By Luke Mountford,Partner and Tim Scanlan, Associate
The corporate structure you choose for your business will have significant consequences as the business grows and upon exit. Ensuring the correct structure is chosen at the start is the best way to avoid costs that may arise if the structure is changed down the line.
However, there is no one 'best' corporate structure. By looking at the key characteristics of the most common types of business structures, a business owner can assess the respective strengths and weaknesses of each structure in a number of key areas, such as asset protection, ability to raise capital and taxation consequences.
Sole trader
Key characteristics
- Simplest and most inexpensive form of business structure
- No separate legal entity - the business owner is personally liable for the debts and liabilities of the business
- Profits taxed in the hands of the owner
This business structure sometimes works for business owners who carry on very small operations, or who provide personal services (such as on a consultancy basis). It is the simplest structure to establish; to get going, you only need to register for GST and a business name, should you wish to use a name for your business other than your own.
However, for most, concerns over the potential for personal liability mean that this structure is inappropriate. There is no separation between the operation of the business and the private affairs of the owner, so any debts incurred in carrying on business will be the responsibility of the sole trader. This means that creditors are entitled to pursue the sole trader for those debts and, in doing so, may have access to the private assets of the sole trader.
There is also limited opportunity to distribute profits of the business to those other than the owner of the business in a tax-effective manner. For some, restrictions in tax laws may make it difficult to stream profits to others in any case, having regard to the nature of the services (ie personal services) that they provide.
Partnership
Key characteristics
- Relatively inexpensive form of business structure
- No separate legal entity
- Partners are jointly and severally liable for the debts and obligations of the partnership (irrespective of the partner that incurred the liability)
- As there is more than one party involved, it is critical to record how the partners intend to deal with one another
- Profits are split in accordance with the agreement between the partners and are taxed in the hands of the partners
A partnership exists when two or more people (or entities) carry on business in common with a view to making a profit. A partnership is relatively inexpensive to establish and there are few regulatory requirements, other than the requirement to lodge tax returns.
Partnerships are not separate legal entities. Like sole traders, each partner will be liable for debts incurred in operating the business. In addition, each partner is jointly and severally liable for the actions of all the partners. This means that if one partner incurs a debt in conducting the business of the partnership, all the other partners will be liable to the creditor as if it was their debt.
Because of the potential for one partner to bind all the parties in their dealings, it is critical to have a formal partnership agreement that sets out the partners' respective rights and obligations.
The partnership agreement should also determine how the income and expenses of the business are to be split (if not equally). Business profits are split among individual partners in accordance with the partnership agreement. Despite the need to lodge separate tax returns, a partner's share in the business profits from the partnership are taxed in the hands of each partner individually.
Company
Key characteristics
- Separate legal entity
- Profits taxed at 30 percent
- Profits are distributed by way of dividends to the shareholders
- Profits after tax can be retained in the company
- Ability to raise capital
- More expensive to establish and maintain than other structures
A company is a separate legal entity. This means the assets used in the business are owned by the company, separate from the assets of the principal of the business. This makes it an effective structure from an asset protection perspective for business owners.
Shareholders are not liable for the debts and obligations of the company, but directors may be personally liable for the company's debts in certain circumstances.
Companies are taxed at a flat rate of 30 percent and profits can be distributed by way of dividends to the shareholders. Profits can also be retained in the company. Where profits are distributed, a credit can be received by the shareholders for the tax already paid by the company.
Companies are also an effective vehicle for raising capital, as others can acquire shares.
Companies are more complex structures and subject to more regulation than sole traders or partnerships. There is a cost involved in establishing and maintaining a company, and those costs need to be considered against the benefit of having a separate legal entity.
Trust
Key characteristics
- No separate legal entity
- Potential to split profits between beneficiaries
- Profits taxed in the hands of the beneficiaries unless the trustee fails to distribute profits, in which case they are taxed in the hands of the trustee at penalty rates
A trust is a relationship between two or more people under which legal title to some specific property (called the trust property) is separated from beneficial ownership of that property. The person or entity that holds legal title to the trust property is called the 'trustee'. The beneficial owners of the trust property are called 'beneficiaries'.
The trust relationship imposes an equitable obligation on the trustee to deal with the trust property for the benefit of the beneficiaries. The key here is that the creation of a trust relationship does not operate so as to create a separate legal entity. In essence, the trust arrangement operates to impose equitable obligations between parties to act in a certain way.
Where a trustee enters into transactions in its capacity as trustee of the trust, the trustee is personally liable for those transactions and will also be entitled to be indemnified out of the assets of the trust (provided it is acting in accordance with its obligations as trustee). Often a company acts as trustee of the trust to provide the asset protection benefits discussed above.
There are two main types of trusts: a unit trust and a discretionary trust.
In a unit trust, the beneficiaries have a fixed entitlement to income and capital based on the proportion of units they hold in the trust. The ability to issue further units gives unit trusts the ability to raise capital by introducing further unitholders.
In a discretionary trust, the trustee has discretion to distribute income and capital to one or more beneficiaries of the trust as the trustee sees fit. This is the key characteristic of discretionary trusts, as the trustee has the power to determine the most appropriate beneficiaries (often from a tax perspective) to distribution income to.
Other options
As noted above, there is no one 'best' structure. Each structure has different characteristics, pros and cons that need to be considered. Business owners often combine the above arrangements in an attempt to obtain the benefit of the different characteristics of the structures. For example, partnerships can be constituted between companies or trusts (with corporate trustees) and trusts can be shareholders of companies.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
