- The right business structure depends on your plans, finances, risk appetite and taxation.
- Sole traders and partnerships are the simplest structure, but you are personally liable for the business.
- Companies and trusts are more complex but removes personal liability.
If you are starting a business, there are several things that you will need to consider before you are ready to operate. Once you have come up with a great new business idea, you will need to make some key decisions. One of these decisions is about the structure that you will use to run your business.
When it comes to deciding on a business structure, there are a number of options that you may consider. The best option will depend on your circumstances, growth plans, and other plans for the future of the business including potential risk and tax considerations.
1. Types of Business Structures
The business structures most commonly used in Australia are:
- Sole trader
Each structure has its own advantages and disadvantages and there are several reasons why one may be more appropriate than another. You should consider which advantages are most important to you and which structure aligns best with your plans and goals. A general overview of each structure is detailed below, followed by the relevant advantages and disadvantages, as well as some other key considerations for you to think about.
A sole trader is the simplest form of business structure. It involves the person operating the business, the sole trader, running the business in their personal name. Anything that the business does is connected to the person. As a result, any business or other registrations, contracts and any transactions will all be done in that person’s name and they are legally responsible for them.
As a sole trader, if you are running a business, it is likely that you will need to register a business name, which is the name under which you conduct business. While the operating entity itself would be you as an individual, any contracts would typically be entered into by the sole trader trading as the registered business name, so that it is clear that the individual is the same as the business.
A partnership is, in many ways, similar to a sole trader structure. The key difference is that a partnership involves multiple individuals (two or more) carrying on a business together. Like a sole trader structure, in a partnership, the individuals are the legal entities who are carrying on the business.
A partnership will likely involve the partners registering a business name on behalf of the partnership. Any ownerships or registrations are made or done in the names of the partners.
A company is a separate legal entity that undertakes activities in its own right. A company is equivalent to a person in the eyes of the law when it comes to running a business (for most purposes). A company will enter into contracts and transactions in its own name and will also own any assets or registrations.
A company is made up of directors and shareholders. The directors of the company are the individuals who are appointed to run the company and the business. They are responsible for the day-to-day running of the business and (most often) making key decisions on behalf of the company.
The shareholders are the owners of the company and are the ones who want a financial return. The directors and shareholders may, or may not, be the same people (although they often are in smaller companies). Each company shareholder will own a certain number of shares in the company and will be entitled to a return based on the number of shares that they hold. This will come in the form of either dividends, which are payments of the company’s excess profits, and/or they will generate a return through the company’s eventual exit (typically a sale or listing).
A trust involves an entity, which can be either an individual or a company (known as a trustee), holding and managing the trust’s assets on behalf of other individuals (known as beneficiaries). When a business is run through a trust, typically the trust will be either a discretionary or unit trust.
A discretionary trust gives the trustee the discretion to distribute any profits to the beneficiaries as they see fit. A beneficiary’s entitlement under a unit trust is fixed, based on the number of units that they hold.
When a business is run through a trust, the trustee owns the assets and operates the business. It is also responsible for distributing the business’s income to the beneficiaries. The trustee is the entity that enters into contracts with other parties and conducts the business on behalf of the trust.
2. Which business structure is appropriate?
The business structure that you choose will affect your personal asset protection, tax liability, set up and ongoing costs. The following are some general recommendations; however, it is important to note that these may not apply to each particular case.
A sole trader structure is typically suitable for a small business with limited growth or expansion plans that wants to become operational easily and quickly. It is the simplest business structure and is inexpensive to set up.
Because the person operating the business is the legal entity, that person’s personal assets are at risk because the person and the business are the same. Any debts or other liabilities that the business takes on, the sole trader is responsible for. Therefore, it is also generally suitable for small businesses whose exposure to risk is reasonably limited.
A partnership is generally suitable for the same type of businesses as a sole trader, however, where multiple individuals will be operating the business together (often a partnership is used in family businesses). A partnership is also simple to set up and is reasonably inexpensive.
Given that the partners together are the business’s legal entity, the partners’ personal assets are again subject to risk. One key risk with running your business through a partnership is that your liability is connected to your other partner(s).
All partners are typically liable for the business both joint and individually. This means that each partner is liable for the other partner’s actions and for the business as a whole, regardless of whether they were actually involved.
If you are planning on raising capital through investment, you will likely need to set up a company. This is because you cannot provide ownership in a sole trader or partnership structure because you and/or your partners are the business, whereas in a company structure, you will provide the investor with shares in exchange for their investment.
A company does have additional initial set-up costs and requirements when compared to a sole trader or partnership, however, the requirements are generally not too onerous. To set up a company, you will need to register the company with the Australian Securities and Investments Commission (ASIC) and pay the associated registration fee.
A company is generally suitable for a higher risk business and/or one which is looking to grow and expand rapidly. Typically, a company structure is very suitable for startup companies that are ultimately looking to grow, raise external capital and undertake an exit event.
