Episode 07: What entity type is right for me?

December 14, 2020

One of the first things a new business owner needs to consider is how are they going to structure their business. In this episode Trudi and Sarah discuss the various types of business entities: Sole Trader, Trust, Partnership and Company.

They walk through the differences between these entity types and what factors you should take into consideration in deciding what structure is right for you (and your business). They also discuss at what point you should review your structure to make sure it continues to be right for you. Listen in, reflect on your current business structure and walk away knowing all the questions to ask yourself and your accountant.

Podcast Transcript Available Here

Duration: 22:40

Sarah Eifermann: Welcome to Financial FOFU I'm Sarah Eifermann. Trudi Cowan: And I'm Trudi Cowan.  Sarah Eifermann: Today we have a shorter episode for you to talk about something that I think is super super important.  Trudi Cowan: Yeah, we're going to have a chat today about what business structure is right for you. And look, this is a really common question that I get all the time. And it is something that's important if you're running a business to one understand your structure and two, to know whether that's the right one for you. Sarah Eifermann: Yeah, absolutely and from a lending side it has a massive implication on lending, but not only the lending your asset protection and asset management in the future because decisions you make now have implications later. So it's something that, from a business strategy point of view I often bring up with clients if they're looking at changing their financial positions or their asset positions because it does have an impact later on in life. Trudi Cowan: Yeah. So, firstly, you know, are you actually running a business, or is what you're doing just a hobby. And look, the easiest way to really make that decision is, are you doing what you're doing to make money? Are you doing it just because you enjoy it? And maybe you sell something and recoup some of the cost of it but you're not really out there to try and make money Sarah Eifermann: So a hobby-based business and some types of that could be like a jewelry business or stationery business or what else would fit into that sort of category? Trudi Cowan: There are lots of different ones you might sell some cactuses because you grow lots of succulents and you got some excess ones. Put your bag of lemons on the street for $1 Because you've got too many lemons on your tree, you know.  Sarah Eifermann: Tomatoes are everywhere and it's like.  Trudi Cowan: You might be making, you know, you might be receiving some income for it, but it doesn't necessarily mean it's a business. Yeah, if the purpose is not to be making money, it's just incidental. Same as if you're cleaning out your house and you're selling some stuff on eBay. That doesn't make you a business. It just means that you're just trying to recover some of your cost. Sarah Eifermann: Your cost of living, really, yeah expenses.  Trudi Cowan: So once you get over that hurdle and yes you are actually running a business and you're trying to make a profit and a living, of what you're doing. There's four main types of business structures. We've got your sole trader, partnership, a trust, or a company. Okay, so your sole trader is when you're trading under your own name. So for example, if I was just trading as Trudi Cowan, I had an ABN registered under Trudi Cowan. And I traded my businesses like that.  Sarah Eifermann: That business can be pretty much anything where it's legally allowed to be, so you could be a tax agent or a finance broker, you could be a carpenter, you could be a courier. Trudi Cowan: You could be selling some sort of goods, you'd be selling clothes or plants or household equipment. Sarah Eifermann: So if you were trading as a sole trader, but you wanted to have a business name, yep, you would need to register a business name with that.  Trudi Cowan: That's right. Sarah Eifermann: And that would just link back to your sole trader ABN, and that would be your complete legal structure. Trudi Cowan: And so from, I guess a tax perspective, you then include that in your personal tax return, and you pay tax on that income or that profit from that business, using the same personal tax rates as if you were an employee. Sarah Eifermann: It has a slightly separate schedule though, doesn't it? Trudi Cowan: It does have a separate schedule in the tax return. So there is a bit more information that you would need to fill in your income and the different types of expenses. Sarah Eifermann: Effectively business profit and loss.  Trudi Cowan: It's also important to note that if you are trading as a sole trader and you're making a loss. That loss can actually be offset against some wages you might be earning elsewhere it is quarantined as a business.  Sarah Eifermann: Yes, you need to make some profit in that entity to then offset the losses that you made the year before.  Trudi Cowan: Yeah, that's right. Sarah Eifermann: Okay, what's the difference then between a sole trader and a partnership?  