What legal structure should you use for your organisation?
If you are thinking of starting a business or not-for-profit organisation you need to consider the pros and cons of the different structures available to you.
Each legal structure has different requirements and can affect the tax you’re liable to pay, asset protection and ongoing costs.
For this reason you should seek advice from a professional business adviser such as a lawyer or an accountant before deciding what legal structure to use.
Before you speak to a professional though you may like to gain a basic understanding of these legal structures. In Australia you can get information from the Australian Taxation Office. You can also review small business resource sites specific to your state or territory. A list of small business sites in Australia and New Zealand can be found here.
Here is our brief overview of the five structures to consider for your business or not-for-profit in Australia.
1. Sole trader
A sole trader structure may suit you if you wish to operate your business alone (without any partners, including your spouse). It is often the simplest and least expensive business structure with fewer legal and tax formalities.
As a sole trader you maintain control over the management of your business, its profits and assets.
You’re not required to disclose your profits to the public and taxation can be easier to calculate – you can use your individual Tax File Number (TFN).
One of the disadvantages though of a sole trader structure is that you are solely liable for your business debts, which could put your personal assets at risk if you’re unable to pay your debts.
Additionally, since you pay tax on profits at your marginal tax rate, it may be higher than the company tax rate. This structure also limits future expansion.
A partnership is a structure for 2 or more people who carry on a business as partners or receive income jointly.
It is usually fairly inexpensive to set up and operate but like the sole trader structure, a partnership entity is not separate from its operators. Additionally if you carry on a business under a name that is not the names of each partner, you must register the business name with ASIC.
A partnership agreement should be developed with the advice of a qualified professional such as an accountant or solicitor. Profits and losses are shared between partners according to his/her share as set out in your partnership agreement.
You’re not required to disclose your profits to the public and it’s fairly simple to change the structure in the future to manage expansion.
Like the sole trader structure, all the partners are responsible for business debts, with each partner liable for the other partners’ debts.
Tax is charged at the personal tax rate with each individual partner paying tax on the share of profit they receive. The partnership has its own TFN and must lodge an annual partnership return showing all income and deductions of the business.
A company is a distinct legal entity separate from its shareholders or officers. That is, the company has the same rights and responsibilities as a natural person and can incur debt, sue and be sued. This means the company’s owners (the shareholders) can limit their personal liability and are generally not liable for company debts.
In Australia, the most common types of company are ‘proprietary limited’ companies (Pty Ltd) that don’t issue shares to the general public and ‘public’ companies that may raise or borrow money by issuing shares to the public.
One of the most common small business scenarios is when a person or people (for example, a husband and wife, or two friends) sets up a Pty Ltd company and become directors and shareholders with an initial share offering of a small amount such as $1 for each share.
Setting up and running a company is more complex and costly than other business structures. All companies must apply for a TFN and be registered with ASIC, which plays a governing and regulator role. Public companies must also comply with the rules of the Australian Stock Exchange.
The tax rate for companies is less than the highest rate for individuals. Profits distributed by companies to shareholders are taxable. Companies must lodge an annual company tax return showing income, deductions and income tax liable to pay.
While a company provides some personal asset protection, directors are still be legally liable for their actions and, depending on their actions ca be held liable for the debts of a company.
A trust is not a separate legal entity. It is a relationship where a trustee (an individual or a company) carries on business for the benefit of other people (the beneficiaries). A trust may be discretionary (the trustee decides how profit will be distributed among beneficiaries) or have fixed interests (it will benefit certain people in predetermined proportions).
A fairly common trust scenario may be where a trustee operates a business for the benefit of a particular family and distributes the yearly profit to them. This business structure can be more tax effective than others and can be useful for protecting the income or assets of a young person or a family unit.
A trust provides some asset protection with beneficiaries generally not liable for the trust debts, unlike sole traders or partnerships.
Profits from the trust go to beneficiaries who must pay tax on income they receive from a trust at their own marginal rates.
Establishing a trust is more costly and complex than other business structures and must be set up by a qualified solicitor or accountant. A trust deed must be created and annual administrative tasks completed.
While a trust does not need to register with ASIC (unless the trustee is a company), there are extensive regulations that it must comply with.
A trust must have its own TFN for lodging its annual tax return and must show all income and deductions of the business, plus any distributions to its beneficiaries.
5. Not-for-Profit Organisation
While not considered a typical business, setting up a not-for-profit organisation still requires a legal structure.
The structure will affect the way you hold meetings, the minimum number of members, reporting requirements, tax obligations, cost and other considerations.
Types of not-for-profit structures include:
- Unincorporated associations – this structure is not recognised as a separate legal entity to the members associated with it. The group can remain informal and its members make their own rules on how the group is managed. It is an entity under tax law and treated as a company for income tax purposes.
- Incorporated associations – the is a legal entity separate from its individual members. They incorporated under the state or territory legislation in which they operate. An incorporated association can continue regardless of changes to membership and provides financial protection by usually limiting personal liability to outstanding membership and subscription fees, or to a guarantee.
- Companies registered under the Corporations Act 2001 – these organisations must be registered with ASIC and can include public companies limited by guarantee, proprietary companies limited by shares, registered Australian bodies, and foreign companies, such as a charity formed or incorporated overseas but registered to carry on business in Australia.
- Cooperatives – a cooperative is a type of entity which exists for the benefit of its members. It is only suitable as a not-for-profit legal structure if it has rules to prevent surpluses or profits being distributed to members.
- Indigenous corporations – Aboriginal and Torres Strait Islander organisations can apply to be registered as a separate legal entity with Office of the Registrar of Indigenous Corporations (ORIC) under the Corporations (Aboriginal and Torres Strait Islander) Act 2006 (CATSI Act). They are only suitable as an not-for-profit legal structure if they have rules to prevent surpluses or profits being distributed to members.
Before deciding which legal structure to use you should seek advice from a professional business adviser such as a lawyer or an accountant.
As legislation varies from state to state and countries you should visit your relevant small business sites to learn about your requirements. A list of small business sites in Australia and New Zealand can be found here.
When it comes to business structures you should also consider if Personal services income (PSI) may apply to you. That is, if you’re paid mostly for your personal efforts, skills or expertise, (as opposed to products) you may be receiving PSI, which can affect your deductions and income reporting requirements. A company or trust though may treat income and deductions relating to PSI differently.
Don’t forget to check out our 5 Steps to Starting a Business.