When embarking on a new business venture, the structure you choose to set up the enterprise is a crucial decision with numerous implications in terms of taxation, liability, administrative costs and the scope for future investors to support the business.
In Australia, businesses generally fall into one of four structures – sole trader, partnerships, proprietary limited companies and trusts. Each has advantages and disadvantages, and each may be more or less suitable for you depending on your personal circumstances and the nature of your business.
An important thing for any business owner to keep in mind is that as much as possible, your personal assets (house, car, etc.) should be kept separate from any assets owned by the business, reducing your overall risk.
The pros and cons of each business structure
Sole trader: This is the structure most favoured by – as the name suggests – people working for themselves in a one-person operation. When the business is of that size this structure is preferred because it’s nimble – set-up costs are minimal, ongoing administrative costs can be kept low, you have complete control over all aspects of the business, and you can change your structure quite easily if expanding or closing the business. Additionally, any losses incurred by your business can be offset against other income earned.
Those are the good points. The challenge inherent in being a sole trader is that your business is not a fully separate legal entity from yourself. This means that you are personally liable for debts incurred by the business, any potential legal action by clients or employees, and tax liabilities. In other words, creditors and claimants could potentially have a claim on your personal assets. In addition, because of these risks, it can be harder for a sole trader to secure finance from lenders to grow the business, plus there are ‘after-thought’ issues like managing your own superannuation.
Partnerships: Two to 20 people can join together to run a business in a partnership arrangement (although larger numbers are allowed for professional partnerships such as legal practitioners and accountants’ firms), sharing decision-making on financial and operational matters to share the workload and the risk.
Partnerships require less paperwork to set up although a partnership agreement should be negotiated and put in place between the partners at the outset, with fewer ongoing administrative costs and fewer reporting requirements than company structures. They also make you a more attractive lending proposition because unlike being a sole trader, you are sharing risk with others.
Like being a sole trader, however, the downside of partnerships is that you remain personally liable for your business debts and any litigation against the venture, as do your business partners. You are also potentially liable for any debts incurred by your partners. This last risk can be mitigated by taking out insurance, but it’s strongly advised you seek legal and financial advice on this risk before entering any business partnership. This structure is also not particularly tax-effective, as each partner lodges an annual tax return and pays personal income tax based on their share of the earnings from the partnership.
Company: Setting up a company significantly reduces your risk in running a business because it’s recognised as a legal entity separate from yourself. In effect this means your personal assets and finances are held separately from the assets and affairs of the business – for example, the company will have a separate bank account.
By incorporating as a company, you become a shareholder in the business either by yourself or with multiple others. If there are other shareholders in the company, they will generally also have a vote on any major business decisions. The operations of your company are conducted by directors, who also have certain duties and responsibilities. The voting rights and how your business is managed will be set out in your company constitution and a company shareholder agreement. The rules to be followed in setting up a company are set out in the Australian Corporations Act. It is imperative that if you adopt this structure, you have a shareholders agreement from the outset.
Additional advantages of a company structure include the flexibility to distribute profits to shareholders, tax credits for tax already paid by the company, and greater convenience if it comes time to later sell the company.
The main downside of the company structure is the cost involved. Formation costs and ongoing costs are more considerable, be it accounting costs for tax compliance, registration with ASIC and other bodies, plus other annual reporting costs. It’s altogether more complex. However, if you are looking to protect your personal assets, provided that you manage the giving of personal risks, it is a very useful vehicle to use to carry on business.
Trusts: The trust structure is favoured because it protects personal assets and limits liability from the business, and can also have advantageous tax implications. At its most basic, a trust is an arrangement whereby a trustee acts in an overseer capacity to manage your business assets as manager and distributor of profits, among other things. The trustee can be either an individual or a company and is responsible for any debts and liabilities. Formation of trust requires a formal trust deed detailing how it will operate.
Trusts typically do not pay tax, provided they distribute all the profits annually to beneficiaries, who then pay tax individually. This offers the business some flexibility in terms of its tax burden as the advantage can be taking of different tax-free thresholds and personal tax rates of each beneficiary (though the ATO are also much more aware of this tactic these days!).
Trusts do involve quite a bit more administration and cost to set up the Deed of Trust, with a higher level of compliance and ongoing costs. Most Trustees will also incorporate as a proprietary limited company, adding to the overall costs.
The above points are only a summary of the pros and cons involved in business structures. Consulting experienced legal and accounting professionals to discuss the best way forward for your enterprise is strongly advised if you’re starting the journey to business ownership. It is important that you discuss the best structure to adopt at the outset as changing structures will often result in stamp duty and capital gains tax ramifications which can be avoided by adopting the best structure from the start.
Even if you already run a business and wish to change its structure, it’s best to be aware of how doing so can change your liabilities, tax burden, responsibilities and asset protection before you make major changes as well as any costs involved in making these changes and whether any of them can be mitigated by rollover relief provisions and corporate restructuring concessions or exemptions that may apply. Consult a specialist today.