Careful planning and choosing the right structure for your business makes a lot of difference. So in this episode, we’ll help you understand the different structures, the pros and cons, and what action steps you can do today.
03:06 How to protect your assets using specific business structures
04:23 Understanding the different business structures
08:15 Different types of trusts
10:19 How do Trusts work?
10:59 How are trust income and assets distributed to its beneficiaries?
12:09 Risks and rewards of the different structures
14:25 What are personal guarantees?
14:56 Four things to consider before entering into a trusts structure
15:25 Which entity is right for you?
17:04 What happens if you don’t get this right?
18:45 Three action steps you need to take
Thanks for tuning in to the talking law podcast. Today we’re talking about different types of business structures and how to know which is best for you.
So why are we talking about this today? It’s a topic that I’m asked about by business owners time and time again, by business owners that are just starting in their first business, seasoned business owners starting up a new entity or a new type of business that they are getting involved in, and businesses that have been in place for many years but are thinking about setting themselves up for future potential sale.
So this question is really important for business owners to ask themselves at many points during the term of their business. And so what’s really important about this?
I want to start by sharing a story that really demonstrates why today’s topic is crucially relevant for every business owner.
I want to tell you about a client that I had many, many years ago that came in when they were already in a bit of trouble. The history of their business was that they had set up a construction supply business years and years ago and they’d spent a lot of time over the years building up this business. But suddenly, as they grew, they hit an issue that growing companies often had which is a cash flow crunch.
Cash flow crunches comes often suddenly and without warning. In this case, the cash flow crunch was related back to a big client that had suddenly stopped paying. So there was a lot of money that was owing and because the business was growing so quickly they didn’t have a cash buffer to protect the new level of overheads.
When the cash crunch came, they therefore couldn’t trade through it because they’d grown so quickly that they didn’t have that buffer that businesses usually have and the overheads were so high and because of the structure of the business, the owner was sitting in the position of being personally liable for the debts of the company. So when the creditors decided that they weren’t going to let the business trade out of its cash issues they all came knocking at the door of the business owner.
I’m not going to go through the whole long saga but the story ended up with this owner ending up with the whole business collapsing, him ending up in bankruptcy and a failed marriage to boot because of all the stress. So essentially, he lost everything at that point and that was really one of those pivotal moments for me in thinking about the importance of being on top of legal understanding for business owners.
Business is really hard to predict so the most important thing is for us as business owners to make sure we find ways to protect ourselves and to protect our assets that sit outside of the business. And one of the best ways to do this is by having a fundamental understanding of the concept of business structures and which business structure is most relevant for us at different paces in our business.
That’s a real doom and gloom story but an absolutely true one that I have seen repeated over and over again. I’ve seen people lose their businesses and face personal liability to the ATO of hundreds of thousands of dollars and to other creditors, but also I’ve seen the flip side in a sale where businesses have lost millions from having the wrong structure.
One example of this comes to mind, a business owner who came to us when It was way too late for us to do anything about the structure before the sale (because they came to us at the time of sale).
The result was they ended up paying about $2,500,000 in tax more than they should have. If they had known us even just a year before the transaction, they could have been in the position of paying possibly absolutely no tax at all.
I think you’ll all agree two and a half million dollars is a lot of money in anyone’s books just for getting one aspect of their business wrong from a legal perspective. So today, we are talking about the different types of business structures that are around, to help you understand what points in your business life cycle you should be coming back to this question and asking again because the structure that is right for you today may not be the structure that’s right for you tomorrow.
Alright, so what are we talking about here what kind of different structures are available?
Simply speaking, we have five different main types of structures.
Sole Trader Structure
A sole trader based structure is essentially where as individual conducts the business themselves without any other entity. They might be trading under their name, or have a business name that they own that they are trading in. But the legal entity is them individually. The business owner is tied personally to the business and holds all of the assets and also all of the liabilities, personally.
The next type of structure that we have is a Partnership, we also have Companies and Trust so we’ll go into each of this in a little bit more detail and just so that you understand what the difference is between them.
A Partnership is a collection of two or more people, or entities, who might be collected personally as individuals or they might be collected by entities. One of the issues with partnership is that you can have joint and several liability, which I know sounds like a bit of legal jargon ,and we’re trying to keep away from legal jargon. What this means really simply is that each of the partners, together and separately, are liable for the liabilities of the business.
Sometimes partnerships might be set up with companies being partners or trusts being partners or individuals being partners; so there’s lots of ways that we can have a partnership.
Then the next type of entity is a company. A company is a separate legal entity from the owner or the owners, so a company in Australia is a proprietary limited generally or you might be setting up a public company if you have grand plans for the business considering listing or something like that at the end of the day.