Trudi Cowan: So a sole trader is one individual, a partnership is two or more entities so those entities may be individuals, or they may be two companies that join together to run a business together. It's not an entity that you register specifically with anyone other than going to the HEO and getting a tax file number or an ABN for that business, but typically a partnership would have an agreement between the two entities that would basically lay out what each of the partners does so it might be that each of the partners is required to contribute $1,000 To start the business off, and then you will jointly run that business activity together. Sarah Eifermann: Partnership Agreement Trudi Cowan: Partnership between two people. So, at the end of the day from a tax perspective. You split the income based on your partnership agreement so it might be a 50 50 agreement, it could be a 70 30 agreement, and that would come down to your written document, and what that says the split is okay. And then each partner puts that share back into their own Tax return.  Sarah Eifermann: And then they pay tax in that position so if there was money made in the partnership, it will filter through to the partners, yeah, and then the legal entity or individual entity that applies based on that structure. Trudi Cowan: So the partnership itself doesn't pay the tax, but the partners do. Sarah Eifermann: Interesting. Alright so then where do we go from there. What's the next one? Trudi Cowan: Next one is trust, this is probably the most misunderstood one, but also one of the most common ones you use for small businesses. Sarah Eifermann: True.  Trudi Cowan: So, in a way of, I suppose, trying to explain a trust, a trust is me saying Sarah here have $1 Look after this on trust for me.  Sarah Eifermann: So trust is not a legal entity though? It’s a tax entity.  Trudi Cowan: It’s a legal I guess creation, and you would then take that money  Sarah Eifermann: A trustee Trudi Cowan: As a trustee and you would look after that money for me. And you would only do what's in the interests of me in terms of that money, alright  Sarah Eifermann: Because I'm holding it in trust?  Trudi Cowan: In Trust, right I trust then has beneficiaries. They're the people that are then entitled to that dollar so what I might be saying is Sarah here have this dollar, I want you to hold this in trust for my daughter. Okay. So, Sarah, you don't actually get to keep that dollar, you're just taking care of it until such time as my daughter needs it. Okay. And that's how the relationship kind of works. In reality, I guess I suppose from a business concept and structure you trade within that trust entity the trust itself has a tax file number and an ABN, and what is required is at the end of the year you distribute the profit out to the beneficiaries. Sarah Eifermann: Can you distribute the loss?  Trudi Cowan: No. Sarah Eifermann: The less has to stay within it. Trudi Cowan: Yeah Sarah Eifermann: I think it's important at this point is that we point out that you can have an individual trustee of a trust or you can have a corporate entity or a company which is our next structure that we're going to talk about as a trust and there are different implications of either that need to be considered, but when it's being held in trust, it has to be held in trust by a legal entity because trust in itself is not a legal entity, it's a tax entity. Trudi Cowan: Yeah, that's right. And look, you know, in terms of choosing whether you have an individual trustee or corporate trustee, often it comes down to the nature of your business and the liability that you want to have associated with this whole reason a lot of businesses moved from a sole trader intervene, something like trust is because as a sole trader, someone has to sue your business, they are suing you. They are suing your assets, you have a house that can be at risk, and look you don't like to think about your customers may be suing you but in reality, when you're in business you do have to think about these things and protect yourself as well.  Sarah Eifermann: And so, I mean one of the main points, then, is that a trust can provide some sort of personal and asset protection.  Trudi Cowan: Yeah,  Sarah Eifermann: Because the business itself is owned in the trust  Trudi Cowan: In the trust so if someone Sarah Eifermann: You don't own that business. Trudi Cowan: That's right. If someone wants to sue the business, they're suing the trust and not you. Yeah, you know, it's not, I'm not saying it's 100% protection on your personal assets, but it makes it more difficult. Sarah Eifermann: Which is the point.  Trudi Cowan: That's right Sarah Eifermann: Right, so we did mention it a little bit earlier then that gives us our next structure as a company. Trudi Cowan: Which is a company and again probably a more common one and one people probably understand a little bit better, you know, a company you register with as a formal co-registration corporate entity you have a constitution which governs what the company can and can't do and how it will operate.  Sarah Eifermann: Usually, a Proprietary Limited Company.  