There are several ways to structure a business in Australia, each with its own advantages and disadvantages. Choosing the best legal structure for your own situation therefore requires careful consideration. The most common structures in Australia include a sole trader, a partnership, a company, and a trust.
Before addressing the structures in detail, lets discuss some factors for you to keep in mind.
Each of the available business structures has different characteristics, meaning that it is well suited to some types of business, and not to others. What is right for another business might not be right for you. Therefore, you should think carefully about the true nature of your business as it is now, as well as how it is likely to change in future. It can be costly and disruptive to change business structures at a later date.
This is the other side of the equation. Some business owners want to be able to distribute income between various family members. Others might be receiving pensions or other forms of benefit, that might be affected by some business structures (for example, if it leads to an increase in personal income). Others might have assets (such as a personal home) which they want to protect from creditors (which may make a trust or a company more appealing). Others might just be setting up hobby business on the side, and want something which is going to be cheap and easy to manage (such as a sole trader or partnership). Think carefully about your own circumstances and your priorities as you read through this guide.
Any business venture involves some level of risk. Some businesses involve much more risk than others. It is in the interest of a business owner to reduce the risk of personal liability. This can be more important to business owners who operate in high risk environments or to those who hold valuable personal assets. Companies and trusts are more protected from liability than partnerships or sole traders are.
The various business structures are taxed in different ways. In many cases, business owners can reduce their tax liability through intelligent business structuring. For example, some trusts enable the business owner to distribute profits to family members with a lower personal income tax rate. Companies enable business profits to be taxed at the corporate tax rate. Sole traders and partnerships do not have such flexibility, with profits generally taxed at the business owner's individual tax rate.
Some businesses need to raise capital from investors. Many investors are reluctant to provide funding to sole traders or partnerships but may invest in companies.
Companies and trusts are more complicated and expensive to set up and to operate, but can provide more benefits in terms of liability protection, tax, and distribution of profits.
Let's now have a look at the four main business structures available in Australia.
A sole trader is the most basic business structure in Australia. It is also the most common. It is popular among contractors and other small businesses.
As a sole trader, the business owner is effectively operating the business on their own and is responsible for all management and operational decisions. All of the assets and liabilities of the business are their own. This means the business owner does not have protection from liability.
Business profits are taxed at the business owner's personal tax rate. This can be an advantage in some cases (such as when the business owner can take advantage of negative gearing or capital gains tax concessions). It can also be a disadvantage in some cases (for example, if the business owner has a high personal tax rate).
As mentioned above, investors may be reluctant to invest in sole traders.
A sole trader structure is cheap and easy to set up and to operate. However, it is fairly inflexible and may struggle to adapt with a growing business.
Partnerships and sole traders have some similarities, although a partnership involves two or more people (whereas a sole trader only involves one person).
Like a sole trader structure, a partnership is fairly cheap and easy to set up. Also like a sole trader structure, a partnership does not offer protection from liability. In fact, a partnership goes further than this, and makes all partners liable for the liabilities of all of the other partners. This means it is very important to choose your partners carefully, as you will be liable for losses which they cause.
A partnership needs to have a Tax File Number. However, the partnership does not actually pay tax. It distributes income to the partners, and they pay tax on that income at their individual tax rates.
As mentioned above, investors may be reluctant to invest in a partnership, making it harder to raise capital through this structure than through a company.
For those wishing to create a partnership, we have a Partnership Agreement available.
A company is a more complicated structure but provides some benefits, particularly for businesses that operate in high risk industries, or that are likely to grow over time.
A company is a separate legal entity from the owners of the company. This means that the owners have some protection against liability, because the business's assets and liabilities are separate from their own personal assets and liabilities. As a result, many business owners that operate in risky industries choose to take advantage of the company structure.
A company is able to raise capital from investors by issuing shares (we have a Share Certificate available for this purpose). As the company grows, it can bring on new shareholders as well as new directors. For these reasons, this structure is often chosen by startup businesses.
Companies are taxed at the corporate tax rate, which is a flat rate, and is not affected by the business owner's other tax obligations. At the same time, the business owner may not be able to offset company tax losses against their own personal income.
It is possible to have a single person company (that person is the sole shareholder, director and secretary). However, it is still important that the company be treated as a separate legal entity (for example, company funds should be kept separate from personal funds), and that all actions of the company comply with the requirements of the Corporations Act 2001 (Commonwealth). If in doubt, seek legal advice.
Companies are highly regulated by the Australian Securities and Investments Commission under the Corporations Act 2001 (Commonwealth) and there are penalties for failure to comply. For these reasons, they are more onerous and costly to manage, and some small businesses and contractors decide that they prefer the simplicity of a sole trader structure.
For those who are planning to register a company with the Australian Securities and Investments Commission, (or for those who have already done so), we have various company documents available, including a Shareholders Agreement.
A trust is another more complicated business structure but some business owners choose to take advantage of it for various reasons such as asset protection or taxation. A trust is not actually a legal entity at all (unlike a company), but is more accurately described as a relationship whereby one party (the trustee) holds property "on trust" for one or more other parties (the beneficiaries).
A trust involves a trustee, which can be a person or a company, and which makes decisions on behalf of the trust. A trust also involves beneficiaries, who receive profits in accordance with the rules of the trust (as set out in a trust deed).
A trust may be discretionary, meaning that the trustee gets to decide from year to year what share of profits each beneficiary receives. Some family businesses like to take advantage of this structure, as it allows them to distribute profits as appropriate (for example to the individuals with lower personal tax rates). Alternatively, a trust may be fixed, meaning that the beneficiaries receive business profits in predetermined proportions (much like shareholders in a company).
In some cases, in fixed trusts, investors may buy units in the trust (similar to shares in a company), enabling the trust to raise capital.
There are a number of considerations to take into account in relation to tax on trust income. The Australian Taxation Office provides some guidance and an accountant can assist with minimising tax obligations. Beneficiaries which are adults or companies pay tax on their share of the trust's net income, at their applicable tax rates. If there are beneficiaries which are minors or which are non-residents of Australia, then the trust pays tax on their behalf, based on their share of the trust's net income. If there is any trust income to which no beneficiary is presently entitled, then the trustee may be taxed on the corresponding share of net income. However, for this income which is not distributed from the trust, the trust will generally be taxed at the top marginal tax rate (49%). There are some exceptions though (eg for deceased estates).
Therefore, to avoid this top tax rate, the trust needs to distribute income every year. This can be an issue for business owners that want to keep profits in the business in order to grow.
If the trustee is an individual person, then this person will be liable for the debts of the trust. If the trustee is a company, then the liability of this company may be limited (as described in relation to companies, above).
A trust can be complicated and expensive to set up and to run, so it is not appropriate for all business owners. If in doubt, seek legal advice.
As you can see, these business structures vary significantly, and each one is appropriate for some circumstances but not for others.
Business owners need to think carefully about their current circumstances as well as their future plans. They should consider whether they require liability protection and/or tax advantages. They should also consider whether the various startup and running costs are reasonable, given the size of and prospects for their business.
Many business owners who are starting to discuss and investigate their options with potential business partners choose to use a copy of our Agreement Between Co-Founders (Non-Binding). This document allows the parties to set out their expectations in the beginning, and helps to keep their initial discussions on track.