Companies have shareholders and companies also have directors and there’s lots of pros and cons for companies, but the one big positive of a company is that they are a separate entity to you as the business owner. So that means that all the assets are contained in the company and the liabilities of the entity are also contained in the company.
We can also get a little bit more tricky later on and we can have multiple entities, or multiple companies where we’d split out assets into a number of different entities or potentially liabilities into a number of different entities and you might do this to achieve both asset protection and tax minimisation or flexibility if you’re looking at doing some different things with different business units.
And then the final type of entity or structure that we are going to talk about today is Trusts. Trusts aren’t technically a legal entity. They are essentially based on a legal document that we call a trust deed. The trust deed details how the assets of the trusts will be dealt with. The concept of trusts can cause a lot of confusion. I have people coming to me a lot because they’re confused about what trusts are and they don’t understand how trusts work and this might be people who have had trusts structures set up for them, for example by their accountants or by their lawyers, and they simply just don’t understand them and they don’t know how they work. Or it might be people who’ve been told they should think about having a trust created for them but they don’t quite understand why.
The Different Types of Trusts
Very simply speaking there’s a few different types of trusts. One is a Discretionary Trust. A family trust is a type of discretionary trust which essentially means it has a lot of flexibility.
Another type of trust is Fixed Trusts, which can be called Unit Trusts, which have less flexibility but are a good type of trust to use in business or if you’re dealing with parties that aren’t related to each other. The last kind of trust is a Hybrid Trust which essentially is a combination of both discretionary and fixed components.
So what’s this all about? Why would someone want a trust? And what’s the real difference between them and company structures or individual structures like sole traders and partnerships.
Trusts and particularly, discretionary trusts, can provide really strong asset protection because essentially the assets of a discretionary trust aren’t held by any one person, but are held by the group of people who are the beneficiaries of the trust.
The beneficiaries of a trust are the people who are named in the trust deed as the class of beneficiaries. You might have just a few people who are the beneficiaries, on the other hand some trusts like, for example family trusts might include a very large range of beneficiaries. Family trusts for example might have a main named beneficiary and all of their family members as additional beneficiaries.
What this means is that all of the assets are effectively owned by all of the people who are the beneficiaries of the discretionary trust. Things are a bit different for fixed trusts but let’s keep it really simple because family trusts are the most likely type of trust that will be used as an asset protection vehicle. You get asset protection because all of the assets in the trust are owned by all of the beneficiaries collectively, however none of the beneficiaries have the right to a particular portion of the assets.
How Do Trusts Work?
So how does this actually work in practice then, you might ask?
You may be thinking “I don’t want to be putting all of my assets into a particular type of structure if suddenly then I don’t own any of them”. The way it actually works is that the assets held by all the beneficiaries collectively and that gives you a benefit of asset protection because if there are creditors of any of those individual beneficiaries those creditors don’t have the right to seek any of the assets of the trusts because none of the beneficiaries fully own any of those assets. I hope that make sense. It’s bit of a complicated concept.
How Are Trust Income and Assets Distributed to Its Beneficiaries?
Effectively at the end of the day the trustee of a discretionary trust usually has the discretion to distribute the income and the assets as they see fit. What happens in practice in a discretionary trust is that at the end of the year the accountant generally reviews the accounts of the trust and then distributes the income of the trust in a way that is most tax effective and in consideration of any asset protection elements that are relevant to consider. So that’s why trust provide both a high level of flexibility in distributing income so that can be really useful for a perspective of splitting income of the business to achieve a minimisation or a lowering of tax and also for asset protection.
As you can see, trusts can be a little bit complicated, but at essence they are vehicle that can be used for asset protection and for income distribution and flexibility.
So that’s a bit of an overview of the different types of structures.
Benefits and Risks of the Different Structures
One of the things that I want to do is just give a little bit of a snap shot of the benefits and the risks of each type of structure.
Bearing in mind that quite often we can also achieve a combination of a different mix of multiple types of these structures to achieve different things for a business.
Acting as a sole trader is easy, fairly cost effective because it cost very little to set up and to maintain but it has a lot of risk attach to it because the assets of the sole trader are exposed.
A partnership can be potentially a good structure. It can be a simple structure to set up if it is 2 or more individuals, but it’s a very risky structure when it is 2 or more individuals because all become potentially liable for debts that might be created by the other/s and that’s where an agreement between the parties is essential.
But if you’re involved in a business with someone else I’d recommend staying away from a partnership of individuals. You might instead look at something like a partnership of companies or partnership of trusts. Or keep it really simple and move to an entity like a corporate (company) structure.
