There are several considerations when deciding which business entity is best for your company.
The correct business entity will depend on your business objectives, need for asset protection, exit planning strategy, financial goals, and tax planning issues.
As this article primarily applies to starting a new business, you would want to know more about the Pros and Cons of each business entity before you invest money, time, and resources to build your business.
So, let’s get started.
The 4 common business entities.
Before we answer, here are some questions to help you choose the correct business entity for your company.
- What kind of business do you want to start?
- Will you be the sole director, or is there another co-owner to share the load? If so,
- What is the equity/ profit split?
- And what kind of business exit strategy do you have in mind?
It is essential to consider these questions as it can be costly and time-consuming to swap/ change to a different entity halfway through your business journey. Such as completing a new set of authority, account/ client, and application forms for your Bank, telephone company, your service providers, and relevant stakeholders.
So choose wisely.
Here are four (4) general entities to choose from.
- Pty Ltd Company
- Sole Trader
- Partnership
- Trust
DISCLAIMER: For more information, speak to your Accountant or Commercial Solicitor. The information provided above is for educational and information purposes only and is not intended to replace paid professional advice.
Proprietary Limited Company (Pty Ltd)
Pty Ltd stands for Proprietary Limited company. With this entity, you can have limited members as shareholders, usually formed to acquire profit. The Corporations Law binds it.
Specifically, there can only be a maximum of 50 shareholders in a proprietary limited company, and such a company is privately held and not open to the general public to purchase.
A sole proprietorship risks your assets if claims or debts are not paid, which is not the case here. With Pty Ltd, there will be a limited liability (not zero liability) to the assets if your business proceeds to liquidation. If you have borrowed from the Bank or other financiers, you cannot escape paying your debt. Similarly, the director cannot hide behind the Company if one commits fraud.
Benefits:
- It is a separate legal entity
- Most business owners who operate under this entity intend to limit their losses and protect their wealth in case of business liquidation. However, should a business owner intends to avoid paying their creditors and suppliers who render services for their business and manage to escape it, there will be karmic retribution and consequence along the pathway.
- Convey a professional corporate status.
- Limit your liability as an individual.
- The business operations are controlled by directors and owned by the shareholders, meaning members have limited liability.
- Set up costs $1200-1500 AUD at the time of writing.
Disadvantages:
- Pay ASIC fees, tax Returns costs, record-keeping, and comply with the Corporation Law.
- You can be fined a hefty penalty if you forget to pay the ASIC fee.
- It is a separate entity comprised of other members, meaning you do not have ultimate control if you have multiple owners.
Sole Trader
Operating as a sole trader can be viable for those looking for a low-cost business structure. It is also a business entity that requires business owners to keep financial records of at least five years.
The major drawback with this entity is to be 100% liable for the whole company’s debt and losses
Benefits:
- It entails fewer reporting requirements and is often less expensive
- doesn’t need a separate business bank account but is encouraged to open one to manage income and expenses separately.
- It enables you to file your tax returns using your tax file number (TFN).
Disadvantages:
- Uncapped liability to your name if your business files for liquidation, and you may file for bankruptcy.
- It does not permit sharing company gains or losses with relatives
- to obligate you to pay tax on all of your company’s earnings.
- It has unlimited liability, and all your assets are at risk if things go wrong.
Partnership
A partnership entity is when Two or more people enter into a formal legal connection known as a partnership to do business. It is like a marriage contract but without intimate activities.
Here are the pros and cons of being in a partnership before jumping onto the wagon together:
Benefits:
- shared profits and benefits (depending on the agreed ratio)
- shared or designated contributions and workloads (presumably)
- everything (entitlement, profits, benefits) is shared legally
- each partner pays tax on their share ratio or net partnership income.
- Each partner would manage their superannuation.
Disadvantages:
- Shared liabilities and losses
- If your partner took out a loan under a Partnership agreement and ghosted you, you’re responsible for repaying the loan.
- Requires separate tax file numbers (TFN), considering two or more individuals are running a business
With these disadvantages, you might be thinking of why you should still be in a partnership. There are many ways to “partner” without being held liable if one partner decides to flee the scene.
But there are always exceptions to the rule. Therefore, here are three types of partnerships for your reference.
General partnership (GP)
– where partners have equal responsibility for the business’s administration and are personally liable for any debts or obligations the company may incur.
Limited partnership (LP)
– is made up of general partners who are only liable for the money they have invested in the partnership, not their debts. Limited partners are typically passive investors with no say in the company’s day-to-day operation.
Incorporated Limited Partnership (ILP)
– must have at least one general partner with unlimited responsibility. The general partner (or partners) is personally accountable for the difference if the corporation cannot meet its obligations.
Discretionary Trust
Business owners often set up business or family discretionary Trusts for asset protection. Discretionary Trust allows the trustee the discretion to decide and allocate an agreed benefit (monetary or asset) to the beneficiaries (trust recipients)
Sometimes the beneficiaries: trust recipients, fund receivers, heir/ heiress, and inheritors, can often claim that they have control and rights of a particular Company, Real Estate, Asset, or IP, but they do not own it legally, hence giving them the asset protection.
Benefits:
- A way to reduce tax by distributing income to beneficiaries using the discretionary framework
- Asset protection
Disadvantages:
- A Trust Surcharge might be at two or three times the standard rate multiplier if your property is under a trust. Check with your local Council.
- That means, if your standard land tax for the year was $1000, by adding a Trust Surcharge, you get billed for $2500 – $3000
- If you want to set up a bank or supplier account, you need to provide extra documentation as suppliers or creditors, as banks are more administratively cautious with Trust.
- It would cost $1500-2,000 AUD at the time of writing to set up a standardised templated Trust Deed.
Besides discretionary Trust, there are two (2) other common types of Trust.
- Property Trust
- Unit Trust
We will not discuss it as business owners rarely use these trusts for typical business set-ups unless they are in real estate and involved in significant acquisitions and mergers.
If you want to set up a Trust, your Accountant or legal advisor can set this up for you. However, if you need to insert or tweak a customise clause in the Trust Deed to suit your business and life strategy, do expect to pay their professional hourly fee for this service.
Conclusion
Choosing the correct business entity for your requirements is crucial to the success and growth of your company. We think the best business entity will depend on your goals.
With the correct business entity, you can protect the value of your business and not just the assets held in it. You also want to choose the entity that makes sense for your business.
By referring to your business needs, you have four options: a trust, sole trader, partnerships and proprietor limited companies. There are both advantages and downsides to each type of company entity, so choosing the correct one is critical.
You’ll need to make sure you’re in the right business entity for your business before you can begin operating. If you don’t, it’s not just a waste of time and money—it can also be costly in terms of penalties and even legal trouble.
Whatever your business structure is, you will always need a solid business plan. Let us help you come up with your own. Click on this link to learn more > eBook Business Planning for more information.
DISCLAIMER: For more information, speak to your Accountant or Commercial Solicitor. The information provided above is for educational and information purposes only and is not intended to replace paid professional advice.
