The Pros & Cons of Key Business Structures

In a separate blog, I outlined “5 factors to consider when choosing a business structure“.

In this article, I want to share a quick run-down of the pros and cons of 4 common business structures:

–   Sole trader

–   Partnership

–   Company

–   Trust

This discussion is in the context of a for-profit private business, and public company is treated as the next plane in the evolution of a business and hence is also excluded.

Basic requirements

Regardless of the structure, all business entities must apply for a tax file number (TFN), register for an ABN and for GST if its annual GST turnover is $75,000 or more, and lodge quarterly or annal BAS (Business Activity Statement) and/or IAS (Instalment Activity Statement) if applicable.

Sole Trader

As a sole trader you conduct business as an individual. All legal rights and obligations of the business are yours. The assets and liabilities of the business are essentially your personal assets and liabilities. Since there is no separation between the legal identity of the business and your own, you have unlimited liability for the debts of the business, meaning that in the event your business become insolvent, your personal assets including your home may also become the subject of creditors claims.

From a tax perspective, there are less tax planning options open to sole traders, and the business’ profits are taxed at personal rates.

Key points

–   You can use your tax file number (TFN) to lodge tax returns

–   Any losses incurred by your business can be offset against other income earned

–   You’ll need to pay yourself, usually out of the business profits

–   You are responsible for your own superannuation

Pros

–   Simple and inexpensive to set up and run

–   Complete control

–   Little ongoing red tape or paperwork

–   No need to register a business name as you can use your own

–   Relatively easy to change your business structure if you want to expand or stop operating

Cons

–   Complete responsibility for the business’ liabilities like debts or employee claims – your personal assets are at risk if things go wrong

–   Difficult to take time off

–   Harder to get finances

Partnership

A partnership is a a business structure that allows a group of people to combine resources and run a business together and share profits.

While a written partnership agreement is not essential, it is highly recommended to prevent misunderstandings and dispute by clearly defining each partner’s rights and obligations, share of profit and how the business is managed and controlled.

Unlike employees, the partners in a partnership are not employees, but the partnership might also employ other workers. Partners are responsible for their own superannuation arrangements. However, the partnership is required to pay superannuation for its employees.

The partnership profits are taxed in the hands of the partners at the individual tax rate and may be eligible for the small business tax offset.

Key points

–   Made up of 2-20 partners

–   Requires a separate TFN

–   Each partner will pay tax on the share of the net partnership income they receive

–   Partners can offset their share of business losses against other income earned

–   Each partner is responsible for their own superannuation

Pros

–   Simple and inexpensive to run

–   Responsibility is shared

–   Easier to get finances as you have the resources of at least two people

–   Little ongoing red tape or paperwork

Cons

–   Each partner shares responsibility for the business’ liabilities, regardless of how much of the partnership they own

–   There can be disagreements among partners when working so closely together

Company

A company is a separate legal entity from its shareholders and therefore provides some protection over its owner’s personal assets. However, its directors can be legally liable for their actions and the debts of the company if in breach of their directors duty.

A company pays tax at the company tax rate and may be eligible for small business concessional rates. It must pay super guarantee contributions (SGC) for any eligible employee and directors.

In addition to filing tax return, companies must also submit an annual return to the Australian Securities and Investments Commission (ASIC).

Key points

–   Is a separate legal entity

–   Money earned belongs to the company

–   Corporate tax rates apply; check the latest details on the Australian Taxation Office (ATO) website

–   Business operations are controlled by directors and owned by shareholders

Pros

–   Reduced personal responsibility for any business debts and liabilities

–   Flexibility in distributing profits to shareholders

–   Dividends can come with franking credits – credits for the tax already paid by the company

–   Easy to pass on or sell ownership

Cons

–   More complex to start and run

–   More paperwork

–   Higher levels of compliance and setup costs

Trust

A trust is a structure where a trustee carries out the business on behalf of the trust’s members (or beneficiaries). A trust is not a separate legal entity.

A trustee may be an individual or a company. The trustee is legally liable for the debts of the trust and may use its assets to meet those debts. However, if there is a shortfall the trustee is responsible for the difference.

A trust is set up through a trust deed and there are two main types: discretionary or unit trusts.

In a discretionary trust, the trustee has discretion in the distribution of funds to each beneficiary. In a unit trust, the interest in the trust is divided into units with their distribution determined by the number of units held by each member.

The advantages of a trust includes limiting liability especially if corporate trustee, asset protection, and most importantly, flexibility of asset and income distribution.

The disadvantages include high setup and admin costs, difficulty to dissolve or change particularly where children are involved, penalty tax rates on profits retained in the business, inability to distribute losses, only profits.

For more information regarding your tax obligations as a trust visit the ATO website.

Key points

–   Profits are distributed annually to beneficiaries who pay tax individually

–   Trusts typically do not pay tax, provided they distribute all the profits

–   Requires a formal trust deed that outlines how the trust will operate

Pros

–   Reduced personal responsibility for any business debts and liabilities if the trustee is a company

–   Flexibility in distributing profits to beneficiaries

–   Easy to pass on or sell ownership

Cons

–   More paperwork

–   Higher levels of compliance

–   Higher setup and ongoing costs

–   Limited lifespan (usually 99 years)