Choosing The Right Business Structure
Choosing the right business structure is one of the most important decisions you will make regarding your business.
Why? It will affect the decision-making & operating process of your business, how profits & losses are shared, your tax & reporting obligations, and asset protection & your potential personal liability.
For some just starting out in business, this essential consideration is often overlooked resulting in the blending of business interests & personal interests – a situation that may lead to personal assets being at risk.
Types of Business Structures
Before deciding which structure is right for your business, it is essential you understand the key differences between the various structures.
In Australia there are 4 commonly used small business structures:
- Sole Trader
- Partnership
- Company
- Trust
Each have their own characteristics & the advantages & disadvantages must be considered to see how they align with the size & type of your business, your future business goals, and your personal circumstances.
As with any critical business decision, we recommend you discuss your proposed structure with an experienced financial, legal or business adviser before proceeding to avoid potentially costly mistakes.
You need to consider not only the start-up costs of a particular structure, but the long-term costs of maintaining that structure.
The Business Structures in More Detail
Sole Trader:
This is the simplest form of business structure & is relatively easy & inexpensive to establish & involves minimal reporting requirements.
As an individual operating your business in this manner, you are the only owner & have complete control of the business.
You will pay tax at normal marginal income tax rates on all income earned by your business. If certain conditions are met, losses incurred by your business activities may be offset against other income.
On the downside, a sole trader is not a separate legal entity & you are personally responsible for the liabilities of the business. This liability is unlimited & personal assets (including your home) are at risk if something goes wrong in your business.
In addition, as all income generated is assessed to the individual there are few opportunities for tax planning – business profits or losses cannot be shared with other family members.
Whilst many small businesses in Australia (e.g. tradies, contractors, home-based businesses) are sole traders, the structure is not particularly effective or flexible.
Partnership:
What is a partnership? It is an association of two or more people carrying on a business with a view to making a profit.
In Australia partnerships are regulated on a State-by-State basis, though under section 115 of the Corporations Act 2001 (Cth), partnerships are generally limited to between 2 & 20 partners.
In Western Australia partnerships are governed by the Partnership Act 1895.
Similar to a sole trader structure, partnerships are relatively easy & cost effective to set up & have minimal reporting requirements.
A partnership doesn’t pay income tax on profits – each partner reports their share of partnership income or losses in their individual income tax return & pays tax on that share at normal marginal tax rates.
The most common type of partnership adopted by small business owners is a ‘general’ partnership. Under this model all partners share management & control of the business, along with income & losses.
Partnership Agreement
Whilst not mandatory, a written Partnership Agreement is a good idea. It should outline how the business will be controlled & managed, the extent of each partners’ financial contribution, & how income & losses are to be distributed amongst the partners.
Think of a Partnership Agreement as a ‘rule book’ that binds each partner & a mechanism for preventing disputes & conflict. Where no Partnership Agreement exists, the provisions of the relevant state Partnership Act will apply by default.
If no agreement is in place, all partners are deemed to own an equal share in each partnership asset & all income will be distributed equally amongst the partners.
A well drafted Partnership Agreement should also establish the procedure for modifying the partnership – admitting new partners, resigning/exiting partners or what happens if a partner dies.
In the absence of these procedures, a partnership can sometimes be difficult to dissolve, or reconstitute & a new partnership will have to be entered into.
What are some of the disadvantages of a Partnership? A partnership is not a separate legal entity & partners are personally liable for the debts incurred by the partnership.
In Western Australia, the Partnership Act 1895 imposes joint & several liability on all partners for any debts & obligations of the partnership. This means that a creditor may sue any one partner for repayment – you may be personally liable for your partners’ debts. Effectively there is no asset protection, as this liability is unlimited.
Similar to sole traders, tax planning opportunities are extremely limited as all partnership income (or losses) flows to the individual partner– partnership profits or losses cannot be shared with other family members.
Notwithstanding the significant risks associated with a partnership, it is a model adopted by many small businesses across Australia.
Company:
A company is a separate legal entity (as distinct from the shareholders) & can incur debt, sue others & be sued.
A company is owned by its shareholders & run by its directors. Companies are incorporated under & regulated by the Corporations Act 2001 (Cth).
Companies must abide by their Constitution or Replaceable Rules & if your company has more than one shareholder, it is advisable to have a Shareholders Agreement in place as well.
Individual shareholders can limit their personal liability for debts incurred by a company, making a company an attractive vehicle for more high-risk undertakings.
Companies are an accepted business structure so can make commercial dealings more straightforward.
If you’re looking to raise capital to fund your business, companies are well suited to this via the issuing of shares, in exchange for contributions of capital.
