Choosing a Business Structure
There are four types of legal entity used to own most private businesses in New Zealand: sole-traders, partnerships, companies and trusts. Before choosing your business structure, consider the pros and cons of each below.
If you start your own business without forming a separate entity, you are automatically a sole trader. Many contractors or self-employed people operate as sole traders due to its simplicity. However, being a sole-trader leaves you personally exposed to all the commercial risks of the business.
I generally would only recommend trading as a sole-trader if your business is very straight forward with very low risks. If your business fails for any reason and cannot pay its debts, you are personally liable. This can result in you losing your assets such as your house and/or being made bankrupt.
Sole Trader Advantages
No formation of a separate entity required
No additional legal administration obligations like a company or trust
If the business makes a tax loss it is automatically offset against your other income, reducing your tax bill
Sole Trader Disadvantages
You are personally liable for all debts and legal problems of the business as there is no legal separation between you and the business
All income is taxed at your personal tax rates which can exceed those of other entities
It is hard to split income with others such as a spouse
If you take on a business partner, you will have to form a new entity, creating potential tax issues when transferring the business and business assets
If you start operating a business with one or more others, without forming a separate entity, you are operating as a partnership.
A partnership is like a sole-trader in that there is no legal separation between the partners and the business. If the business cannot pay its bills, the partners are personally liable.
While being a sole-trader carries risks, a partnership multiplies the risks as each partner is joint and severally liable for the results of actions of the other partners. Should your partner run up a large debt in the name of the partnership, the creditor can demand payment from you.
A partnership is a risky business structure. If you are going into business with someone else, I would strongly recommend considering a company structure as below.
Simple to setup and administer
If the business makes a tax loss, it is automatically offset against the partners’ individual taxable income
Unlimited legal exposure to the risks of the business and your partners’ business actions
All income taxed at the partners’ personal tax rates which maybe higher than necessary
If one partner leaves the business, the partnership is effectively ceased, and a new entity must take over the business, creating administrative and potential tax
The company has been the business structure of choice for commercial ventures for centuries. A company, or corporate structure, is a separate legal entity that can act as a (non-natural) person forming contracts and owning and operating assets and businesses.
By trading through a company, you are building a wall of protection between yourself and the business. The company owns and operates the business. You, as an owner of the company, have a limited liability investment.
“Limited” at the end of the company name indicates limited liability. The limited applies to the shareholder(s), limiting their liability to the amount of capital they have paid for their shares and they cannot be forced to contribute any more if the company cannot pay its debts. If you form your company with 100 shares paying $1 for each, your loss is limited to $100.
In practice this limited liability is often compromised. Shareholders of small companies often personally guarantee the company’s loans and debts. If the company is formed to run your business, you will also be a director. A company needs at least one personal director who takes on legal duties to manage the company properly and can face liability if they breach these duties. Directors also often give personal guarantees for the company’s debts to suppliers as part of their trade agreements.
Despite the disadvantages, forming a company is often the most effective risk management move when going into business.
Limits your personal exposure to commercial risks
Allows you to raise funds from investors in exchange for a share in the business
Enables tax-efficient splitting of taxable income
Requires some additional cost and compliance
Brings legal responsibilities to directors
The final business structure option discussed here is a trust. Trusts are very common in New Zealand for their ability to protect assets.
A trust is not strictly a separate legal entity. A trust is an arrangement whereby one or more people (the trustees) legally own assets for the benefit of one or more other people (the beneficiaries). By forming a trust and transferring your assets into it, those assets are no longer in your ownership. If you go bankrupt, the assets are safe.
Trusts are probably the best vehicle for protecting assets. Commonly, New Zealanders put their house into a trust, especially when they are personally involved in business or other risky ventures. Trusts can also help you to control what happens to your assets and who will ultimately benefit from them.
A trust, subject to the rules contained in the trust’s deed, can run a business. A trust that runs a business is called a trading trust. Trading trusts are not as common as family trusts that own personal assets such as a home and investments. It is more common for a trust to own the shares in a trading company that runs your business. This provides limited liability protection from the business activities and asset protection of the value of the investment in the company.
Protects assets from personal risks
Helps control who ultimately benefits from your assets and investments
Allows for tax-efficient distributions of income to people with different tax rates
Adds complexity to managing your affairs
Means you no longer own the trust property
Can be a complicated method of managing a business if the trust itself runs the business
If trusts are not managed properly, they can be deemed to be a sham and set aside by a court
Business Structure Conclusion
Sole-traders and partnerships are the simplest ways to run a business as they don’t require setting up and managing a separate entity. However, the benefits provided by a trading company will usually outweigh the moderate cost and compliance requirements. A company is generally the preferred vehicle for managing even small businesses.
A trust is probably the best vehicle for protecting assets but is less commonly used to own and operate a business. Trusts are great for protecting personal assets such as homes and investments including shares in trading companies.
Go to the first post in this business basics series
Contact Robb with any questions.