What business structure should you choose?

When starting a business, it is important to decide firstly the legal structure of the business.

How should I structure my business?

There is no 'one-size-fits-all' when it comes to business structures. Your options include operating as a sole proprietor, a partnership, a company or through a trust. You may even want to use a combination of these structures.

This article outlines the most common business structures, their advantages and disadvantages.

Sole proprietor

If you are running a business on your own, operating as a sole proprietor is simple. There is very little paperwork required to establish your business as a sole proprietorship. Even though you are a sole proprietor, you may want to register a business name under which to trade. But, this does not mean your business is a separate legal entity. You are still carrying out the business in your personal capacity. Most businesses will also need to obtain an ABN and register for GST.

There are two major drawbacks to operating as a sole proprietor. The first is that you are personally exposed to liability if your business finds itself in financial trouble. This means that creditors could go after your personal assets, such as your family home, if your business cannot pay its debts.

The second major drawback is that it offers very little flexibility when it comes to tax. All the income of the business will be deemed to be your income and you will pay tax at your personal marginal tax rate.

Partnership

Two or more people can operate a business as a partnership. A partnership is established by an agreement between the parties (which can be a written or verbal agreement). If you are establishing a partnership, in most cases you should enter into a written Partnership Agreement.

Like a sole proprietorship, a partnership does not have its own legal existence. The business is carried out in the names of all the partners. Each partner is bound by the actions of the other partners.

Partnerships allow the profits of the partnership to be distributed between the partners, so it offers more flexibility than a sole proprietorship. How profits are to be distributed is determined by the partnership agreement. The partners pay tax on their share of the income, at their personal marginal tax rates.

The major drawback of a partnership is that each partner is personally liable for 100% of the partnership's debts. Not only are the partner's personal assets at risk, but the risk is not limited to the proportion of the profits the partner receives. In a standard two person partnership, a partner is entitled to 50% of the partnership's profits, but liable to creditors for 100% of its debts.

Company

Most business in Australia is carried out by companies. Companies have shareholders and directors. The shareholders own the company but it is the directors who are responsible for governing the company. In small companies, the shareholders and directors will often be the same people. Companies distribute their profits by paying dividends to shareholders.

Companies have several features that make them attractive as vehicles through which to operate a business. These include:

  • Companies have their own separate legal existence. This means that companies own their assets and operate their business separate from their shareholders.
  • Companies offer limited liability. A company's shareholders are not personally liable for the debts of the company. If something goes wrong, usually it is only the company's assets that are at risk. The personal assets of the shareholders are protected.
  • Companies have a lower income tax rate than many individuals (currently 30%, or 28.5% for some small businesses). Shareholders pay tax on their dividends at their personal tax rates but profits reinvested in the company are taxed at the corporate tax rate.
  • The company exists independently of its management and shareholders. This makes it simple to change the management and shareholders of the company, if required.

If you are operating a small company with multiple shareholders, it is advisable to have a Shareholders' Agreement in place. The Agreement governs such things as how the shareholders are to be involved in the running of the company and what happens if one of the shareholders wants to sell their shares.

Trusts

There are various types of trusts that can be used as part of a business structure. One of the most common is a discretionary (or family) trust. A discretionary trust overcomes one of the disadvantages of a company, namely that dividends can only be distributed to shareholders in proportion to their shareholdings. A trustee of a discretionary trust, on the other hand, has discretion in how and to whom they distribute the trust income (subject to the Trust Deed).

Discretionary trusts are often used to share business profits among family members. They can have tax advantages as they allow profits to be distributed to certain family members who may have lower marginal tax rates. They can also provide asset protection, as the trustee can keep profits from flowing to high risk individuals.

Trusts are governed by their Trust Deed. You would ordinarily have a company as the trustee of a discretionary trust and your family members would be beneficiaries.

How can Sharrock Pitman Legal assist? 

There is no shortage of options when it comes to choosing a legal structure for your business. It is worthwhile making sure you use the structure that best suits your business, personal and estate planning needs.

At Sharrock Pitman Legal, we have an Accredited Specialist in Commercial Law, and can assist you with determining which structure best suits your needs and once decided, establishing the legal structure for your business. If you would like any assistance, please contact Mitchell Zadow, Managing Principal of Sharrock Pitman Legal, on (03) 8561 3318.

The information contained in this article is intended to be of a general nature only and should not be relied upon as legal advice. Any legal matters should be discussed specifically with one of our lawyers.

Liability limited by a scheme approved under Professional Standards Legislation.

For further information contact  
Mitchell Zadow

Mitchell is the Managing Principal of our law practice.

He is an Accredited Specialist in Commercial Law (accredited by the Law Institute of Victoria). He also deals with areas of Employment Law, Wills & Estate Planning and Probate. For further information, contact Mitchell on his direct line (03) 8561 3318.

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