Many entrepreneurs choose the organizational form of their business based on what seems to be the easiest solution at the moment.
The truth, however, is that the optimal form of organization depends on the life cycle of the business, as well as on the financial capabilities and goals of the founder. In order to answer the question of what is better for a particular company, let’s take a closer look at how the four classic forms of organization differ from each other in 5 key areas:
sole proprietorship,
partnership,
corporation,
limited liability company.
What each structure does to your liability
Sole proprietorship is, in many ways, the simplest way to start a business. There is virtually no setup cost. Moreover, the reporting requirements are minimal, thus enabling you to start earning money right away. However, you should understand that in terms of liability, you and your business are one and the same. If the business has debts, these are your debts. If the business is being sued, you are being sued. If the business fails and you have to pay off a 200 thousand dollar debt to your supplier, they have every right to take your home, car, and other personal assets.
One of the main advantages of a Proprietary Limited Company (Pty Ltd) is that a company is a separate legal entity that owns its assets, incurs liabilities, makes contracts, and sues and is sued. Pty Ltd provides you with the coveted protection of limited liability. In other words, the company’s debts and obligations are the company’s own debts and obligations. Creditors cannot simply come to your house and take your personal assets. Nevertheless, there are exceptions, including situations where directors intentionally place the company in a state of insolvency in order to hide its assets. Apart from that, it is essential to remember that when choosing this form of organization, you must separate your personal and business assets.
Partnership, in turn, is a middle ground between a sole proprietorship and a company. Two or more people run the business, sharing both profits and liabilities. This is beneficial, but if one of your partners invests some money in cryptocurrency and then goes bankrupt, you will have to cover the costs.
Other differences in the context of taxes
Some differences are much bigger than others. For example, everyone knows that companies pay less taxes than other forms of business organization. However, there are significant differences even within the framework of companies. For example, a small business that pays tax as an individual entrepreneur will have to pay up to 45% in taxes if their income is significant. A company that falls under the category of a base rate entity, on the other hand, will pay only 25% in corporate tax. In addition, it is essential to highlight the potential for tax savings. By creating a company, you can save significantly on taxes by holding profits in the company and paying less tax when withdrawing these profits as a dividend.
Finally, trusts are another option. A trust is different from all the above forms of organization because, in a discretionary trust, the trustee must distribute income to beneficiaries. By setting up a trust, you can greatly reduce the tax burden, especially if you have several beneficiaries with low incomes. It is important to understand that the tax savings from using a trust are significant, but the cost of maintaining it is quite high. The benefits of a trust make sense when a family needs regular income from a business, while the income received by each beneficiary is within the tax-free allowance or the marginal tax rate is relatively low. Fortunately, there are also concessions for small businesses, including significant discounts on Capital Gains Tax (CGT) when selling a business or assets. These concessions can be particularly useful to small businesses that were operating for many years.
Setup costs and ongoing costs
A sole trader can be any individual who is engaged in entrepreneurial activity and who conducts transactions in their own name or under a different name (a company name). Sole trader does not require registration, unless it differs from the trader’s name, in which case it must be registered with the state. At the same time, a sole trader can operate under a company name (for example, John Smith trading as Professional and Co Accountants).
The trader must report income and expenses in their personal tax return and must pay tax at their own tax rate. A sole trader can offset losses against other income and pay no tax at all. It is important to note that superannuation is not paid on income received by a sole trader, while superannuation is withheld from payments to a sole trader if an employee works for them at the same time. Finally, a sole trader has unlimited liability for the debts of the business.
Unlike sole proprietorship, a Pty Ltd company must be registered, which entails mandatory costs. After registration, companies must pay an annual review fee, must maintain records in accordance with legislation, must prepare financial statements, and must comply with other requirements, including director duties under the Corporations Act 2001.
The duties of a director of a company are to act in the interests of the company, avoid conflicts of interest, and prevent the company from entering into transactions with related entities, as well as to exercise due diligence when making decisions. On the one hand, this is useful for structuring a business, since it prevents fraudulent actions on the part of the directors, such as transferring the property of the company to their own. On the other hand, these duties must be fulfilled by the directors of the company, which places additional restrictions on them compared to employees of a sole proprietorship.
The issue of costs is a controversial one. Naturally, running a company is more expensive and more complicated than running a sole proprietorship. Therefore, whether it is cost-effective to use this form of organization depends on the specific situation and the size of the business.
Differences in terms of equity, raising investments, and future plans
If the goal of raising funds is to develop the company, then it is necessary to approach this question with an honest assessment of its current capabilities. If the founder understands that the business cannot continue for more than 2-3 years relying only on their own efforts and current assets, then it is necessary to think about the choice of the form of organization from the beginning. The best option in this case is to use the structure of a Pty Ltd company.
It is this structure that allows one to attract new investors most easily, since, for example, a sole proprietorship does not provide for the possibility of raising funds through shares. It is easier to raise funds within the framework of a partnership, but this type of structure is more suitable for situations when the founder wants to continue to develop the business on a small scale. At the same time, it is essential to consider that both partnership and sole proprietorship imply joint liability, which can be a decisive factor when choosing a form of organization. Finally, raising funds within the framework of a Pty Ltd company allows you to provide investors with a wide choice of assets: you can offer shares in the company, leave the option of an employee share scheme open, and much more.
When does the family law intervene in the affairs of a Private Company?
