Explain why the legal structure a business starts out with may not suit its needs as it grows

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Much will depend on how many people will be involved, whether you’ll need to hire others, the nature of the business, how much income you think it’s going to bring in, and how you plan to grow in the future.
 

The costs and risks of each legal structure are quite different. You should think about issues such as your time, money and the paperwork required when deciding which business structure to choose. This structure will also determine what registrations and applications are required.

What acronyms will I come across in this article?

• TFN – tax file number
• ABN – Australian Business Number
• ACN – Australian Company Number
• ASIC - Australian Securities & Investment Commission
• ATO – Australian Taxation Office

What are the different types of business structure?

There are four main types of business structure. Before choosing which is right for you, review the differences between each and consider their pros and cons.
 

1. Sole Trader

As a sole trader, you are the sole owner of your business and have full control over it. The business can trade under your legal name (such as Oliver Smith) or a business name (such as Oliver Smith Plumbing). If you choose a business name you must register it with ASIC.
 

The income you earn from the business is treated as your own, so you will pay tax at your individual tax rate. As a sole trader you can employ others to help you, but this will come with obligations such as providing worker’s compensation insurance and paying super.
 

As a sole trader you don’t have to have a business bank account1, but it’s a good idea to get one to keep your business dealings separate from your personal finances.
 

2. Partnership

If you are considering setting up a partnership, your business will be owned by two or more partners, with income received jointly. In creating the partnership you’ll need to draw up an agreement or contract covering areas such as salaries, drawings, profit share, loan agreements, termination clauses, if new partners can be admitted, how books are kept and how disputes are settled and losses handled.
 

Your partnership will need its own ABN and TFN, plus a bank account that’s separate from any of the partners’ personal accounts. Each partner pays tax on their share of the net partnership income.
 

3. Trust

A trust is an entity that holds property or income for the benefit of others. If you operate your business as a trust, the trustee (which can be a company, providing some asset protection) is legally responsible for its operations.

Trusts can be complex to set up and administer, so you should check with your solicitor on whether it suits your individual circumstances. If you go ahead, you will need an ABN and a TFN in the name of the trust.
 

4. Company

The words ‘Pty Ltd’ after a business name, indicate that it’s a registered legal entity trading in its own right. Your company will have shareholders (who invested when the business first started, or along the way) and directors (people appointed by the company to run it).
 

Profits are either shared out among the shareholders in the form of dividends or reinvested in the company. Directors can be asked to give personal guarantees to cover any debts incurred.
 

You’ll need to register the company with ASIC, which will then issue you with an ACN. Your company will need its own TFN to lodge its annual income tax return, and may need its own ABN for trading purposes.
 

Do I need an ABN or an ACN?

Once you have decided on a business structure, you’ll need to think about the registrations and applications required. Here’s an overview plus a reminder of what those acronyms stand for.
 

If you are in business, you should apply for an Australian Business Number (ABN). It is a unique number assigned by the Australian Tax Office (ATO) to all business types including sole trader and partnership.

If you’re required to be registered for GST (see below) you must have an ABN. But even if you don’t charge GST, you should still feature an ABN on purchase orders and invoices – otherwise those paying you may be obliged to withhold tax at the highest marginal rate.

If you are setting up your business using a company structure (as opposed to a sole trader or partnership structure) you need to apply for an Australian Company Number (ACN). It too is a unique number, this time assigned by the Australian Securities and Investment Commission (ASIC) following registration of a company.

Do I need to register for GST?

If your projected annual turnover is going to be $75,000 or above, or you drive a taxi or are involved in hire cars or intend to claim fuel tax credits, you will need to apply for an ABN and register for GST.

How should I make the final decision on business structure?

Each business structure becomes more complex as you move through the list above, particularly trusts. There are different tax concessions and reporting issues, which will vary by structure, by state and by industry. And they keep changing.
 

If you’re unsure or undecided, your accountant and financial adviser will be able to explain which structure is the most suitable for you – and help you manage the issues for each one.
 

Once you have decided what structure your business will have, you can carry out all the necessary applications and registrations in one place.
 

This webinar is produced by the Davidson Institute, Westpac's home of free financial education resources, building confidence today for a better financial future.

A business structure is a legal entity. Business.gov.au can help you decide which business structure best suits you needs. In Australia, which is typical of developed economies in this respect, the following main choices exist:

Sole trader

This is an individual, a person, who has legal responsibility for all aspects of the business, including any debts and losses, which cannot be shared.