Trudi Cowan: So there are two types Proprietary Limited and a public company, public companies are typically basically the ones that are listed on the stock exchange, that's your public company, in most circumstances, that's a public, and then a private company is one that's privately held so it's not available for anyone to jump on the ASX and buy shares, the ownership is private. So the ownership is your shareholders, you can have as many or as few shareholders, as you like, you know, typically if I was setting up a new company for a client, it might only have between one and five shareholders and it might have only issued between 1 and 50 shares.  Sarah Eifermann: Yeah, depending on the needs,  Trudi Cowan: Depending on the needs and the size of the business. Sarah Eifermann: Yeah. So, a company, though, as we mentioned earlier can be a trustee for a trust. There's one other variant on this that I'd really love to have you explained to people because I think it's quite intelligent, in terms of use. Often, I say from a lending point of view and it's probably important to let our listeners know from a lending point of view these days if you operate via a trust and you have debts in that trust that debt gets passed through to your personal liability or your borrowing capacity, so it can greatly affect if you've got motor vehicles or equipment finance or an asset like a property or a commercial lease building that you're renting the deck as posterity poster comes so when you try and do any personal lending or buying your house. It then affects that so there is when it's in a company, though, the debt gets quarantined into the company. And so that's great, but then there is one other way to maybe give you a little bit more flexibility and protections, almost you could say a hybrid but it's not really, it's about ownership share. Trudi Cowan: And so I think what Sarah is getting at is you can have a trust, and all that trust does is it acts as the shareholder of a company.  Sarah Eifermann: Correct.  Trudi Cowan: All right. The benefit of this is that you get the company benefit of having a corporate structure, you know, there's some limited liability protection, a company pays tax at 27 and a half percent which if you're a high-income earner is quite a good rate, but you also get some flexibility when you pay that dividend, up to your shareholder. It's in a trust structure, and that trust, if it's a discretionary trust can have some choice about where it distributes that income. So, instead of the income all being channeled to one individual, you may be able to, I guess widen the scope of who gets that income, which from a tax perspective can allow you to share the tax burden on that income as well. Sarah Eifermann: Which can potentially reduce the tax that's payable or outgoing on that debt, and it also then means that from a personal borrowing position, you've still protected the impact to your borrowing capacity as a result, it's important then to note that this is not a trading trust because the discretionary trust that owns the shares isn't trading, the company is trading, which is where the differences in our third structure of trust being a trading entity. Do you want to maybe elaborate a little bit more on that, using your technical Idea accounting terms?  Trudi Cowan: So look the trading entity, you know, a trust being trading that's just the entity that you're actually operating the business through that's where your income and your sales.  Sarah Eifermann: So whether you're a sole trader or a partnership or trust or a company, they can all be trading.  Trudi Cowan: Yes,  Sarah Eifermann: Yeah. But when you have a company, it can have the ownership being an individual person or trust  Trudi Cowan: Or a trust.  Sarah Eifermann: Is there any other or another company potentially  Trudi Cowan: Another company and I guess that's when you start to go. There are actually lots of different permutations and combinations of how you can structure these, you know, four different entities to make a structure that's right, Sarah Eifermann: I think it highlights once again why getting quality advisors around you is really important, and if you have been a sole trader for many years and I often say the question comes up, you know, should I change your company when is the right time. Can someone help me, it's such a personal circumstance-based, you know, a decision that is made on the grounds of what is going on in your life and what's the future is going to look like.  Trudi Cowan: There's certainly not a one size fits all solution when it comes to a structure and there are a lot of different factors that you should consider. Sarah Eifermann: So how do you go about what's right for you? Trudi Cowan: Preferably with the assistance of an accountant or a lawyer who is familiar with different structuring.  