What is a Business Structure and Why is it Important?
Your business structure is the type of legal entity that owns and runs your business and commercial affairs. Structure options include sole-trader, partnership, company and trust. When starting a business, choosing the right business structure is the most important initial decision and here are three reasons why.
Nothing offers higher potential financial rewards than building a business, but the cost of those rewards is risk. While an investor in a portfolio of shares of large companies may accept a return on investment of 7 – 10%, a professional investor in start-up companies will look for 25 – 30% knowing that about 40% of their investments will fail.
Many threats can destroy your small business. Your well-meant advice might cost your client a ton of money, leaving you exposed to being sued. A ramsomware attack might lock you our of all your systems and data. Or you may just not make enough money to pay your bills. You can’t eliminate all risk, but you can manage it and the first and most effective protection is your business structure. Your business structure owns your business and therefore owns the risk. If you setup no structure, the risk is all yours.
If you start a business without creating a new entity, such as a company, you are a sole-trader by default. I.e., you own the business and all that goes with it, with no legal separation between you and the business. Make a mistake and you can get sued. Can’t pay your debts and you can be bankrupted.
Not only are you personally exposed to the business risks but everything you own is too. If business creditor bankrupts you and you own a house, your house will be sold.
Your creditors include Inland Revenue. All taxes owed by the business, including income tax, GST or employer PAYE deductions, are your debts. When it comes to Income Tax, not only is a sole-trader personally liable for it all but it may be higher than it needs to be.
As a sole-trader, all your income is taxed at your marginal tax rates. Individual tax rates range from 10.5% up to 33% for income over $70,000 per year. If your total income exceeds $70,000, you will be paying 33% tax on income that could be taxed as low as 10.5% with a more efficient structure.
Cost and Complexity
Companies and trusts provide many benefits, but they also need to be managed. There are costs and time involved. Your structure should be appropriate for the size and complexity of your business affairs and no more. A structure involving multiple companies and trusts may look smart on a whiteboard, but the costs may outweigh the benefits. If you don’t understand your structure it is probably too complicated.