Starting a business is an exciting yet daunting task. While many start-ups initially lack the capital to spend on complicated legal structures, it is vital from the outset to choose the right business structure that provides flexibility to grow and, at the same time, provides you protection.
You must consider the structure that best suits your needs, which will depend on the type of business or industry that you are in, the cost of establishment fees and maintenance costs, tax implications and the level of asset protection you require.
No matter the reason for starting your business—whether it is a desire to earn more money or to become financially independent—start-ups should always ensure they do background research first: get to know the industry you are involved in and your competitors.
Here’s a look at the four main types of business structures.
1. Sole trader
This is exactly what the name suggests. All the assets and liabilities of the business belong to you, the individual. This means there is no separate legal existence—you are the owner and the business. As you are using your own name, you do not ordinarily have to register a separate business name. Sole traders are able to employ staff, and are subject to the same tax rates as individuals. There are greater risks for sole traders, as personal assets in your name (not connected with the business) are at risk from any liabilities that the business incurs—this is sometimes referred to as unlimited liability.
This involves an association of two or more individuals (or entities) joining together for the purpose of carrying on business, with a view to making a profit. The partners may operate under their own name or with a registered business name. Limited partnerships involve passive investors who are not involved in managing the business.
While partnerships don’t have to be equal in terms of each partner’s interest, all partners share the responsibilities and risks involved in running the business.
The partnership is not a separate legal entity and does not pay income tax on the income earned by the partnership, though each partner pays taxes on their share of the net partnership income (individual rates). Partnerships typically register a business name, and will also require a deed that states clearly to the obligations and rights of each partner, which is governed by the Partnership Act.
Some partnerships are formed between friends using a verbal agreement and in such cases, the law assumes that everything is shared equally—not only profits but losses as well. When complications arise it can be difficult for partners to come to an agreement and maintain their relationship. It is recommended that partnerships enter into a partnership agreement at the outset, which clearly defines their roles, responsibilities and liabilities.
A Proprietary Limited (Pty-Ltd) company is the most common business structure adopted by small to medium businesses in Australia. It is an independent legal entity able to do business in its own right. The shareholders own the company but the company is run by its directors.
As a separate legal entity the company will have its own assets and liabilities. Companies are registered through the Australian Securities and Investments Commission (ASIC) and have added reporting requirements. Upon incorporation, the company will be assigned a unique Australian Company Number, which enables it to conduct business throughout Australia.
There are costs associated with registering a company and the company’s tax rate is currently 30% of all profits. However, a company often offers a greater level of asset protection as opposed to some of the other business structures, as the shareholder’s personal assets are separate from the business. Where disputes arise and the company is found liable, the company’s assets would be at risk, not the shareholders’. This is unless the dispute arises because of misconduct by the shareholders, such as insolvent trading, in which case shareholders may be held liable.
Here, the business is governed by a trust deed, which appoints a trustee to be the operating entity of the business. The trustee holds property in its name, earns income and makes distributions to the beneficiaries of the trust, in accordance with the trust deed.
A trustee can be an individual, a number of people in partnership or a company. One of the most common types of trust is a discretionary trust, where the trustee has the discretion as to how and when distributions are made to the named beneficiaries. Distributions are often made in such a way as to minimise tax, e.g. to beneficiaries in a lower tax bracket. However, the trustee often offers a greater level of asset projection as opposed to some of the other structures, especially where the trustee is a company with limited assets in its own name.
Unit trusts are also a common form of trust, which are an extension of a Family Trust into the field of commerce. Here, at the end of each year, income is distributed to the unit holders (similar to shareholders of a company) in proportion to the number of units that beneficiary holds. The trustee has no discretion here. Units may be held by family trusts, companies or by individuals. A unit trust serves a different purpose to a discretionary family trust.
A unit trust has:
– negotiability (you can buy and sell units);
– fixed annual entitlements to income and capital (the trustee can not reduce your entitlements);
– The importance of getting it right;
– It is critical that business owners understand the legal effect of their business structure to ensure they can make plans about how the business is to run and its future growth.
When choosing the business structure that best suits you, you should obtain both legal and professional accountancy advice. There are a number of important factors that you need to consider. For instance, generally sole traders attract the greatest personal risk, as they can be personally liable. However, a company is a separate legal entity and the owner is not usually at risk, only the directors who have very limited liability.
Also, tax rates vary depending on the type of structure you choose. Although company structures are generally more expensive to set up and run compared to sole traders, there are various tax benefits with company structures.
A vitally important document for companies and partnerships to have in pace is a shareholders and/or partnership agreement. Soles traders do not require these documents as the individual retains the control over the business. However, with Proprietary Limited companies and partnerships, it is essential that all partners and all shareholders enter into an agreement in which they agree to regulate and exercise some of their rights as shareholders and/or stakeholders.
These agreements should set out what happens if an owner wishes to sell its shares upon:
– any other reason.
Many company constitutions are silent on these details. An effective agreement sets out the specific conditions, rights and duties of each owner and should include the method of resolution. The agreement also enables you to provide an outline as to the distributions of profits, asset protection for owners and shareholders of the business and any restraint of trade of provisions.
An agreement will also include the following:
restraint of trade provisions for directors and/or shareholders
directors meeting procedures
business plan and budgeting requirements
individual directors and/or shareholders duties
how and if loans are provided to directors.
Often business are started with friends and/or family members and many people don’t feel the need to enter into such agreements.
In my experience, this is the most essential part of the start up, and the agreements should be discussed and finalised from the outset.
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