Choosing the Right Business Structure
Rhennen Ford | Solicitor
When entering into the commercial world it can often be difficult to decide how and where to begin. Choosing the appropriate business structure is one of the most important steps before even considering arranging for finance, finding a premises, or contracting with suppliers and clients. Throughout this article we detail the different type of structures available, each structure’s advantage, risk and liability and how to create each structure (including their costs).
Step 1 – Know the difference
There are essentially three main types of structure that you can adopt when beginning your business:
- a Sole Trader/ Business,
- a Company, or
- a Partnership.
When using the Sole Trade structure, all that is required is the registration of an Australian Business Number (ABN) and registration for GST. Under this structure, a person conducts their business alone, and typically only engages in small- to medium-sized ventures. A Sole Trader scenario does not create a separate legal entity, rather the business enters into a contract with another party in a personal capacity.
The Company structure creates a separate legal entity through the registration of a company and allocation of an Australian Company Number (ACN) with the Australian Securities and Investments Commission (ASIC). Directors and shareholders are nominated within the company’s structure. There are multiple types of companies that can be created, including companies limited by shares, limited by guarantee, or unlimited companies. The most common type, however, is the standard proprietary limited company where the shareholder’s liability is limited to the amount left unpaid on their respective shareholding. This structure can be utilised for any type of venture.
Finally, the Partnership structure consists of the combining of resources and expertise between persons through mutual agreement to carry on a business in common with a view of profit. Each partner is then essentially an agent for the remaining partners. This structure does not in itself create a separate legal entity.
Step 2 – Know the advantages, risks and liability of your structure
Each structure has various advantages and risks associated with them.
The Sole Trader structure is relatively simple, given that one person is in control of all finances and decisions. The initial start-up costs are relatively low; all income is paid to the business owner; there are less statutory frameworks and rules that require compliance; and in certain circumstances, losses of the business can be offset against the profits of the business. These are also easy to dissolve should the business owner wish to cease trading.
The business owner in a sole trader structure is, however, personally liable for all claims and debts related to the business. It is typical for all funds raised for the business in the operation to be provided through personal loans. It is also potentially more difficult to raise funds for the business, given that the only guarantee which can be given extends to the assets held personally by the business owner.
The Company structure is more complex and heavily regulated by legislation. This structure has higher initial start-up costs, as a company constitution is required in addition to registration. While legislation provides for specific rules to fill the gaps in a company constitution, it is prudent to ensure that the constitution is drafted to suit the specific company. A standard constitution can be obtained, or the appropriate version can be drafted by a lawyer.
Directors typically make all decisions for the company unless the company’s constitution requires particular decisions to be voted upon by its shareholders in a general meeting. The company then enters into all contractual arrangements as a separate entity rather than as an individual.
The profits made by the company are also distributed to its shareholders depending on the class of shares they hold. In a typical company, the directors are the only shareholders and therefore obtain the profits. This can be altered if the company constitution provides otherwise. Further, the shareholder’s liability at any point is limited; should the company become financially unstable, an individual shareholder cannot not liable for the complete debt, only for the amount left owing on their shares.
A company can also issue shares to raise further capital to progress the company, and generally pays a lower rate of tax.
Losses are borne solely by the company, as legal arrangements are entered in to in the company name. This will apply unless personal guarantees have been given by directors indemnifying a third party for money owed, or the company has traded whilst insolvent
There are, however, more stringent obligations imposed on a Company than any other structure. Company documents must be compliant with the relevant legislation, and detailed records must be kept. Further, the company is obligated to specific disclosure and mandatory reporting obligations throughout its life.
The company’s director or directors are also obligated to act in a particular manner, given that they owe a fiduciary relationship to the company as a whole. They must ensure that they act in the best interest of the company, that they act in good faith, and that they do not misuse information or take advantage. Breaching these obligations can result in a breach of civil penalty provisions which can lead to heavy fines or imprisonment.
The Partnership structure is generally a more complex business structure, as a partnership agreement is typically a detailed document that needs to outline each partner’s rights and obligations within the partnership. The partnership must obtain it’s own Tax File Number and can apply for an ABN, the costs of these are relatively minimal.
This structure is also governed by statutory framework, however the requirements are not as strict as a company regarding reporting and disclosure obligations.
A Partnership arrangement works best when established persons combine their resources for a mutual purpose, and limit their liability and authority through strict agreement. Failing to do so results in each partner being jointly and severally liable for the actions of the other partner, whether they are aware of them or not. Each partner is also given the right to participate in the management of the partnership unless otherwise agreed, or an incorporated limited partnership is formed.
It is important to note that although a partnership does revolve around a partnership agreement (somewhat similar to a company’s constitution), it is not in itself a separate legal entity because each partner is an authorised agent for the other.
Profits from the partnership are distributed in accordance with the partnership agreement, regardless of the contribution of funds made by each partner. This is the same situation for losses incurred by the partnership. Liability for loss or any claim that may be relative is shared equally between partners, although losses can be offset against a partner’s alternative income in certain circumstances.
When a person wishes to leave a partnership arrangement, they must do so by agreement between the partners or in accordance with the mechanisms of the partnership agreement. This is the same situation should a partner wish to join.
The partners are obligated to act in a particular manner, given that they owe a fiduciary relationship to each of the other partners. They must ensure that they act in the best interest of the partnership; act in good faith; and do not misuse information, take advantage, compete, or gain a benefit from the partnership agreement outside the other partners.
Capital for the partnership is more difficult to raise as the partnership cannot offer shares to shareholders in return for funds. Instead, each partner would need to contribute funds from their own personal borrowing facility which incurs personal liability.
Step 3 –Create the structure
In order to create each type of structure, there are different processes that must be followed, and various costs incurred.
When creating a Sole Trader structure, all that is essentially required is the registration of an ABN and registration of GST. At present, there is no fee for this application.
Creating a Company structure is more in-depth. The type of company must firstly be selected (typically a proprietary limited company). The directors and initial shareholders must then provide their written consent; the constitution must be drafted (or alternatively replaceable rules can be adopted); and the lodgement and registration fees must be paid to ASIC.
If your company wishes to have a more tailored company constitution, it is recommended that a solicitor create a document that suits your needs.
When creating a Partnership structure the only real requirements are the registration of a Tax File Number, and ABN for the partnership if needed in addition to a partnership agreement. However, a prudent person would draft a complete partnership agreement in order to ensure that all obligations and rights of each partner are dealt with appropriately.
At Streten Mason lawyers we can assist you in finding and creating your appropriate business structure and complete all steps in the process.