Sarah Eifermann: Or structure specialists. Trudi Cowan: But some of the things that you might take into account is, what are your current operations look like how much money are you making at the moment. What's the potential for future growth. In this business are you in a growth stage are you actually winding down the business where do you sort of sit, you may want to take into account some tax efficiencies, and is that appropriate to restructure to have a better tax to allow structuring and better tax outcome. Are you looking to take on investors in this business or is it always going to be something that's just run by you and retained in the family? Sarah Eifermann: I mean I think that's a really good one because depending on circumstances people do at times need to look at the opportunity for investment, and if they don't have a structure that allows them to do that, it means to be able to do the growth, to get the investment to do the growth, they now need to change their entity type.  Trudi Cowan: That's right.  Sarah Eifermann: So it's, you know, swings and roundabouts as to what is the right way to do it, I'm a firm believer in doing it properly, the right way based on where you believe this business is going to go, whilst limiting your potential outlay because as we know the differences in price then too, right, so do we want to run through some of the costs. Trudi Cowan: Run through some of the costs so look, it depends on who you're going through obviously and who's doing the work for you and to help you. But if we look at, let's take an example off if you went to just an internet supplier to set up one of these for you. Sarah Eifermann: But wait for a question as a sole trader is there any cost?  Trudi Cowan: No,  Sarah Eifermann: Yeah, only ABN required right  Trudi Cowan: You just got to go and get an ABN with HEO which is free to obtain  Sarah Eifermann: And the same for a partnership?  Trudi Cowan: A partnership I do recommend that you get a partnership agreement, trusted drafted up so you would need to go and speak to a lawyer, to have that drafted up for you and depending on the complexity as to how much that's going to cost. Yeah, and who the lawyer is. Sarah Eifermann: There are some template contract templates online that you can get from some of the legal firms that offer them, but it's important to note that they're not specific to your needs so if you don't have the capacity to amend them to allow them to reflect your individual circumstances and amend them without impacting the quality and legality of the contract or the agreement between you then yes you are looking at a solicitor or a lawyer to assist you with getting it done right the first time. Trudi Cowan: And that's exactly right. So, if I’m just looking online and because lots of lots of online providers to do a company or a trust set up for you. If you wanted to set up a company just a straight company, you're looking at about $650 and that's including an asset fee. Yeah, and if you wanted to go a trust that had a corporate trustee, the fees are going to be more at eight or $900 Yeah, now look, if you went to an accountant, and if you came to me, the fee is going to be higher. And there's a reason for that, it's time because I'm doing the setting up for you but it's also the advice, I wouldn't just go and set up a company for someone, I would have a discussion with you, and determine whether that's actually the appropriate structure for you.  Sarah Eifermann: But here's the thing to get your advice, there's years of experience, that has allowed you to be able to form opinions to provide that advice piece and that is also what they're paying for when they pay for your time. Yeah, and as we, we can openly say like I have set up companies on my own, and I’ve also had Trudi set up companies because I wanted to make sure they were done properly and I didn't have the knowledge and a new Trudi did, to allow that. So it depends once again on your individual circumstances and your needs. For that reason. Trudi Cowan: That's right. And I’ve even heard lawyers ask me to set up structures for them because they're not corporate lawyers and it's not a specific space that they're that they move in, and they just wanted to have that extra assurance that what was going into the legal documents was correct and appropriate. And that's exactly why I came to you, and I wanted to make sure that it was done correctly and that there was no potential in the future for issues to arise as a result of ticking the wrong box on a form because I didn't understand it when I was setting it up the first time. Yeah, so what is the right time to pick a structure or change a structure we already sort of talked about it for me, as a business strategist and in finance, I believe if you can do it right the first time you're doing it very well. Trudi Cowan: Yeah, but it doesn't work for everyone, so it may have been that you intended to start it up as a small business you are intending on making 10 $20,000 a year, you don't want the cost of running a more costly or a larger structure, so you stay as a sole trader and look for a lot of people that is an appropriate structure, but quite often what you intended to be a small business grows quicker, or grows bigger than you plan and that's amazing, but it may be that what your original intention changed. And it's when your intention and when your business doesn't fit that original plan anymore, that's the time that you need to start having that conversation about, okay, is that structure still appropriate for me. Does that still make sense with a new plan, and do we need to consider something else and sometimes the answer is yes, and sometimes it's No, but it's just important to have that conversation, to work out the go-forward plan, but in a lot of cases from the word go sole trader may not be appropriate structure.  