Sin number 13 - Not getting your business structure right
By Greg Carroll
Once you decide to go into business for yourself, things can't happen fast enough. You want to open your doors straight away and start trading. But if you rush off without putting much thought into how you are going to structure your business, all your good efforts could be undone by paying more tax than you need to; or worse, you find your personal assets under attack from legal action. So before you rush out and get your business cards printed I would suggest a visit to your accountant or solicitor to discuss what type of structure will suit your business and your personal situation.
There are a number of different structures available each with their own pluses and minuses so there is certainly not a one size fits all structure. It is also often the case that it may be necessary to change your structure over time as your business and your circumstances change. This can be costly, and can be avoided with a clear business plan. If the business plan identifies what the business will look like a number of years down the track then it may be practical to put a structure in place that compliments this plan.
Let's look at some of the more common structures
Sole trader
The simplest and lowest cost form of small to medium sized business structures. Applicable where the business is owned by one person and that person retains all profits and bears all losses. Also the easiest to establish. The income of the business is treated as the owner's own personal income. There is no distinction between a sole trader and their business; therefore in the event that the business is sued the sole trader is 100% responsible.
Partnership
Partnerships are similar to a sole trader structure, except that a partnership involves more than one person. Partnerships can exist up to 20 partners except in certain industries where this can be exceeded. All partners are 100% liable for all activities of the business. Therefore is the business is sued because of the activities of one partner, all partners are equally responsible. The profits of the business are generally distributed according to each partner's share of the business. It is prudent to have a partnership agreement which lists the rights, duties and obligations of partners.
Company
The main characteristic of a company is that it is an incorporated body and is a separate legal entity from its owner or owners. Ownership of a company is determined by the issuing of shares. The company is run by elected officers including directors and secretary. Larger companies will have a number of directors which form a board which oversees the operations and governance of the company.
There are different company structures but two common ones are Proprietary Limited companies and Public Companies.
Proprietary Limited (Pty Ltd)
This is the most common structure for privately owned businesses. The owners of the business are also the shareholders and directors. The key benefits of this structure are:
- the company is taxed separately
- it is a separate legal entity from a litigation perspective
The company maintains a separate set of financials and pays tax on profits at the company rate. The shareholders only pay tax on payments either through drawings, salaries or dividends that the company makes to them. In some circumstances the company may pay tax on the dividends before they are issued. The shareholder does not have to pay tax on these earnings if their income is taxed at a rate below or equivalent to the company tax rate.
This structure can be very effective for minimizing tax as business owners can split the income earned by the business between themselves and the business to suit there personal tax situation. If their personal income is above the company tax rate then they can leave a larger percentage of the profits in the business so tax is paid on the company tax rate. Vice versa if their personal income is less than the company tax rate that may draw out a larger percentage of profits.
From a legal perspective if the company is sued it is not possible to sue the shareholders of the company. Their exposure is only limited to the value of their shares. So other assets they hold outside the company may not be touched. It is however possible that officers of the company may be sued in connection with activities of the company in the case where negligence, misrepresentation or illegal behaviour may be evident. A number of cases have now occurred where this has been tested. So a company does not provide 100% protection in all circumstances but it certainly provides a barrier between your business and your personal assets.
Under this structure it is not possible to make a public offering of shares or to list on the stock exchange.
Public
Public companies are usually larger companies that are listed on the stock exchange. The levels of governance and cost for this type of structure are much higher, as there must be an appointed board, production of annual audited reports and a range of other compliance items. Public companies can be either listed or unlisted.
The cost and compliance of this structure would make it impractical for most small businesses unless there was a clear plan to move towards a public listing. If this was the case then it may be appropriate to establish this structure at the start as it can be more costly to change this later on.
Trusts
Trusts are another vehicle essentially used by small business owners to provide added flexibility from a tax perspective and added protection from litigation perspective. A trust is a separate legal entity which appoints a trustee to manage the assets and affairs of other individuals or entities known as beneficiaries.
There are a number of trust structures available. A typical structure for a small business is to create a discretionary trust with a Proprietary Limited company as trustee and with the owners of the business being the beneficiaries of the trust. The company may also be a beneficiary.
A trust generally pays no tax, so any profits it makes from its activities must be distributed to the beneficiaries. The advantage of this in a "discretionary trust" is that income can be distributed as the trustee see fit. So if we had a situation with A and B as beneficiaries and A was on a high income and B was on a low income. The trust could distribute any profits to B so tax is paid at a lower marginal rate.
Because a trust is a separate legal entity it again provides a barrier against litigation with liability limited to the assets owned by the trust. In most cases the equity retained by the trust is minimal because the income is distributed to the beneficiaries. Also having a company as the trustee creates another barrier, because someone has to get through the trust, then the trustee before they can get to you.
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