It is quite simple to run your business in your own name, but there are four other types of legal entities to choose from: partnership, trust, self-managed superannuation fund, and company. Some entities may be more appropriate to your situation than others, but they can be complicated to understand initially. This post provides an overview of the five main types of legal entities and some basic advantages and disadvantages of each.
First a disclaimer: I’m not a lawyer, I’m a tax accountant, and I don’t know your specific situation. This post is for educational purposes only. Speak to your qualified legal or tax advisor.
If you are running your business through your own name, you are considered a sole trader.
This legal entity is very quick and cheap to set up. Simply register for an ABN (Australian Business Number) by filling out an online form for 15-20 minutes, and you are ready to go.
Preparing taxes is also relatively simple: the income and expenses from the business go on your personal tax return.
For these reasons, running your business as a sole trader is usually the best option in the beginning, when your business is showing little profit.
There are two major disadvantages to this structure. The first is that the net profit goes on your personal tax return, which means you can pay very high tax rates as your profit grows. The second disadvantage is that all of your assets are at risk if the business is taken to court, and there are some circumstances that can not be covered by insurance.
Due to the above disadvantages, it is often best to move to another legal entity as the business becomes more successful.
You can run the business in partnership with someone else, e.g. spouse, relative or other business partner. Legal and accounting firms used to run under a partnership structure, but now they generally use a trust or company structure.
Partnerships are almost as quick to set up as a sole trader. As part of the ABN registration process, you will also need to register for a TFN (Tax File Number) for the partnership.
The partnership needs a tax file number because it must lodge it’s own tax return, itemising how the the net profit or loss is split between the partners. These portions of net profit or loss appear on the partners’ personal tax returns, under the partnership/trust income section.
There are two major disadvantages with a partnership. The first is that adding or removing partners is difficult from a legal perspective, as well as the risks of partner conflicts. Most sources recommend drawing up a legally binding partnership agreement. The second disadvantage is that all partners are liable for the legal liability created by any one of the partners, so if one of your partners screws up, your personal assets could be at risk.
Due to the major disadvantages, I generally recommend against using the partnership structure.
A trust is created by a trust deed, which provides authority to a trustee to manage the trust’s assets on behalf of unitholders or beneficiaries.
There are two main types of trusts, fixed and discretionary. A fixed trust has unitholders who hold units in the trust, and the profit of the trust is distributed among the unitholders on the ratio of how many of the total units they hold.
A discretionary trust has beneficiaries, and the trustee can distribute the profit among the beneficiaries however they see fit. The term ‘beneficiaries’ usually includes close relatives of the beneficiaries that are written in the trust deed. A ‘family trust’ is a special kind of discretionary trust.
A trustee, unitholder or beneficiary can be any legal entity, and they can be changed much easier than partners in a partnership. There may be capital gains tax consequences for transferring units.
Trusts can be set up with a standardised, flexible trust deed for a fee. A custom trust deed prepared by a lawyer, can be very costly, but can help with later disputes. The initial cost to form a trust sometimes includes the cost of forming a company to be the trustee. A trust must also register for an ABN and a TFN.
A trust has to lodge it’s own tax return, like a partnership but more complicated. The distributions must be entered on the trust’s tax return, and they appear in the partnership/trust section of the recipients’ personal tax returns.
Many small businesses choose a family trust (or are advised to) due to the flexibility of distributing business profits to beneficiaries with lower/no income, such as non-working spouses or children.
The major disadvantage of trusts is that trust law does not completely align with trust tax law, and both are constantly changing. Historically, trusts have a fixed life, linked to the life of the reigning monarch or a certain number of years.
Due to the above disadvantage, trusts can be a poor choice for running a business. However, they can be beneficial for people with significant financial resources.
Self-Managed Superannuation Fund (SMSF)
A self-managed superannuation fund (SMSF) is basically a special kind of trust, with a large number of rules and regulations in place to protect the members’ superannuation savings.
A SMSF can be expensive to set up, particularly if a company is formed to be the trustee. A SMSF must also register for an ABN and TFN.
SMSFs must prepare particular financial statements, submit to an audit to ensure compliance with regulations, and lodge a tax return. This can be expensive, compared to other legal entities.
A SMSF is a very poor choice for running a business, but the rules are changing all the time and it is best to speak to a specialist if you have questions.
A company is a separate legal entity owned by shareholders and run by directors. There can be one or more shares in the company, owned by one or more shareholders. There must be at least one director and one secretary/public officer, who can be the same person. The directors are appointed by shareholder vote and run the company on behalf of the shareholders. The director(s) and shareholder(s) can be the same individual(s).
There are many types of companies, but the two most common are limited (Ltd) and proprietary limited (Pty Ltd or P/L, not to be confused with “P&L” for profit & loss statement). Limited companies are generally used for larger businesses that want to list on a stock exchange or raise money (or borrow) from the public, so there are significant costs and regulations involved.
A proprietary limited company is commonly used by small-to-medium businesses that have achieved a certain level of profitability or complexity. These companies are fairly simple to run, but there is a cost to set up.
Companies must also register for their own ABN and TFN, and lodge an income tax return.
By carefully choosing who to issue shares to initially (and how), you can achieve the distribution flexibility of a trust without the constant legal changes. Changes to shareholders and directors are fairly simple, but there may be capital gains tax consequences for transferring shares.
Pty Ltd companies are increasingly common, particularly in specific industries, such as transport and construction. Sometimes this is part of an attempt to convert employees to contractors and save on employment costs, however the government is aware of this and various departments have put in place rules for determining who is an employee or contractor.
Pty Ltd companies are often a good legal entity for sole traders who have grown in profitability, so I have written a separate post about the details of this type of legal entity.
A reminder about my disclaimer: I’m not a lawyer, I’m a tax accountant, and I don’t know your specific situation. This post is for educational purposes only. Speak to your qualified legal or tax advisor.