Changes in ownership can be effected relatively easily & companies provide some flexibility to structure earnings from the business in the most tax effective manner.
Company profits are taxed at a special corporate tax rate (currently 25% for base rate entities with a turnover threshold of $50m & 30% for all other companies) which may be more attractive than individual marginal tax rates.
Profits may be distributed to shareholders via payment of a dividend or retained in the company to fund expansion & growth. Losses are not distributed but remain within the company to be offset against future profits.
Costs & Complexities
At face value, a company business structure may appear attractive but there are some drawbacks to consider.
Forming a company is more complex & expensive than opting for a sole trader or partnership structure.
The ongoing costs of maintaining a company also need to be considered. Companies come with more complicated reporting requirements & as they are taxed separately, a company tax return needs to be prepared & filed annually with the ATO. Company tax law can be complex, so it is better to have an experienced accountant & tax agent undertake this task. This may amount to many $000’s depending on the complexity of your operations & your financial records.
In addition, an annual ASIC Review Fee needs to be paid by all companies (currently $276 for proprietary companies).
All company officers need to be mindful of their legal obligations as outlined in the Corporations Act 2001 (Cth).
Trusts:
Although traditionally used a wealth transfer or succession planning vehicle, private trusts have been very popular in Australia since the late 1970’s as a general business structure for carrying on a business or for investment purposes.
A trust is not a separate legal entity but is a legal relationship between persons or entities (the trustee) to hold property for the benefit of other persons or entities (the beneficiaries).
In a business sense, this means the trustee carries on the business on behalf of the beneficiaries.
The trustee is legally liable for all the debts of the trust & may be an individual or a corporate trustee (i.e. a company). The trustee may use the trust’s assets to discharge the liabilities however where there is a shortfall in those assets, the trustee is legally responsible for the shortfall.
In the case of an individual trustee, they would be personally liable in this situation. On the other hand, if a corporate trustee is used, its shareholders have limited liability.
Types of Trusts
A trust is established by a Trust Deed & there are two main types:
- Discretionary Trust (also commonly known as a Family Trust); or
- Unit Trust.
The key difference between the two is that in the case of a discretionary trust, the trustee normally has the discretion to determine which beneficiaries receive distributions & how much they will receive.
In a Unit Trust, defined shares called ‘units’ are issued to unitholders (similar to the issue of shares in a company) who are entitled to the trust capital & income in proportion to how many units they own.
One of the main reasons trusts have enjoyed increased popularity is their flexibility. This is particularly relevant in the case of discretionary trusts where the trustee can give different people rights to income & capital & this can vary from year to year.
This has been an important consideration in the tax planning context – family groups are able to maximise the use of tax-free thresholds & marginal tax rates of family members to limit.
A trust is generally not the most suitable option if you want profits to be left in the business to fund growth or expansion because if a trust doesn’t distribute its income to beneficiaries at year end, the trustee will be taxed at the top marginal tax rate.
Losses cannot be distributed to beneficiaries but are carried forward until such time as they can be offset by trust income.
Setting up a trust can be a complex & costly exercise & there are ongoing administrative costs as well. Depending on the type of trust used & how many parties are involved, a Unit Trust Agreement and/or a Shareholder Agreement may also be prudent.
Trusts must prepare & lodge a separate trust income tax return each year & the Trust Deed generally imposes obligations on the Trustee to maintain appropriate financial records, so there is an increased & ongoing administrative burden to be considered.
Considerations When Choosing the Right Business Structure
When you first embark on your business venture it is crucial you consider which structure will likely confer the best long-term benefits & reflect your future strategic goals & direction.
Whilst you are able to change your business structure along the way, indeed this may be necessary or unavoidable at some point, it can be very complex, costly & often attracts significant tax liabilities.
Each structure is different & has its advantages & disadvantages. Therefore we believe these points should be considered before making your decision:
- What type of business are you considering (e.g. industry sector & size)?
- What are your plans for growth & expansion?
- What involvement of others is likely, or desirable?
- What is the risk profile?
- Who is to have control over decision making?
- Do you intend to employ others?
To assist you when considering the right business structure, we provide a table comparing the various aspects of the common business structures used in Australia.
