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Getting into Business? Understand Your Business Structure

If you’re buying a new business or starting a new one, an essential starting point is understanding your business structure.

What do we mean by that?

We mean this: what is the vessel through which your business will function, and what are its benefits and risks? Unfortunately, many business owners simply leave this up to their accountants. As a result, they end up with structures they don’t really understand. This can lead to many issues down the track that are easily avoided by spending a few minutes asking the right questions.

In this article we will set out a few of the standard options for business structures, as well as some practical questions to ask when deciding how you’re going to set yourself up.

Sole Trader – Just Yourself

By far the most straightforward structure to set up, being a “sole trader” simply means that you are in business for yourself.

So if John Smith decides that he’s going to start offering handyman services to the local neighbourhood, then he simply starts doing it – as John Smith.

Of course he will probably need to register an Australian Business Number and might need to think about GST, but he could be up and running within a short space of time.

The clear benefit here is speed and simplicity. John is simply himself – he earns money for himself and will pay tax on it as part of his personal income.

But there is a big downside – if John decides to fix someone’s stairs one day, and that person subsequently falls through those stairs and decides to sue, then John is personally on the hook for all of the potential liability. If John owns a house, then that’s on the line.

Partnership – You and Others

So if you take “sole trader” and you make it “sole traders” – then you probably have a partnership.

A partnership, in simple terms, is two or more people carrying on an enterprise with a common view towards making money.

Traditionally this was the model that law firms were required to use. That’s why in some TV shows you see preposterously long firm names like Smith, Smith, Smith and Smythe – Attorneys at Law. (These days, it’s a bit different, thankfully.)

Partnerships come with the same risk – if you get sued, it’s the partners being sued personally. Bear in mind that EACH partner is completely liable for ALL of the debts of the partnership. So if your partner has no money, you don’t just have a 50% liability to your creditors – you have a 100% liability. That said, at a practical level, when there’s more than one of you then hopefully more people can contribute to solve any debt or liability problems that might come up.

There is a considerable risk to be aware of in partnerships – you are bound by the actions of your partners. So if Sue and John go into partnership, and John decides to do a crazy deal that loses the partnership money – Sue will generally be bound to that crazy deal (and 100% liable for it as we mentioned above). For this reason you need to be prudent about who you go into business with (which is probably true whatever structure you use).

Tax can get a little more complicated with partnerships, so make sure you have a frank discussion with your accountant about that.

In theory, the setup for a partnership can be nearly as straightforward as for a sole trader. In practice, though, you will want to document your partnership agreement to deal with the relationship properly. It’s tempting to skip this step, but while everyone’s getting along, it is by far the best time to talk about the “ifs and buts”. That will be things like:

  1. Who makes what decisions/how are decisions made?
  2. How can we bring on new partners and what is the process for doing that?
  3. What if I want to get out and you don’t? Can I force you to buy me out?
  4. How do we value the partnership?
  5. What happens if there is a disagreement?
  6. What happens if one of us does something that brings the business into disrepute?

A Proprietary Company – “Widgets R Us Pty Ltd”

A simple company is one of the most common structures, and for one major reason: it provides a level of protection against you getting sued personally.

A company, in essence, is a separate “person” in the eyes of the law.

So rather than you carrying on business, it is your company that carries on business. Therefore, it’s also your company that gets sued if something goes wrong. More and more though, governments are introducing ways in which directors of companies can be personally liable for their company’s actions, so it’s not complete protection.

The company functions through the actions of its officers – which will probably be you as the director.

Its profits are then either:

  1. Paid to the shareholders (again, probably you); and/or
  2. Reinvested in the company.

Companies offer a lot of flexibility in terms of you getting paid, which can be used to your advantage sometimes for tax purposes.

On the downside, being a company director does come with additional legal responsibility, compliance costs, tax costs and duties that you need to be aware of. If it’s just you alone, then most of these are straightforward, but if you’re going into business with others, you will need to read up on your rights and responsibilities.

In terms of setup, again if you are going into business with others you’ll want to document many of the same things as we mentioned in the partnership section. This time you will have to deal with both the relationships of the directors (operations) and the relationships of the shareholders (incoming and outgoing, payments, voting rights and the like).

Adding a Trust Into the Mix

A trust is a bit more complicated to understand and explain. We’re going to keep this bit fairly high level, and stress the need for you to get individual accounting and legal advice.

Unlike a company, a trust is not a person, so it’s best not to think of a trust as a “thing” but as a relationship.

A trust occurs when you split the “legal” and “beneficial” ownership of something.

The person who actually owns the thing in name is called the trustee. The trustee can be an ordinary person, or a company.

The person/s who get the benefit of the thing are called the beneficiaries. These can also be either people or companies.

A trust is usually used to help direct money where you want it to go in a tax effective way. It doesn’t really offer many benefits in terms of risk or day-to-day operations – in fact it can sometimes make those things more complicated.

Let’s look at an example. Sue and John from our earlier section go into business. To do that, they form SueJohn Pty Ltd – a company. Sue and John are the directors of that company.

The shareholders of that company are:

  1. Sue Pty Ltd as trustee for the Sue Family Trust
  2. John Pty Ltd trustee for the John Family Trust

Why would they do this?

Well, if SueJohn is successful, then it can pay its profits to its members. This year, let’s say it can pay out $1m to each shareholder.

But Sue obviously doesn’t feel like paying $1m in personal income tax – that would be horrible!. Instead, Sue’s company receives the money as shareholder and then pays it out to the beneficiaries of the Sue Family Trust. That might include Sue, Sue’s partner, some of Sue’s children, and some charities that Sue supports.

As a result, Sue doesn’t need to pay quite as large a tax bill, but the money can end up basically where Sue wanted it to go anyway.

Trusts can be used in lots of different ways, but this is a common form.

The downside? The business structure gets a lot more complicated (you’ve got three companies and two trusts in our example above) – so keeping your head around what’s going on with various entities can be more difficult. You’re also going to be paying your accountant more money because of the various sets of books and multiple tax returns required – every, single, year.

Practical Questions to Ask

So now you know there are plenty of options, even with the simple ones we’ve set out above. What questions should you be asking your advisors when you’re setting up?

Here are some major things to check:

  1. Am I at personal risk in this structure? If so – how?
  2. How do I get paid? Is my tax being minimised by doing it this way? Can I distribute income to others if I want to?
  3. How much more am I paying each year in accounting fees and ASIC compliance using structure X than I would in structure Y?
  4. How easy/difficult is it to bring in an investor or new partner using this structure? What are the tax consequences of doing that?
  5. If I decide to exit the business, can I do so in a tax effective way? Will people be interested in buying a business in this form?
  6. Are my insurance costs greater for structure X than for structure Y? (this might more be a question for your insurance broker).
  7. If I want to change structure later (eg from a sole trader to a proprietary company) how would that work?

A Stitch in Time

Taking the time to get your business structure right is entirely worth it.

It’s entirely possible that your accountant has a “go to” model that they use on many occasions, and it might be just fine for what you’re looking to do.

But making sure you’re asking the right questions and getting a good understanding of your own business is a worthwhile undertaking. It helps you know that your model from the outset aligns with your plans for the future of the business.

This is an area where input from both an accounting and legal perspective is good. Reach out if you want to set up a meeting with us, you and your accountant to go through the options in more detail for your unique situation.