Best Business Structures: Do I Need to Set Up a Company?

When you’re starting a business, choosing what structure to use is a crucial decision. The decision is not always straightforward and may require some guesswork about what will happen in the future. However, there are ways to make the decision simpler.

The first thing to know is that there are four structures that are commonly used for small businesses: sole trader, partnership, company and family trust. This article will outline the most significant differences between these, and then explain in depth the two structures we mostly prefer to use.

Basics of the four common small business structures

Note: There are a variety of other structures that can be considered, such as unit trusts and partnerships of trusts. We’ve kept to the four most common types.

A brief explanation of each component:

• Cost to set up and operate: compares the standard accounting, legal and ASIC costs between the different options.
• Protection of personal assets: compares whether your personal assets can be protected from litigation against your business.
• Tax flexibility: compares whether you may have the ability to split or smooth income in order to reduce taxes.
• Compliance complexity: compares the amount of tax lodgements required each year.
• Tax-effective retention of capital: compares whether you can retain profits in the business structure at a lower tax rate in order to be able to reinvest more money.
• Ability to add new shareholders: not all structures allow you to introduce new business partners. In others, it is possible, but complex.
• Access to government grants: the government prefers giving grants to companies while tending to restrict some other business structures from accessing grants.

The business structures we prefer

Of the four listed, we usually recommend one of two – this is purely because they fit the majority of small business purposes. These two are either as a company owned by a family trust or a family trust with a corporate trustee.

However, it’s worth noting that, should you come to us for advice, we would definitely take your unique circumstances into account before helping you make the decision.

Let’s look at each of the two in detail.

1. A company owned by a family trust

This is one of the more typical family business structures. The main feature is that the company provides asset protection and is well accepted by authorities and banks, while the trust provides tax flexibility.

Business types that might use this structure:

• Innovative start-ups: in this case, the research and development tax incentive applies to the business and it’s also an appropriate structure given the greater likelihood of external shareholders being introduced to the company.
• Home builders: due to the requirements imposed by warranty insurers.
• Queensland-based tradespeople: due to the requirements imposed by the Queensland Building and Construction Commission (QBCC).
• Product-based businesses: due to needing to reinvest profits into the purchase of additional inventory.
• Highly profitable businesses: in the event that the profits exceed the amount the owner’s household needs to live on.
• Diversified ownership: when multiple people are going into business together or if there’s a likelihood that other owners might be introduced in the future (which includes offering ownership to key employees)
• Lifetime businesses: owners that have no intention to sell their business in the short to medium term.

How do companies owned by family trusts work?

In short: the company operates the business. This means that the company earns the sales, pays the bills and hires employees. You will likely act as director of the company.

Any tax or legal issues that the business encounters will be addressed to the company, not to you. It must be noted that there are an ever-increasing number of situations whereby a director can be held personally responsible for certain matters, particularly in relation to ATO compliance. (We’ll help you stay abreast of these situations.)

You will likely be an employee of the business and will receive wages. If the company earns profits that exceed your own wages, these profits may be paid out as dividends to the shareholder: the family trust. This provides the opportunity to distribute and pay income amongst family members.

Pros of a company owned by a family trust:

• Compared to structures like a sole trader or a partnership, you’ll be taking steps toward protecting your family home from business risks.
• If the business has fluctuating profits year-to-year, then effective tax planning can allow you to smooth the income paid to you as an owner, resulting in tax savings.
• Can accommodate multiple business partners/owners.
• Any profits left in the business can be taxed at a low company tax rate, thus allowing you to have more working capital to work with.

Cons of a company owned by a family trust:

• Based on the way that most small businesses are sold, the capital gains outcome is generally not as favourable when using a company, compared to a business run from a trust.
• Losses are carried forward to offset future business profits, rather than being claimed by the individual. Certain other structures (such as sole-trader or partnership) may allow losses to offset other income.

2. A family trust with a corporate trustee

This is perhaps less common than the previous structure, but this is somewhat more a reflection of a lack of understanding of this structure, rather than it being less relevant for Australian family businesses.

Business types that might use this structure:

• Built to sell: owners who are aiming to build up their business for sale in the short to medium term.
• Those that aren’t looking to reinvest profit and have a reasonably stable profit year-to-year: the ability for the owners to take distributions can simplify compliance.

How does a family trust with a corporate trustee work?

This structure is usually a little more difficult for people to understand than a standard company, so it is helpful to put it in historical context.

Back in the Middle Ages, fathers alone would hold the title to the land and property used by their family. They were also regularly away for many months, engaged in battles. For this reason, they needed someone they trusted to manage these assets for them until they returned. Or, if they died, until their sons were old enough to take ownership.

The person they entrusted was known as the “trustee” – and the trustee’s responsibilities were taken very seriously. Under this arrangement, the children and their mother were known as the “beneficiaries” while the land and property were known as the “trust assets”. Centuries later, modern trusts still use these basic concepts and terms.

Under this particular structure:

• A company will act as trustee (to protect your personal assets).
• You will likely act as director of this company.
• You and your family members will be beneficiaries.
• Your business will be the trust asset.

Tax or legal issues that the business encounters will be addressed to the trustee company, not to you.

You can be considered an employee of the business and receive wages. However, it’s also likely that there will be a profit left over in the trust. This profit can be distributed amongst the beneficiaries, i.e. yourself and your family members.

Pros of a family trust with a corporate trustee:

• Compared to structures like a sole trader or a partnership, you’ll be taking steps toward protecting your family home from business risks.
• Flexibility, particularly in allowing you to split profits among your family members in a tax-effective manner.
• You may be able to save significant amounts of tax when selling your business due to capital gains tax concessions that work most effectively within a family trust.

Cons of a family trust with a corporate trustee:

• Trusts are out of favour with some industry regulators. For instance, home builders within NSW cannot use trusts, while tradespeople in Queensland would be wise to avoid trusts.
• You cannot retain profits in the trust. This means that each year you will generally need to pay individual rates of tax on your profits and then re-contribute to the trust. This can mean paying more tax, at least in the short term.
• Trusts are unable to access some government grants; most notably, the research and development tax incentive.
• Losses are carried forward to offset future business profits, rather than be claimed by the individual. Certain other structures, such as sole trader or partnership, may allow losses to offset other income.

Making the business structure decision easier

Choosing a business structure can be difficult. None of us has a crystal ball. You won’t know with certainty whether you’ll be introducing business partners in the future, whether you’ll be applying for government grants or whether you’ll be approached to sell your business for a crazy sum of money.

Nonetheless, we’ve worked through this decision with thousands of business owners over the years and each time it tends to boil down to one or two key factors. Finding them, exploring them and understanding their implications is what it is all about.

We’ll work with you to go through this process and then, once decided, we can help set up the structure that is appropriate for you, your family and your future.