In a company, the shareholders and directors are usually not personally held liable for the company’s liabilities and/or debts. However, there are some limited circumstances where, in the case of directors, they may be liable. Any potential claims or liabilities made against the business sit with the company itself and not with the individual directors and shareholders. This differs from a sole trader or a partnership where any liabilities sit with the individual sole trader or partners.
As a company shareholder, you can also hold your shares through a trust, which provides many of the same benefits associated with running your business through a trust, namely tax benefits and increased asset protection. Some companies will also set up a structure where they incorporate multiple companies to better protect the assets.
Usually, this will be done by setting up a holding company that does not trade but owns all the valuable business assets. The holding company will then be the sole shareholder of one or more operating companies that enter into contracts and trade, so all the potential liability from trading sits with the operating companies rather than with the company that holds the assets.
A trust is typically beneficial in circumstances where tax is a key factor or is very important to the individual(s) operating the business. A trust is generally not suitable where your business wants to reinvest its profits into the growth of the business, because a trust will most often need to distribute the income that it earns each year. If the trust does not distribute its income, then it is taxed at the highest marginal tax rate of 49%.
Usually, where the business involves family members, a discretionary trust may be the most appropriate, whereas if the business involves unrelated parties, a unit trust may be more suitable.
Where a trust has an individual trustee, that trustee will be personally liable for the trust’s debts. If a trust has a corporate trustee, then the directors and shareholders are protected from liability as they would in a standard company. A key disadvantage with a trust is that it can be difficult to sell because it is so connected with the individuals. Most buyers would not want to purchase a business that is run through the trust and it would be very difficult for them to do so.
3. Taxation and other considerations
Where you operate your business as either a sole trader or a partnership, any income that you earn is taxed at your personal income tax rate. A company’s income is taxed at the company tax rate, which is currently either 30% or 27.5% for companies that are considered a small business.
A trust’s tax liability depends on the individual beneficiaries under the trust, however, generally a trust can be used to reduce the overall tax liability of the business. Each beneficiary is taxed on their income at their personal tax rate, so where a discretionary trust is used, and certain beneficiaries are in lower tax brackets, the trust’s income can be spread to take advantage of this.
As mentioned previously, if a trust does not distribute its income each year, it will be taxed at the highest marginal tax rate.
4. How to set up your business structure
To set up as a sole trader, you will simply need to apply for an Australian Business Number (ABN) with ASIC, and you may also need to register a business name. Once you have an ABN and registered a business name, you can trade in Australia using that registered name.
Setting up as a partnership is similar to the requirements to set up as a sole trader: the partnership will need to apply for an ABN and register a business name. The ABN will be registered in the names of both partners together. Where you operate as a partnership, you should also consider preparing a partnership agreement to clearly set out each partner’s rights and responsibilities, though this is not strictly a requirement. However it is highly recommended.
To set up a company, you will need to register the company with ASIC and pay the associated fee. In order to register the company, you will need to appoint its director(s) and the shareholder(s) will need to apply for their shares.
You can choose whether you wish for your company to have a constitution (which is its governing document) or alternatively you can rely on the Corporations Act to determine the company’s governance. If you set up multiple companies (as in a holding company / operating company structure), you will need to undertake the steps and pay the fee to set up each company.
You should also consider putting in place an intellectual property assignment and licence deed. This facilitates the operations of the group by allowing the operating company to use the holding company’s assets while ensuring that all the assets are owned by the holding company. If you have multiple shareholders, it is usually sensible to put in place a shareholder’s agreement governing the rights and obligations of the shareholders both with respect to the company and as between themselves.
To set up a trust, you will need a trust deed which creates the trust. The trust deed is a document that sets out all the parties to the trust and its governance. The trust deed will specify the parties to the trust and will need to be settled by a third party known as the settlor.
Depending on the state or territory in which you set up your trust, the trust deed may also need to be stamped with the relevant revenue authority in your state/territory. Where the trust is a unit trust, you should also consider preparing a unitholders agreement (which is commonly a unit holder and a shareholders agreement when a corporate trustee is used) to set out the rights and obligations of the unitholders themselves.
5. Changing business structures
It is possible to change structures in the future as your business needs change, however, there may be certain requirements or costs associated with doing so. This will depend on the structure that you currently operate under and the one that you wish to change to. For instance, if you currently operate as a sole trader and wish to set up a company, you will need to pay the costs associated with setting up a company.
In addition, given that the change of business is effectively a sale to a new entity, you will need to prepare the relevant documentation to transfer the business across to the company, including preparing a business sale agreement to ensure that all assets are now owned by the company and contracts are transferred across. You will also need to ensure that any relevant registrations are cancelled from your sole trader business and are opened in the new company, including cancelling your sole trader ABN and having the company apply for one.
When you are starting a business, you will need to consider which form of business structure is the most suitable for your needs and corresponds best with your long-term goals and plans for the business. It is prudent to obtain legal and accounting advice before setting up your business to ensure that you operate using the most suitable structure for you.
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