The best legal structure for your business
Before you start your business you’ll need to consider which legal structure will be right for you. In this article we will take a look at the different options that are available in Australia. This is not legal advice, of course, and you may want to consult your legal advisor before making any decisions.
When you decide on the legal structure for you it’s important that you understand the implications of that decision, particularly the impact that decision will make on your personal liability and your tax liability.
The most common business legal structures in Australia are:
- Sole Trader/Sole Proprietor
- Companies; and
If you’re a sole trader then basically you are the business. You get to keep all the profits from the business but you also bear full responsibility for any debts or legal liabilities of the business. If you are a sole trader then you may operate your business under your own name or you may register a business name. Most people start out as a sole trader because it is the cheapest and simplest structure to establish.
Here are the main advantages of setting up as a sole trader:
- it’s quick and easy to set up
- it’s cheap to set up
- there’s less regulation and paperwork
- you have direct control and authority over your business
- it’s easier to close down your business
- you get to keep all the profits, and
- you don’t need to complete a separate tax return for the business
The disadvantages of setting up as a sole trader are:
- you’re personally liable for all the debts generated by the business. This means that you may have to sell your personal assets, such as your house, if your business goes into significant debt. This also means that if someone sues your business and you’re ordered to pay damages then you will need to pay that money out of your personal finances.
- the owner is also personally responsible for any wrong-doing of the business, even if the wrongdoing was committed by an employee.
- the business income is included in your personal tax return which means that you may pay higher tax rates if your business is making a good profit or if you have other income. Personal income tax rates are higher than the flat rate of company tax.
- You are responsible for all business decisions
- if can be more difficult to raise funding or to get investors for the business
- the business relies 100% on you which can be problematic if you get injured or sick
Partnership businesses are governed by legislation and it is recommended that a partnership be set out formally in a written partnership agreement.
Partnerships are usually formed between 2 or more people who have a long-term trusting relationship, such as family members. This is because the members of a partnership are each liable for the obligations and debts of the business. This means that if one partner makes a bad business decision and puts the business in debt then both partners are equally responsible for those obligations and debts. If partnerships go wrong, things can get very messy.
Here are the main advantages of setting up as a partnership:
- it’s easy and cheap to operate
- the business benefits from the expertise of all the partners
- when you have partners you have more people who can invest time and money into the business
- the partners can share the management and decision-making responsibilities
- there’s limited regulation
- the partnership shares can’t be transferred to other people without the agreement of the other partners, and
- A partnership can split the income of the business between the partners. So if a husband and wife start a partnership business together then the income from the business can be split evenly, even if only one of them is doing most of the work. This can have the advantage of having each of the partners in a lower tax bracket and paying less tax rather than having only one of the partners in the higher tax bracket paying more tax.
Disadvantages of setting up your business as a partnership are:
- all partners are individually and jointly liable for all the debts and obligations that have been established by any of the partners
- for most types of partnerships there is a limit of 20 partners
- It is difficult to transfer your share in a partnership
- business decisions will need to take into account the interests of all of the partners and this can lead to disagreements; and
- a partnership is a relationship between a set group of people so if anything happens to one of those people then that can result in the original partnership dissolving which can have tax consequences.
A company is formed when ownership of the business is divided into shares and the shares are split amongst a group of individuals or businesses. A company can be a Public Company which can issue shares to the public or a proprietary company which cannot. A company is a separate legal identity to the shareholders of the company. Because the company is a legal entity in itself that means that the company can be bound by legal obligations, it can own property and it can be sued.
To set up a company you must comply with many legal and administrative requirements. As a result it is usually necessary to have a professional do this for you and it means that setting up and running a company is much more expensive.
The advantages of setting up a company are as follows:
- shareholders have limited liability which is capped at the amount of money they invested. This means that you can protect your other personal income and assets, such as your family home, if the business went into debt.
- the directors of the company are elected by the shareholders
- a company is a separate legal entity which can mean it is easier to sell
- it can be easier to attract investors
- shareholders may also be employees of the company
- the company taxation rate is a flat rate which is lower than the higher personal income tax rates
- it is easy for a company to grow and to introduce new owners by the issuing of more shares; and
- the company continues to exist and operate even after the death of any of the shareholders
The disadvantages of setting up a company are:
- There is a lot of government regulation
- companies are complex entities and you’ll require the advice of a professional
- it is an expensive structure to set up and operate
- the company submits separate tax returns
- there are special requirements for record keeping and reporting; and
- Directors of the company have additional responsibilities and in some cases the directors can be personally liable for the debts of the company
A trust is a entity which holds assets in trust for nominated beneficiaries. A trust may be set up to make it easy to distribute the income of the business to a number of people, which may have tax advantages or it may be set up to protect personal assets from possible legal liabilities. Trusts are complex structures and you’ll need to seek professional advice before setting one up.
The Trust Deed is the legal document which formally establishes the trust and determines the rules by which the trust must operate. The Trustee (which may be a company or an individual) must administer the trust in accordance with the trust deed.
The advantages of setting up a trust for your business are:
- liability is limited
- it can be effective for reducing tax
- it’s expensive to establish and operate
- it can be difficult to attract investors
- it is a complex arrangement; and
- it may be inflexible because it’s limited by the terms of the Trust Deed.
There are a number of other legal structures that are available when setting up your business but these are less common and you should seek professional advice before going down that path.
So there are clearly pros and cons for each business legal structure. When choosing the right one for you you should consider the following factors:
- The size of your business
- The number of people who will be employed by your business
- How much tax you’ll need to pay
- the financial situation of the business
- how much ownership and control you want
- and the costs of getting set up
Again, I’ll stress that this is an important decision and you really need to understand the consequences of the decision for you. Therefore, you may wish to seek individual advice from your legal advisor.