Most business structure guides completely ignore this issue, and the founders of small companies, in most cases, do not know what to do when their business is affected by a family dispute. Statistics published by Australian Bureau of Statistics (ABS) in 2023 showed that approximately 50-55% of businesses survive for four or more years. Thus, in half of the cases, one way or another, the business fails in the first four years. In addition to purely business factors (pricing, management, etc.), there are also family factors behind this rather low indicator. It is not always the problem of internal policy or the lack of vision that leads to the bankruptcy of small businesses. The dissolution of a family or relationship problems can have the same effect on the development of a business as financial difficulties.
The Federal Circuit and Family Court of Australia (FCFCOA) has wide jurisdiction in the division of property in the event of a separation. In particular, Section 79 of the Family Law Act 1975 allows the Court to modify the property interests between the parties to the marriage. At the same time, it is crucial to understand that both the Family Court and the AAT (Administrative Appeals Tribunal) are guided by the idea that in the context of a property dispute, the legal fiction of separate legal personalities is ignored. The court does not recognize trusts as separate legal entities; the court does not recognize a Pty Ltd company as a separate legal entity. All transactions are considered in relation to actual assets and liabilities.
When it comes to business partnerships, the situation is similar and no less problematic. A dispute between business partners is no different from a dispute between former spouses in terms of complexity and consequences. When a business was originally created between family members (spouses, siblings, and parent-child), a divorce may also lead to the breakup of the business because of family discord. The only difference is that sometimes such disagreements are resolved amicably: with the help of lawyers, for example, Bell Lawyers has extensive experience in resolving such disputes through mediation.
In this situation, the difference between a dispute between entrepreneurs who are also spouses and a dispute between independent entrepreneurs is manifested only in the nuances of the dispute resolution process. Spouses in dispute will have to decide whether to go to court or resolve their problems through mediation. The mediation process preserves the possibility for the company to continue to exist, as well as to achieve the parties’ agreement on certain issues. It should also be noted that in comparison with litigation, mediation is much faster and cheaper, and is therefore a preferable option for resolving disputes between entrepreneurs in any relationship.
It is always necessary to consider that family disagreements can damage the company, and therefore the founder should take this aspect of law into account when selecting the form of his organization. Moreover, the more partners there are in the organization, the higher the risks associated with potential disagreement. The more complex the structure of the organization is, the higher the risk of problems associated with its collapse.
When and why to change the structure as the business grows
The decision on what structure the business should use in the long run should be carefully made taking into account all aspects of the business. The option of using the structure of a sole proprietorship will be cost-effective only if the business is indeed small and the risks incurred are low. The decision to use a Pty Ltd company is made based on the opposite reasoning: if you want to minimize the risks, you need to separate your business from your personal funds. At the same time, it is often wrong to confuse these two concepts when selecting the form of organization.
The decision to change from the structure of a sole proprietorship to the structure of a company is final and should be made only when the potential risks exceed the potential benefits. The longer a business operates as a sole proprietorship, the more the risks increase as the assets of the sole proprietor increase. However, it is important to note that moving from one structure to another is a decision that requires careful consideration. If you structure your organization as a company, you may find yourself paying too much tax and incurring extra expenses.
When calculating corporate tax, tax law provides small businesses with an opportunity to save significantly on taxes. For example, when moving from one structure to another (for example, from a sole proprietorship to a company), you can use the CGT relief by transferring assets from one entity to another without paying CGT. The way this works is as follows: a company is created, which in turn buys assets from your proprietorship at market price. This purchase will be treated as an asset disposal event for tax purposes, and the market value of the assets will be their cost base. Not all assets are eligible for CGT relief; in particular, shares and collectibles are excluded from the list of available assets. However, all the other assets (business stock, assets that decrease in value, and capital assets) are eligible for CGT relief. Cash is one of the assets that is not eligible for CGT relief; however, it is possible to transfer cash to a company within the framework of a loan account.
The optimal time to make the transition is when the business owner expects sustainable cash flows in the future and wants to take advantage of the CGT relief. However, this should be done before the urgent need arises when the transition to a new structure is associated with difficult financial problems for the organization.
How to structure your business in the long term
The choice of a structure for a young growing business is a rather complex task. It is important to consider that for the initial period, a sole proprietorship is acceptable only for the smallest and least risky business. However, the choice of a sole proprietorship should not be final since the transition to another structure (for example, a company) will allow you to save on taxes and protect your personal assets. In particular, if a small company has outgrown the sole proprietorship structure and has become a larger business, the transition to a company structure is appropriate. Nevertheless, when choosing this business structure, it is important to carefully consider the tax implications.
If the entrepreneur wants to attract new investors to participate in the development of the company, it is necessary to choose a structure according to this requirement as well. The structure of the sole proprietorship gives the entrepreneur no opportunities for raising funds, and the opportunity to attract new investors within the framework of a partnership is limited. The structure of a Pty Ltd company allows one to use a wide range of methods to raise funds: for example, to offer shares to new investors.
Using a trust is an option when the income of the company is stable, and there are multiple beneficiaries who need regular income. The tax benefits provided by a trust may be especially beneficial to families with several members: for example, if several adult children can receive some of the company’s income as income, the total tax burden for the family will be significantly lower.
The structure of the organization of a company is more predictable and safer in the sense of protecting one’s assets, while a trust can be a great way to optimize taxes within the framework of a single family. However, it is wrong to treat these two tools as mutually exclusive, since they can and do work together. The creation of a trust within the framework of a company allows you to use the benefits of both structures at once. This will allow you to protect the assets of the company, as well as optimize the tax liabilities of the company and the family as a whole.
