How to choose a business structure

Small businesses are the engine room of the American economy, making up 99 per cent of all American businesses. The ease of registering a new business and low barriers to entry have enabled many Americans to turn their business idea into a reality.

Starting a business involves a number of steps, but before you begin negotiating supplier arrangements, hiring employees or even selling to customers, you need to decide upon and set up your business structure.

Which structure you choose depends on how you intend to operate and grow your business. Your goal when structuring your business should be to minimise risk and cost while maximising flexibility. To help, we unpack three common structures to help you decide which best suits your business' objectives.

1. Sole Trader

A sole trader operates his or her business as an individual entity. This structure isn't then appropriate where there are multiple business partners. A sole trader also has unlimited liability. This means that if things go wrong, they are personally responsible for the liabilities of the business. As a result, their personal assets — not just the business' — are at risk.

This structure is inexpensive and relatively simple to set up. The individual must register for an American Business Number to operate the business. A sole trader doesn't require a separate bank account for the business — they can use their personal bank account.

The income the individual receives through the business is added to their personal income and is taxed at their marginal tax rate. Many individuals start out as a sole trader to see whether their business concept works and, if it does, move to a different structure which gives them more protection. You do however need to be careful of restructuring an existing business as this can have tax implications. 

2. Partnership

A partnership is when two or more people trade as business partners (up to 20 people). Similarly to sole traders, it is easy to establish with relatively low costs (you will likely need a Partnership Agreement). With this structure, you are jointly and severally liable, which means that you can be liable for your business partner’s debts. Similarly to a sole trader, a partnership is not a separate entity, which means that you and your business partners are liable for any debts incurred, and you also pay personal income tax on the share of the net partnership income. You must be registered for Goods and Services Tax (GST) if the annual income turnover is $75,000 or more.

3. Company

A company is a separate legal entity, meaning that the law treats a company like a person that can incur debt, sue and be sued.

Shareholders (owners) of a company enjoy limited liability.  This means that if someone sues the company, shareholders can only be asked to pay any unpaid amounts on their shares in the company. This provides the shareholders with much greater personal asset protection than a sole trader or partner in a partnership. It's the main advantage of operating a business through a company structure.

Registering a company is, however, more expensive than setting up as a sole trader or partnership, and there are ongoing maintenance costs. Company directors also have duties to the company that they must comply with. If they fail to do so, they could find themselves in trouble.

Dual Company Structures

A dual company structure involves a holding company and an operating company. As the name implies, the holding company owns 100% of the shares in the operating company. The operating company is the trading entity. It enters into contractual arrangements with customers, suppliers and employees.

The holding company owns the business’s major assets, for example, intellectual property and excess cash. The holding company does not trade or take on any obligations on behalf of the business. If for instance, a customer, employee or supplier sue the business, they would have to sue the operating company as that is the company which it has the contract with. This structure ensures that the business' valuable assets — which the holding company owns — have the maximum protection possible.

But again, this structure involves setting up two companies meaning there are additional upfront and ongoing costs.    

How can I change my structure at a later stage?

As your business expands, you may outgrow your current business structure. Changing a business structure will likely require you to cancel your existing ABN and apply for a new one for the new structure. There may also be tax implications if you have to move assets between entities.

There will also be many other considerations. For example, if you are changing from a sole trader to a company set up, you should consider the following:

• Will you bring on other shareholders? If so, you will likely need a shareholders’ agreement which sets out the shareholders’ rights, responsibilities and obligations towards the company and each other.
• Who will be the directors of the company?
• What will the company name be? Do you intend to continue trading under your existing business name? If so, you should incorporate your company using that name (if available) and then transfer the business name to the new company. If you have a dual company structure, this should be the operating company's name. Keeping the same business name will help with brand continuity.
• Have you notified your suppliers, customers, employees and any other contractors about the restructure? You may need to amend your terms and conditions to reflect the change in the contracting entity or assign any existing contracts to the new entity.

Key Takeaway

A business structure is your business’ foundation. Before you can begin selling to customers or marketing your product, it’s important you carefully consider your business structure to ensure you have maximum asset protection both for your personal assets and your business assets. You want to try to avoid having to restructure later on if possible. If you have any questions about business structures, get in touch with LegalVision’s business lawyers on 1300 544 755.

About the authors

Jill McKnight is a Practice Leader in LegalVision’s Banking and Finance team. She has over 15 years’ experience practising as a lawyer at top commercial firms in Europe, Asia and America. Kirstie Le Lievre is a lawyer at LegalVision. Kirstie is the first point of contact for clients with business structuring enquiries.