Often people who start their own small businesses start out as sole traders or as a partnership if they are building the business with an partner or with their spouse.
Particularly when you are talking about online businesses.
Because, let's face it setting yourself up as a sole trader is easier than setting up a partnership or a company, there are fewer tax reporting or other legal requirements, and you can always decide to change your structure in the future, when and if your business needs change.
Although I have provided an overview of all three business structures below, it is important that you discuss your thoughts on your business legal structure with your accounting, tax, and legal advisers and consider all your options before you make your final decision!
Sole Trader Business Legal Structure
The sole trader business legal structure is one of the choices you will consider when you are determining which legal structure will be the most suitable for your business.
A sole trader is an individual who operates their business in their own name. They can make their own decisions and run the business in whatever way they see fit, but they also bear full liability if anything goes wrong. This is because the business of a sole trader has no identity in its own right.
Any debt incurred or any liabilities created by doing business, belongs to the business owner and not to the business. The owner is also personally responsible for the actions of any employees.
Advantages of Being a Sole Trader
The advantages of being a sole trader include, complete control of the day-to-day running of the business. As the obligations and property of the business are in the name of the owner, there are fewer legal requirements, making it easier to set up the business, and there are lower compliance costs (than for a company).
You also get to keep all of your profits as a sole trader, you still get to pay tax of course, but you do not have to share the cash with anyone else.
Are There Any Disadvantages?
As a sole trader you have unlimited liability for all of the businesses debts, and the only way to raise capital is to borrow. As the owner is the business, it can be difficult to sell if the owner wants or needs to move on as often the owner is the business. The profit of a sole trader is also treated as the personal income of the owner and taxed at the individual tax rate.
A Partnership business legal structure involves a legal arrangement between two or more people who intend to carry on a business together. The partners, in whatever proportions agreed to in the partnership agreement, own the business.
Basically the assets of the business are owned in 'common'. Each of the partners has an interest in the profits of the business and the partners acting together manage the business. Partnerships can only have a limited number of partners; the number varies depending on the type of business the partners are operating.
In a partnership each partner is responsible for all of the liabilities of the business, and as with a sole trader the partners are not limited to their investment in the business. The term for this is joint and several liability. If the business gets into trouble, a creditor can go after any one of the partners to recover the full amount of the debt, even if that particular partner is not responsible for what ever the trouble is.
Advantages of the Partnership Legal Structure
The advantages of a partnership includes the ability to split the income of the business between the partners (which for a family business can have tax advantages), and as the income is viewed as the personal earnings of each partner, any businesses losses can be offset against any other the income earned by a partner.
The joint and several liability of a partnership also make it more attractive as a borrower than a sole trader.
The disadvantages include a dilution of the ownership of the business and the need to manage the day-to-day operations by consensus. As a partner you are also personally responsible for all of the debts and liabilities of the business, and you may find yourself responsible for a debt that you knew nothing about!
Another disadvantage of a partnership legal structure is that if one of the partners wants to leave or dies, the partnership no longer exists and a new partnership must be formed. This can have tax implications as the dissolution of one partnership and the formation of another is viewed as a transfer of ownership (e.g., in Australia this creates a liability for capital gains tax).
What About A Company for Your Business Legal Structure?
Unlike Sole Trader or Partnerships, companies are considered to be separate legal entities from the individuals who own shares (i.e. the owners). A company can legally own assets, incur debt, sign contracts, and employ people it is own right. A company can also sue or be sued.
For tax purposes a company has its own identity and must pay tax on its earnings and lodge tax returns, separate from those of its owners. If a company gets into financial trouble, creditors can only claim assets held by the company, and not the personal assets of the shareholders, unless the shareholders have made personal guarantees for the company or offered any other personal security against the company's liabilities.
Ownership and control over the business is not necessarily the same thing in a company. The shareholders 'own' the company but unless they also hold a position on the board or are employed as a director (or manager) they do not have day-to-day control over the business.
There is usually no requirement for company directors, who do have day-to-day control over the business to own shares. In a new (small or family owned) company, this separation of ownership and control tends to be "in theory" rather than the usual practice, as the company founder is generally also the managing director.
There are two main types of companies, public and proprietary. While public companies can have any number of shareholders, there is a limit on the number of shareholders a proprietary company can have. The shares of a public company are publicly available for purchase through the share market, whereas the shares of proprietary companies are only traded privately.
Advantages of a Company Business Legal Structure
There are many advantages to incorporating a company. Your liability is limited to the amount you have already invested in the company (unless you have offered personal guarantees to creditors), companies can be expanded quite easily by increasing the number of shares available for sale, it is relatively easy to increase the number of owners and it is reasonably easy for existing owners to leave, and a company can continue to exist if the founder, managers or shareholders leave.
Disadvantages of a Company Structure
However, there are disadvantages as well. A company can be expensive to set up, and they face high compliance costs due to the greater degree of scrutiny they receive from government organizations (i.e., the tax office).