Despite the word ‘sole’, a sole trader may employ others in his/her business.

This is the simplest and least expensive business structure, with maximum personal control. Changing it to an alternative business structure is simple. Thus it may be attractive for IP ventures at an early pre-commercialisation stage, or for micro ventures.

However, it can have disadvantages:

• it does not permit multiple entities to share ownership or control , which can be unacceptable to IP venture funders and other venture participants.
• it has unlimited liability; all the sole trader’s personal assets (not just business assets) are at risk if the business fails.
• business profits or losses cannot be split with family members in order to take advantage of a common tax arrangement that allows a reduction in tax payable.

These three disadvantages are addressed to variable extent in each of the alternative business structures described below.

Partnership

A partnership is a business structure in which two or more people carry on a business together. A written partnership agreement is prudent but not mandatory.

A partnership may overcome disadvantage (a) listed above in an inexpensive manner, but it still suffers from disadvantages (b) and (c). Therefore it is likely to be attractive for IP ventures only at a pre-commercialisation stage, or for micro ventures.

The partnership may employ people who are not partners. The partners share income, losses and control of the business. As with a sole trader entity, it’s not legally separate from the people in it, meaning each partner is personally liable for partnership debts, including their share of the partnership tax obligations.

Private company (Proprietary company)

A private company is a legal entity with, for control purposes, at least one person as a director who has responsibilities governed by the Corporations Act 2001. It has at least one shareholder, not necessarily a person, as owner(s). Unlike a sole trader or a partnership, it’s a separate entity from its directors and shareholders – profits, losses and tax obligations belong to the company.

Shares may be sold, but not publicly.

The Australian Securities and Investments Commission (ASIC) regulates companies. Each company has its own set of rules, its constitution.

Pty Ltd is an abbreviation for Proprietary Limited that is often placed at the end of the company name. ‘Proprietary’ means the company is privately held and ‘Limited’ means the liability of each shareholder to pay company debts is limited to the amount unpaid (if any) for his/her shares in it. (Proprietary companies can by choice be unlimited.) Most small companies in Australia are Pty Ltd companies.

A Pty Ltd company almost comprehensively overcomes disadvantages (a) and (b) mentioned above, i.e. excessively limited control and ownership, and unlimited personal liability.

Further, particularly in combination with the use of trusts (described below), the tax-related disadvantage (c) is alleviated in companies.

A private company is relatively complex and expensive to establish and maintain. However, for on-going small-to-medium IP ventures, it’s a highly practical, flexible and robust business structure.

Public company

Unlike private companies, public companies may sell their shares publicly.

They may be ‘listed’ or ‘unlisted’. Listed public companies are included in the official list of a prescribed financial market such as the Australian Securities Exchange (ASX) where their shares can be bought and sold by the public. 

For large IP ventures in particular, this business structure may facilitate the raising of funds by increasing the number of potential shareholders.

A disadvantage when a company is publicly listed is that shareholders usually demand some control in a manner that may be difficult for the original venture participants to manage.

In addition, because ownership is public, the conduct of the business must be transparently of high integrity; this increases the management workload and costs. A potentially disadvantageous consequence is that public companies must have at least three directors, two of whom must be Australian residents.

Trust

A trust is a business structure in which a legal obligation exists on a person or company, known as a ‘trustee’, to hold assets for the benefit of others, known as ‘beneficiaries’. The trustee is legally responsible for the business’ operations. It’s important to note that you cannot register a trade mark or design registration under the name of a Trust.

A formal trust deed is mandatory to define how the trust operates and who the beneficiaries are, so a trust is generally as complex as a company, but less flexible as regards control. Therefore it’s not usually appropriate as the main business entity for commercialisation.

However, when the trustee is a private company, the trust operates like a private company, and the beneficial features of a private company mentioned above can be realised for small ventures.  

Many trusts have an additional legal advantage: they enable a person who is a beneficiary to split his income amongst family members so that he/she can reduce the overall family tax payable (in contrast to disadvantage (c) mentioned above for sole traders).

This advantage is a significant consideration at the very beginning of a commercialisation venture. A person with shares in a company formed for commercialisation purposes may benefit by having his/her shareholding registered on behalf of a trust rather than him/herself.

Next step to consider: decide how to fund your idea.