Then we have the company structure as we talked about which is a separate entity to the business owners. It’s fairly cheap to set up and to run. It’s a fairly simple type of structure to understand. It has a lot of benefits because you have access to the company tax rate which is lower than the highest marginal tax rate for individuals. And it also provides asset protection as I said because the entity is separate to the individual/s as owners. But you have to be careful about companies because companies also have directors. And directors can potentially be personally liable for the debts of a company in certain circumstances if certain triggers are met.
So you have to be very careful about who you choose to be directors of a company.
You have to make sure that the directors understand the risks and manage the risks appropriately.
You also have to be very careful about personal guarantees. A personal guarantee is another way that the asset protection provided by companies can be broken.
And then the last entity that we talked about was Trusts.
Trusts can provide a lot of opportunity in terms of flexibility and asset protection but they can also be a little bit confusing to understand.
Now I‘ve seen a lot of people end up in trusts structures who don’t understand it and have never used their structure.
So my advice to you is before you even consider entering into a type of structure
- Make sure you understand it
- Make sure you know why the choice has been made to go to with this particular structure
- What does it mean for you and how do you functionally work within that structure on a day to day basis
- How do you work with that structure if you want to bring in business partners, if you want to sell components of your business, if you want to sell assets out of your business
So, which entity is the right one for you?
Alright so how do you know which entity is better for you? I guess the answer is that there is absolute answer, there is no one size fits all answer.
Companies can be flexible and simple so I think companies are great but trusts on the other hand are good if a the time of exit you are likely to sell the assets of the business (instead of the shares).
There is often a place for multiple structures or multiple parts of these structures to be put together but there’s also times, many times, when I’ve seen structures being overly complicated and involving far too many elements than really is necessary for the situation.
So this is the sort of topic where it’s really important that you consult your accountant and lawyer and then have them work together, looking at you as an individual and your business as a whole to understand what approach is appropriate for you today and what approach is going to be appropriate for the growth that you have planned or the plans that you have in place for the next few years of the business.
And then come back and review that approach every few years.
Sometimes there are points in a business where it can be beneficial to have multiple layers, multiple entities, and as I’ve said, it can be sometimes beneficial to separate out assets from liabilities. But you should always do this trying to keep your structure as simple as possible.
Make sure you take advice and that you go and get that advice updated in relation to your situation regularly or at any key crucial points in your business.
What happens if you don’t get this right?
I started off by telling you a few stories that I’ve seen in the past. The answer to this question then goes back to the concept that you might be exposing your personal assets (even sometimes if you have a trust or company structure, if you’re doing things that are incorrect) so you need to fully understand how to work with your structure to get a maximum benefit out of them.
If you don’t get the structure right you might also be missing out on tax benefits. We’ve seen cases of businesses that could have saved literally millions of dollars in tax by understanding this and as I said earlier, if you don’t get it right you might otherwise end up in a structure that is too complex which can also cause problems for business. It can cause problems for the business both in terms of a creating complexity for the business owners when they’re trying to do things like bring other partners to the business, bringing investment into the business, and when they’re looking at selling a business.
I’ve certainly seen many instances where sales of a business have been complicated because the owner has had a structure that’s way too complicated for the situation that they’re in.
Quite often buyers dislike complexity that isn’t appropriate for situation, and particularly international buyers because they’re dealing with the jurisdiction that they don’t necessarily fully understand.
So there’s a lot to be said for keeping this as simple as possible also making sure you maximise the potential benefits that clever business structuring can provide.
Your Action Steps
So what are the action steps for you out of today’s podcast?
- 1. The first step is to understand the structure that you are in at the moment and understand the alternatives that are available to you and why those alternatives might be of benefit.
- 2. The second component that is crucial is to get good advice. My recommendation is to get advice from both your accountant and your lawyer, who as I said should be working together looking at your business as a whole. I’m all about holistic approaches to business, and lawyers and accountants both bring components that are equally as important for consideration so they shouldn’t be working in silos, they should be working together in looking at your business.
- 3. And the third element is to review the approach regularly. So set an appointment for yourself whenever there is a key change in your business or at least every few years so you come back and reassess with those professionals whether or not the structure that you have in place today is the right structure for you now and into the future in relation to the plans that you have for your business.
As part of these actions steps, I invite you to download our five step guide which will help you to understand the questions you should be asking about your current business structure.
So thanks for tuning in today, if you like what you heard please leave us a review in ITunes, we’d really appreciate it.
If you’d like to get the show notes from today or that free guide on the top questions you should be asking about your current business structure visit our podcast page at talkinglaw.com.au and leave us some questions. If you have any we will address them in future episodes.
Thanks a lot and see you next time!