Business is risky. Risk is the price we pay for the rewards we hope to get from owning a business. Risk is the reason we expect a higher return from a share investment than a bank deposit.
If investing in a portfolio of businesses via the share market is risky, it is nothing compared to investing in one small business. While we may be very happy with a 10% return on our share portfolio, a venture capitalist may look for a 30% return on his investment in small, growing companies, knowing a good portion of them will fail.
It would be foolish to go into business ignoring the fact that things can go wrong: consultants get sued by client for advice gone wrong; businesses lose key customers and can’t pay their bills; professional firms are attacked by ransomware and cannot operate.
Your best defence is your business structure.
A sole trader is the simplest business structure. Just start doing business on your own account and you are a sole trader by default.
But, as a sole trader, you are the business and the business is you. You have no legal separation from the business with all its hazards.
When your business cannot pay its debts, your personal assets are fair game for your creditors. When your business fails, it is not just the value of your investment at risk, but your house, your cash and everything else you own.
If things were to go wrong, you need to be legally separated from your business and the most common method of separation is using a company to run your business.
How a Company Protects You
A company is a separate legal person able to run commercial activities in its own name.
You own your company and your company owns your business.
Company ownership is divided into shares.
A small company may have 100 shares for which a sole-owner pays $1 each, investing $100 into the company.
While the company itself carries unlimited exposure to business risks, the company’s owner’s risk is limited the $100 invested.
In practice, however, the limited liability can be compromised.
Examples of losing your limited liability
If you neglect to include your company name on agreements and correspondence, you can inadvertently form legally binding contracts in your own name. Always make it clear it is the company doing the business.
As an owner-operator of your company, you will also be a director.
The Companies Act puts legal responsibilities on directors such as requiring them to act honestly, in the best interests of the company, and to not trade recklessly. Directors must also ensure their company prepares financial statements, files tax returns and complies with other legal requirements.
Breaching these responsibilities can result in personal liability or prosecution.
Banks and other lenders to the company usually require personal guarantees from the company so if the loan cannot be paid, the directors must cover it.
When a company cannot pay its creditors, including IRD, those creditors can try to break through the corporate structure and go after the directors personally.
You can protect yourself from this “lifting of the corporate veil” by making sure your legal duties are complied with.
Other Advantages of a Company
Two of the main advantages of a company are tax planning and the ability to raise funds through shares.
A company can save you tax. A sole trader pays tax on all profits at personal tax rates, up to 33%. A company pays tax at 28%, providing a potential 5% savings on profits retained by the company.
A company makes it easier to split income with others such as a spouse. With individual tax rates starting from 10.5%, even a modest share to a spouse with little other income can save thousands in tax annually.
The division of the company’s ownership into shares helps capital raising. Others can invest in exchange for shares, entitling them to a share of future profits and gains. You can’t split the ownership of a sole trader business.
Cost and Complexity
No one likes adding costs and compliance requirements, but we are lucky that New Zealand is ranked one of the easiest countries to start a company.
A company can be setup within a few hours at minimal cost.
Companies do require some additional compliance such as filing returns, preparing annual resolutions and maintaining legal registers.
Neglecting these puts the director at risk.
The good news is that, for a small privately-owned company, these things are not difficult. Your accounting firm can take care of the routine requirements as part of their annual accounting service.
Get it Right at the Start!
The risks of business are real, even for one-person operations, so why stand in the firing line.
Just make sure you get some advice on how to structure it before incorporating your company.
It is much easier to set it up properly than try and fix it when things go wrong.