Start-up legal basics: Getting the right structure
Over the coming weeks, StartupSmart will be running a five-part series that covers the legal basics involved in starting a business.
This first instalment, by Lachlan McKnight, CEO of LegalVision, looks at the crucial decision of choosing a legal structure for your venture.
Launching a new business is all-consuming. Unfortunately, in the rush to develop a viable product and sales strategy, many entrepreneurs forget to complete a crucial task: choosing an appropriate legal structure.
As with anything in life, choosing a legal structure requires trade-offs. The simpler structures (sole trader or partnership) are cheaper and easier to set up but less flexible in the long term.
Setting up a company, and potentially a family trust to hold your shares in it, is more complicated and expensive, but if your start-up does turn into the next Instagram you will benefit from your foresight.
This article will give you a brief rundown on the benefits and drawbacks of the three most popular structures in Australia – sole trader, partnership and company. We will then discuss the benefits of using a family/discretionary trust structure to hold the shares in your company.
Small and simple – sole trader
A sole trader is an individual who operates a business in their own name.
There are very few legal or taxation requirements to setting yourself up as a sole trader. A sole trader controls and manages the business. Any profits made during the operation of the business, as well as on its sale, are counted as the income of the individual who is the sole trader.
Setting yourself up as a sole trader can make sense if you’re launching a business that will generate limited revenue, you don’t plan on taking on many liabilities and you are operating in an industry where the risk of being sued is low. A good example would be a PR consultant who works by herself.
The key downside to being a sole trader is the fact that you, as an individual, take on all the risk of the business. This means that, for instance, you personally owe suppliers and lenders any unpaid amounts. Additionally, if you have a great year and generate over $180,000 in profit, a portion of your earnings will be taxed at the top marginal rate.
If you’re more successful than expected you could end up with a huge tax bill!
All together now – partnership
A partnership is a group of individuals and/or entities that run a business together as partners. Although a partnership is not a separate legal entity (and as a consequence each partner pays tax on their proportion of the partnership income in a financial year), it must have a TFN and an ABN and it must lodge a tax return.
Setting up a business as a partnership is cheap and easy, but only a limited number of businesses should consider this structure.
The key downside to a partnership is the fact that each partner is legally responsible for all the liabilities and losses of the business (including taxation obligations and superannuation contributions), even if another partner incurs those liabilities. This means that each partner’s assets are at risk.
When launching your business with a partner you will probably think nothing will ever go wrong – but this is rarely the case!
If businesses start to fail it is not unusual for entrepreneurs to take on risks, hide these from their partners, and end up saddling the partnership with huge liabilities. Unfortunately, if you’re in a partnership, the debts your partner incurs become yours.
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From SME to behemoth – company
A company is a legal entity that is separate from its shareholders or members. The shareholders are therefore not liable for the liabilities and losses of the company. This protects the assets of the shareholders.
A company is a more complex, and consequently more expensive, way of structuring your business compared to a sole trader or partnership structure. There are initial establishment costs, regulatory costs (e.g. annual fees payable to ASIC) and compliance costs (e.g. accounting and other expenses relating to tax reporting).
Incorporating is, however, the best way to go if you’re building a business that is going to take on liabilities, employees or investors. A company is a flexible structure which allows you to raise capital easily and ensures you are not personally liable for your businesses debts.
The additional costs and complexity of setting up and running a company are heavily outweighed by its benefits.
Reduce taxes and protect yourself – family/discretionary trust
When launching a start-up which you’re aiming to build into a multimillion dollar company, it’s also a great idea to set up a discretionary or family trust.
A discretionary trust is a trust in which the trust fund is held by a trustee and administered in accordance with the terms of a trust deed. In each financial year, the trustee determines which beneficiaries (if any) will receive distributions of income and/or capital from the trust, and in what proportions.
Using a trust to hold shares in your company is a great option for a few reasons. The first relates to tax.
If you end up selling your start-up to Google for $10m you will receive an extremely large windfall over one or two financial years.
If you hold shares in your company personally, your tax bill will be immense given the top marginal rate in Australia is 45%. Holding your shares through a trust structure allows your clever accountant to significantly reduce your tax liability.
Secondly, using a trust structure will reduce the risks associated with being a director of a company.
Although it is unusual for a company director to be sued, it is not unheard of. If you set up a family trust and transfer all of your assets into it (including your shares in your company), suing you becomes a thankless task; you are penniless!
Before you get into the details of product and marketing strategies it is crucial that you think about your company structure. Choose the structure that will work for you now, but more importantly, make sure it will work in the years to come.
Lachlan McKnight is the chief executive of LegalVision, a start-up that provides SMEs with access to online legal services, including customised legal documents.