Comparison Table
| Business Structure | Sole Trader | Partnership | Company | Trust |
|---|---|---|---|---|
|
Difficult to set up? |
NO |
NO |
YES |
Yes |
|
Costly to set up? |
NO |
NO |
YES |
YES |
|
Complete control retained? |
YES |
NO |
NO |
NO |
|
Offers limited liability/asset protection? |
NO |
NO |
YES |
YES |
|
Easy to raise capital? |
NO |
YES |
YES |
NO [1] |
|
Do I retain profits? |
YES |
NO |
NO |
NO |
|
Tax planning opportunities/Benefits? |
NO |
NO |
YES |
YES |
|
More complex reporting requirements? |
NO |
NO |
YES |
YES |
|
Can I employ others? |
YES |
YES |
YES |
YES |
|
Easy to dissolve or sell? |
YES |
YES |
YES |
NO |
|
Can others be admitted? |
NO |
YES |
YES |
NO [1] |
|
Can structure be easily changed? |
YES |
NO |
NO |
NO |
[1] Depends on the type of trust – when using a discretionary trust it is difficult to raise capital; selling interests & admitting others is virtually impossible, though all are easier when using a unit trust.
(The above are general indicators only – they are relative to each individual’s needs & circumstances.)
As you can see from the above, all the options have pros & cons – none is ever likely to tick all the boxes. Approach it as you would a puzzle, finding the right pieces for a solution that will best match your needs.
No one factor in isolation should drive your decision – you should consider all the elements when deciding which business structure is most suitable for your specific needs.
We often see business owners making that critical decision based only on potential ‘tax benefits.’ Whilst that is no doubt important, it should not be the sole reason for choosing a particular structure.
The Small Business Development Corporation provides good, easy to read information that may assist you in choosing the right business structure:
https://www.smallbusiness.wa.gov.au/business-advice/business-structure
For more information regarding the tax implications of each business structure, see:
What happens to your Business Structure when things don’t go as planned?
Another key factor often overlooked is how easy is the structure to dissolve or unwind? This may be relevant in a variety of circumstances, but we often encounter problems when things don’t go as planned.
For example, the business isn’t as profitable as expected & you decide to abandon it – what happens to the business structure? Partnerships need to be dissolved, companies need to be deregistered & trusts need to be vested or wound up.
That is, they just don’t go away & neither do your obligations!
Dissolution, deregistering & vesting can all end up being complex & costly exercises as they generally require specialist advice to ensure they are carried out correctly & in the most tax effective way possible.
Dormant Entities
Even ‘parking’ or ‘mothballing’ dormant entities will mean you have ongoing obligations & costs. This is a common scenario when say a business venture comes to an end & you want to retain your entity to be able to use losses trapped within that entity or for future use in a new venture.
On the flip side, let’s say things go better than expected & you’ve outgrown your current structure & need something more suitable to accommodate your new business model. The same factors are relevant.
If you are restructuring, not only do you need to consider the complexities & costs of winding up your old structure, but you also need to think about the costs of establishing the new structure.
The tax implications of restructuring cannot be ignored as they can be onerous, despite various mechanisms (e.g. rollovers) within our tax legislation designed to mitigate the tax consequences. Expert advice is needed in these situations, prior to embarking on any sort of restructuring.
Summary
The above discussion merely touches on some of more critical aspects of choosing the right business structure. We understand that first time business owners may find the process challenging & some of the concepts complex.
We also understand budgets are tight when you are setting up a business, but we cannot over emphasise the importance of seeking professional assistance & guidance to help you work your way through the issues.
Failure to do so may prove very costly if say you are forced to relinquish hard earned personal assets to discharge obligations & debts incurred by the business or your business partners.
How we can help - Integrity Impressions – Joondalup Accountant
The Integrity Impressions team have years of experience assisting clients to choose the business structure most appropriate to their needs.
Sometimes your needs may involve a blend of structures – for example, a company to operate your business with the shares owned by a discretionary trust. We have extensive experience with small businesses across many industries.
Integrity Impressions can guide you through the process which can be overwhelming & confusing. If you’ve already determined the right business structure for your needs, implementing it correctly is just as important.
We are able to facilitate the formation of your companies, settlement of trusts, establishment of partnerships & provide expert advice at competitive rates – all the hard work done for you, under one roof.
Important Disclaimer
The above is provided for information purposes only and is a general overview of the factors that should be taken into consideration when choosing a business structure and is not a substitute for specific advice.
Whilst every attempt has been made to ensure this content is accurate at the time of publishing, the law may change over time. Therefore, we cannot guarantee the content’s currency at a future time.
Nothing in this article should be construed as taxation advice, legal advice or financial advice.
Integrity Impressions will not be held responsible for any loss suffered by any person or entity for the inaccuracy of information or any errors or omissions in its contents, regardless of the cause of such inaccuracy, error or omission.
For professional advice relevant to your specific needs and circumstances, we suggest you contact your Registered Tax Agent, your Legal Advisor or Business Advisor as appropriate.
