You are amazing for making it this far! You’ve got a great idea, people are talking about it, heck, you might have even have made some decent sales from it already. Now you’re feeling a bit more confident and must be thinking like: “Yeah, let’s make this official, let’s get my business registered!”
YEAH!
AWESOME!
Love the enthusiasm! But before you go off and register your business – you should know of the three most common forms of business structures!
What are business structures? Well, business structures are essentially the entity that represents your business. Practically speaking, the different business structures are all the same – in the sense that money made by the business is Income, money spent by the business is Expense and at the end of it all, you get Profit!
Where business structures differ is in terms of how tax is calculated on your profit. Also, as we will explore later, your legal liability (liability here meaning what you are liable for – not credits on your loan account!) is determined by the business structure you choose to have.
Also, it’s worth noting that some of the examples given here are based on NZ company laws and regulations – I will clearly highlight this where relevant; otherwise, these three types of business structures are pretty much the norm in most parts of the world:
Sole Trader
Ah yes, the venerable sole trader model. Start a business in your own name. As a sole trader you can pretty much set up without even having to register. You just need to report your earnings to the tax department. A sole trader model is great if you have an idea you want to test out or if you have a little side hustle which you can’t be bothered to go through the process of registering.
It is important to note that as a sole trader, you will need to declare your income to the tax people. But that being said, you can claim expenses related to the operation of your business as well.
This means that you can claim mileage on your vehicle, subscriptions to professional bodies and even meals for yourself and your clients. Any internet, phone and/or power bills relating to you running your business from your home can also be claimed (in NZ, this is based on the size of the area in your house that you use for your business). It is worth noting that these same expenses can also be claimed if you decide to go for a partnership or company structure.
As a sole trader, your profit from your business activity will be added to any other income you have personally (like from a job or other side hustles) and you will be taxed at the individual tax rate of your country.
The downside of being a sole trader is that you can’t exactly sell the business because well, the business IS you and you can’t exactly sell yourself and expect to retire. This is a problem if you are looking at growing the business and then selling it off as part of your retirement plan in the future. The other issue with being a sole trader is that people you owe money to (the bank, your suppliers, friendly neighbourhood loan shark) can legally come after you directly through the courts to demand you pay up any outstanding amounts you owe them – of course this is only a problem if you can’t pay off your liabilities, which as you will recall is a bad thing.
Partnership
A partnership is quite literally Sole Trader 2.0. A defining feature of a partnership is that well, you need to have at least one other partner in the business. A partnership can be described as two sole traders (or more) looking to trade together. It’s quite common for couples to form a partnership together and be in business.
A partnership will prepare a separate set of accounts to calculate its income, expenses and profits. Whatever profit made by a partnership at the end of the year is then distributed to the partners (based on an agreed upon share) and is taxed at the individual partner’s level. What this means is that the partnership itself is not taxed, but the individual partners are (based on their share of the partnership’s profits + any other income earned from other sources). This is true as far as NZ tax laws are concerned. I’m not too sure how partnerships are taxed in other countries – but I reckon it shouldn’t be too different.
Unlike the sole trader structure, you can ‘sell’ your share in the partnership to someone else if you wanted to. However you can only do that with the agreement of the other partner(s) in the partnership. Like the sole trader structure as well though, you are ultimately liable for any liabilities incurred by the partnership and people you owe money to can come after you (and the other partner(s)) if the partnership does not pay up.
Company
A company is what it’s all about! They are cool! Sexy! Flash! Everyone who has ever set up a company can’t wait to put their name as CEO of their brand new company. Its super cool being called a CEO even if you’re actually making less than minimum wage! But I digress. A company is, from a legal and tax perspective a completely different entity to you, the individual that owns the company. Technically this means you could sue the company and the company could sue you (although it doesn’t make sense why you would). A company can cost a bit more to set up compared to the other structures – but it can be worth it in the long run, especially if you are really serious about growing your business.
A company prepares its own set of accounts and pays taxes separately from the individuals that own the company. In NZ, each company has its own IRD number separate from the individuals that own the company. When setting up a company, you get the option of determining how many shareholders there are in the company and allocating each shareholder a certain percentage (%) of ownership in the company. This percentage can be agreed upon by the shareholders based on the amount of $$ they put in or the amount of work that they will be doing for the company.
If you recall – this is called equity, and sometimes, with a lot of shareholders, it can get ugly! At least one of the shareholders must be named the director and the director is ultimately the person responsible to make sure that the company abides by the law, pays their taxes and keeps their promises. Any court action against the company will involve the director(s) in its proceedings – which is why I generally advise anyone setting up a company that you don’t need more than one director (you can if you really, REALLY, want to).
A company is a great business structure for selling off the business in the future. Because it is a separate entity, the assets and income streams of the business are clearly defined and are easily valued.
In NZ, companies can also pay off their profit to its shareholders as shareholder salary. No, you don’t actually get physical money out of the company as a shareholder but it is a rough representation of the amount of drawings you have taken from the company – which needs to be an amount reasonably close to the market rate for the job that you are performing for the company (so, no you can’t willy-nilly pay yourself whatever you want). This shareholder salary will get taxed in your personal tax return. Any profits left in the business are taxed at the company tax rate (this is usually a flat rate for most countries – in NZ its 28% as of the time this article was written in 2019).
The defining feature of a company is its limited liability status. This is represented by the words ‘Ltd’, ‘LLC’, ‘Bhd’ or ‘GmbH’ at the end of your company’s name, depending on which part of the world you are setting up your company in. What limited liability means is that as a shareholder, people that the company owes money to can’t come after you personally. They can’t touch your personal assets – nuh uh, nope, zip, nada. They can take your company to court and if you are the director you will have to represent your company but ultimately, creditors (people the company owes money to) can’t go after your personal assets. In general, some banks and lenders make the shareholders put up their personal home as collateral against business loans for the company (because they know they can’t get to your personal assets otherwise) which, quite frankly, is mean and quite stink.
So there you have, its possibly my longest post yet! Hope it wasn’t too much to get through and I hope that the comics were relevant and provided a welcome distraction! Click here for an official explanation of how business structures in NZ work.