait! It’s not that simple. We need to talk about what happens after the company has paid tax.

These earnings are sitting in the company’s bank account, and belong to the company – a separate legal entity. But the individual who owns it needs the ability to spend money on personal items, eat and go on holidays.

Eventually, money needs to flow to a company’s owners. This could take the form of salaries paid to directors or shareholders as employees or dividends distributed between the owners. This is then assessed as part of their personal income.

But we avoid taxing twice

In Australia, we have an “imputation” system for company taxation.

Profits of a company paid to a shareholder as dividends are the taxable income of the shareholder. But the company has already paid the relevant rate of company tax on these profits.

To avoid taxing the same income twice, those dividends come with an attached “franking” credit for any tax already paid by the company on that income.

Read more: Words that matter. What’s a franking credit? What’s dividend imputation? And what's 'retiree tax'?^[7]

Using our above example, let’s assume our small business owner has now incorporated a company and decided to pay themselves the entire remaining after-tax profit of their company as a dividend.

Here’s the calculation:

After all is said and done, the business has the same total tax bill as before: $64,667!

This illustration certainly oversimplifies the picture. There are many potential alternatives to the above example, such as paying a smaller fixed amount as a salary instead of the dividend or splitting income across multiple shareholders.

Companies also don’t need to pay out all their profit as dividends every year – the flow of income to individuals can be deferred.

The issues with corporate tax avoidance across the world are well reported. However, these types of tax avoidance are typically achieved by deliberately abusing various loopholes in the law, not through the company structure itself.

Though it’s sometimes argued, the reality is that tax savings should not be (and generally aren’t) the primary motivation for using a company structure. Other advantages, such as limiting business and personal risk, ease of growth, expansion and continuity are bigger factors in choosing a business structure.

References

1. ^{^} fees and obligations (business.gov.au)
2. ^{^} most common (www.abs.gov.au)
3. ^{^} Suddenly, there's talk about Labor reforming company tax. What did minister Ed Husic say, and what might actually work? (theconversation.com)
4. ^{^} company tax rate (www.ato.gov.au)
5. ^{^} RomanR/Shutterstock (www.shutterstock.com)
6. ^{^} James Kovin/Unsplash (unsplash.com)
7. ^{^} Words that matter. What’s a franking credit? What’s dividend imputation? And what's 'retiree tax'? (theconversation.com)