Business Structure Pros and Cons to Consider Before Starting Up

When starting a new small business one of the first decisions to make is which structure to utilise. The decision can depend on a number of factors such as cost, beauracracy, control and tax benefits. The four primary structures to be considered are:

•                 Sole Trader

•                 Partnership

•                 Company

•                 Trust

It definitely isn’t a case of one size fits all. Different small business owners will have different reasons for starting their business with varying focus on how they wish to run their organisations. Below we discuss the positives and negatives of each structure in order for you to be able to make a more informed decision.

Sole Trader

This is probably the simplest and cheapest means of starting a small business. Take your idea, get your ABN and make it a reality. Okay, the last part isn’t that simple, it takes a lot of hard work and resilience but the initial setup is pretty straightforward. This structure allows you to get an idea up and running as long as the other factors are in place such as capital, stock, premises etc. In addition, tax returns are submitted by you as an individual and not by the business.

Positives

1. You’re in charge. As a sole trader you are the number one person in the organisation. This means that you are the person making all the decisions as it is ultimately your success or failure.
2. As previously mentioned it is a pretty cheap and simple means of setting up in business. This can be a good move in the early stages where working capital is tight and you wish to spend time on the bits you are good at instead of the onerous administration requirements.
3. The profit is all yours, but be aware you are also responsible for all losses, so this tempers things a little. However, taxable losses may not be such a bad thing where the early stages of the business are part time and the losses can be offset against your individual earnings made in a salaried position.
4. Speed of decision making. As a sole trader you can be very flexible to deal with threats and opportunities as they occur. You don’t need meeting upon meeting of leadership and project teams in order to make a change. You still need a strong decision making process but can react quickly where necessary.

Negatives

1. The risk is all yours and this isn’t just limited to the business assets held. If things don’t work out and you run up a chunk of business debt, your home can be at risk even if there is no debt formally secured against it. While the rewards all belong to you, so do the downsides. While it is great to receive the profit when things are going well, it may be worthwhile to consider having a partner to share the risk and decision making.
2. You can’t know everything. Many businesses fail in the first 1-5 years. Often, it is due to a lack of skills in the areas outside the core skills of the business owner. Skills such as budgeting, cash forecasting and financial management wouldn’t generally be the core skills of a florist and so sometimes it can be necessary to utilise the skills of a professional in this area.
3. It can be difficult to access finance without securing the debt against personal assets such as your home. Banks tend to be quite risk averse and like to see that business owners have put their own funds into the business before they will lend to support. They also tend to want to see security for the loan.
4. What if you get hit by a bus? The sole trader tends to be the life and soul of the business. If they aren’t there on a day to day basis the business can very quickly fall apart, especially in the case of micro businesses.

Partnerships

Partnerships, by definition, will be formed by two or more people with a view to making a profit for all parties based upon the percentages of the partnership owned. It is often 50/50 but can be pretty much whatever the partners agree to. While not as formal as a Company, the partnership is still subject to a formal partnership agreement which forms the basis for the rules governing the operations of the partnership.

While a partnership is more structured than a sole trader, it should be noted that the partners still carry the same risks as a sole trader in that they are personally liable for the debts of the business. It should also be noted that there is joint and several liability on all partners. This basically means that should one partner not have the assets to cover their share of the debts upon insolvency, the other partners will be required to take up the slack.

Positives

1. While slightly more expensive due to the requirement of a partnership agreement it is still cheaper than a company structure.
2. Partners share the responsibility and obligations between them. In addition, they can bring multiple skill sets to the table.
3. Ongoing administration is still pretty straightforward. The partnership still has its own ABN, Tax File Number and GST Registration, and also submits its own tax return. However, will have no tax liability as profits are shared to the partners based upon the % of holding and dealt with in their individual tax returns.
4. Tax losses again can be accessed to offset against other income streams for the partners. This can again be useful in the early days of the organisation when costs can be higher than developing income streams.

Negatives

1. Again, unlimited liability of debts incurred by the partnership are the responsibility of all partners equally, jointly and severally.
2. The administration of the addition and removal of partners can lead to the automatic dissolution of the partnership unless it is dealt with effectively in the partnership agreement.
3. Decisions can be more problematic and time consuming where partners have a differing view on a course of action. Someone may need to compromise in order to move forward.
4. The number of partners can be limited in certain state jurisdictions and so expansion by bringing new partners in with new capital etc. can be limited.

Company

Under Australian company law, the formation of a company leads to the creation of a legal entity in its own right, even though it is owned by the shareholders. The formation of a company is more administrative and is formally governed by ASIC. Due to this bureaucracy, directors of the organisation need to be fully aware of their obligations, both to the organisation and the shareholders.

As a separate legal entity, the company has to submit its own tax returns and pay tax on the profit from its operations at the relevant company tax rate. One point of note is that losses cannot be carried back against tax from previous financial years, only offset against subsequent years until fully allocated. The owners funds are issued in the form of a dividend paid out of post-tax profit, which also carry a credit for the tax paid by the organisation so that shareholders aren’t unfairly taxed.

Positives

1. Shareholders have a limited liability to the debts of the organisation. This is limited to the value of the shares they hold and as long as they are fully paid up no other liability exists.
2. The more formal nature of the organisation leads to distinct clarification of governance and similar matters via the shareholder agreement.
3. Ownership of the organisation can be easily managed via a transfer of shares.
4. Additional shares can be issued in order to raise additional capital.
5. Tax benefits are available to small companies especially, such as lower rates of income tax.

Negatives

1. Setting up a company can incur significantly higher costs, especially where professionals are appointed to undertake the work. Additionally, the cost of ongoing reporting and administration is more than the previous structures.
2. Shareholders may not have as much control over operations, especially where they are not owner directors. This can lead to frustration when decisions are made that the shareholder doesn’t agree with.
3. Directors can be subject to quite severe personal penalties if they have not been deemed to be acting in the best interests of a failed business. For owner directors this can reduce the benefit of limited liability but ensures that the company’s interests are at the forefront of decision making.
4. There needs to be a greater understanding of governance and administration in order to maintain effective operations of the organisation.

Trusts

While there are a number of trusts, we will focus on beneficial trusts as these tend to be the main type used by small business owners and their families. These discretionary trusts, commonly called family trusts, are popular as they can lead to tax benefits for the family group, especially where one party is a low income owner. There are also benefits around asset protection. In recent times, some loopholes have been filled, especially around child beneficiaries, but they still remain a popular choice.

Positives

1. Income can be distributed at the discretion of the trustee in any ratio they deem fit. This can benefit families where one party is a lower income earner and the other is a higher income earner as distributions can be made which will even out which tax bands the parties fall into.
2. Trusts actually provide more privacy than the company model. In addition the trust can be the shareholder of a company and dividends can then be distributed out of the trust accordingly.
3. If the trustee of the trust is a company, liability of debts is limited under normal company limited liability rules.

Negatives

1. It can be difficult to dissolve or alter an established trust and may lead to dissolution and resulting liabilities for Capital Gains and Stamp Duty.
2. The trustee must distribute profit each financial year to beneficiaries or the trust will be subject to high marginal tax rates.
3. The trust has a maximum period, as set out in the trust deed, after which it ceases to be established.
4. Individual trustees can be personally liable for the trusts debts.