How to choose the right legal structure for your business

Most people have heard the parable about the foolish builder and the wise builder. The foolish builder built his house on the sand while the wise builder instead constructed his on a rock. When the rains came, the foolish builder’s house was washed away while the wise builder’s home stood the test of time.

While that tale ultimately refers to the strength of character, it can just as easily be related to the foundation of a business. Specifically, choosing the right legal structure for a business can offer it extra strength and protection.

In Australia, the basic business legal structures are sole trader, partnership, company and trust. Here we’ll provide an outline of each.

But first, it’s vital to realise that the decision should always be made in consultation with a solicitor, accountant or financial adviser. This is an important decision to get right, as it shapes various financial, legal, registration and tax frameworks that must be built around your new business. It affects how much you will pay in tax and how much paperwork must be completed each year, by you and your accountant.

The first two models – sole trader and partnership – are relatively inexpensive and involve the least formal structures. At the same time, they leave the individuals within those structures more open to legal and financial issues. Companies and trusts involve greater up-front and ongoing expense but expose the personal assets of shareholders to less legal and financial liability.

Sole trader

This is the most basic and simple structure, relatively inexpensive and simple to maintain over time. It may be suitable for an individual who is running a business on their own and without any partners.

The sole trader structure gives the individual complete control over everything the business does as well as ownership of all profits and assets, and absolute power over business decisions.

The sole trader has less paperwork compared to other business structures and minimal regulatory concerns in terms of how the business is run.

This model also offers greater privacy, as there is no requirement for profits to be publicly disclosed.

Tax is charged at the individual’s personal tax rate and tax complications (reflected in higher accounting fees each year) are very low.

They’re the advantages. So what is the downside? A sole trader is fully liable for business debts, so potentially loses their house, car, intellectual property, etc., if debts are not repaid. A person’s marginal tax rate might be higher than the company tax rate, and fewer tax concessions are available.

Growth is not as simple, as the structure really only allows for an individual, not a team. Having said that, making a change in the legal structure from sole trader to company is not terribly difficult. It’s the change in business processes that can cause issues along the way.

Partnership

This structure is not dissimilar to that of sole trader, but it allows for two or more people to set up as co-owners and to share income between those co-owners.

A partnership is relatively inexpensive to set up and allows the partners to trade under a business name. Profits are shared between the partners in a way that has been agreed in the partnership agreement, and those profits do not have to be disclosed publicly.

As with sole trading, the partners are all responsible for business debt. Their personal assets are not protected by their business name, and each partner is responsible for business debt incurred by other partners. Each partner will be taxed according to their personal rate, meaning that as the business grows and income increases, so will the rate of tax paid by some or all partners.

Interestingly, in this model a partner cannot transfer their ownership to another individual who is outside the partnership, unless the other partners agree. So in a legal, financial and ownership sense, people working under the partnership model must beware of the potential effects of personal differences.

Company

This is where things become slightly more complex, but also offer potentially greater advantages and protections for, and from, your business.

A ‘proprietary limited’ company cannot raise funds through public share issues. A ‘public’ company can do so.

Most companies are proprietary limited, beginning with one or two people as shareholders and directors. Companies are governed by ASIC under the Corporations Act.

The real protection from a company comes from the fact that shareholders are generally not personally responsible for company debts. They can typically only lose the value of their shares in the company. Similarly, legal responsibility generally goes to the company, not to an individual (unless a director has failed to meet their legal obligations).

Ownership shares are transferrable, meaning people can transfer in and out of the business. Another advantage is that tax rates for a company are lower than the highest personal tax rates (although profits distributed to shareholders are taxable).

What’s the downside? Because of the strict regulatory environment, there is greater expense and reporting. Credit and loans can be more difficult to come by without the personal guarantees made possible by the sole trader and partnership structures.

There are also stricter governance requirements. In other words, freedoms around how the business is run and how decisions are made are not as great as they are in the world of sole traders and partnerships.

Trust

Possibly the least likely and most expensive choice for startups, but an important one to be aware of all the same, is the trust. In a trust, an individual or company (the ‘trustee’) manages the business in order to benefit others (‘beneficiaries’). A solicitor or accountant is necessary for the setting up of a trust.

This structure provides asset and legal protection both for the business itself and for the beneficiaries. It removes control of an asset from its owner, which can be useful if, for instance, the owner is a child or a group of people for whom personal differences may be an issue.

Often utilised for their flexibility around the distribution of income, beneficiaries only pay tax on the income they receive, and they pay tax at their own marginal rates.

There is a great responsibility for the trustee to carry out their role to ensure the best (or pre-defined) interests of the beneficiaries, as well as hefty regulation and governance concerns.

So clearly, it’s important to get this decision right. Build a business on solid ground and it will weather storms. But build it on the sand and it will be too easily washed away.

Find out more about how studying a Master of Business Law can help to develop your career and give you the confidence to navigate legal risks in your business.