It might be that the product that you're developing, has a level of risk associated with it, and you want to have that separated from your personal assets from day one, yeah. Okay, so for some people, they prefer that comfort of knowing that it's always been separated, it might be from day one, it's not just you but you're working with the partner or couple of partners. And so, therefore, you want to have a company so that you've all got that same protection and agreement and comfort over how the business is set up. So day one is a good time to have a discussion. Yeah, but and then you have another discussion once things start to change in your business and there might be a third one down the track as well or even more, it's sort of not a set and forget situation. Sarah Eifermann: I think the thing is as well that a lot of people don't realize is that when they're a sole trader and then they become a company they think, well, it's still me. The reality is that it's a different tax structure it’s also a different legal structure and it could have implications on capital gains tax. For example, so as Trudi said once your intention change or the knowledge as to what the direction of your business changes, that's the time to pick up your phone and speak to your accountant, and even though we always like to be as cost-savvy as possible. A lot of the time if you do this earlier on, you end up saving yourself a lot more money in the future, especially as the brand develops, because you don't need to change bank accounts and the whole range of other things that go when you change a structure. Trudi Cowan: And if the person you're speaking to is really quick to recommend one structure just make sure you ask them questions. Yeah, what are my other options, why should I go option A over B. What are the benefits, you know, what would happen if I sold, what would happen if I wanted to get a partner in? Sarah Eifermann: Yeah, and what other things should I consider when looking at this particular structure, Trudi Cowan: You know, your advisor should be able to answer all of those questions, fairly easily. And we like it when our clients ask us questions so don't be afraid to ask them. Sarah Eifermann: Now I briefly mentioned a little bit earlier about the difference of structures on your lending or your borrowing capacity or serviceability there are about 40 Different names that were referred to in the industry as so bear with me if, I say something, in particular, I'm talking about how much money the bank will lend you. And when we look at trusts structures, as I said earlier trusts or individual business ownership, even partnerships that are in individual entities, have an impact where they, that depth that you might have in that business actually funnels through to you personally and gets impacted on your borrowing capacity or your ability to borrow. So if in the future you were looking at doing borrowing personally, and you've got debt in your business, that is definitely a conversation you should be having with your accountant about how a company or a trust owning a company could potentially assist you to quarantine some of those future debts. And if you've got any questions as always, please hit us up, use our link, send us an email, whatever you need to do to get in touch. And, as always, with any of this stuff, this is general advice, it is not specific personal advice and you should go and speak to your individual advisor or a tax lawyer or financial planner, as well as finance broker if needed to find out what is right for you and your basic positioning and go from there. I think we couldn't stress that enough. We like to share the general information for you to improve your general knowledge but we're not giving you any form of personal or business advice in this scenario that we're talking about today here. So Trudi anything else you want to add to the end of that I know there's a lot of information, there to unpack for people. Trudi Cowan: A lot of information to absorb go back and re-listen to it if you need to. And if you've got multiple advisors to get them talking to each other as well as that can only help the situation.  Sarah Eifermann: Absolutely. Great, great, great points there. Okay, so today, you've got our links in our episode, that's probably all we've got time for we like to keep it short and snappy where possible. And yeah, send us a line or, you know, drop us a line, I should say, if you've got any further questions on this, I think it's a great topic that you should be having that conversation about, so yeah.  Trudi Cowan: See you later.  Sarah Eifermann: Bye. You've been listening to Financial FOFU with Trudi and Sarah.

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