How to Choose a Business Legal StructureScott Williams
The best form of legal structure in which to place your business is something you should get legal advice on without doubt. It will vary from country to country. But it is important that you think about what you want from your structure so that, when you brief your legal advisor, you have a pretty good idea what you want. Once set up, business legal structures are cumbersome to change Yellow Belt
Even the best legal people can only really create something that suits you best if you can tell them what you want. It is quite possible you will have a legal advisor that is average or worse and they might not set you up very well at all.
Go to the article: Choosing Professional Advisors
The discussion below is more a series of points to consider when setting up a business structure than a roadmap on what that structure should be. Because everyone’s business and personal situations are different, we can not, and are not, advising you on the structure most suited to your enterprise.
One of the main reasons for company structures is to limit the liability of the owners for losses, accidents and other events that could result in financial impacts on the owners.
There is an increasing erosion of this protection as governments seek to make at least directors of companies more liable for a whole host of things they were previously protected against.
Even with these issues, a limited liability company structure may give you more protection than owning the business in your name or a partnership because of the liability protection
Directors are members of a Board and are the highest ranking managers of a company.
As such they can also carry ultimate responsibility if something goes wrong with the company. They can be fined or imprisoned by government agencies if the problem is serious. They can be sued by various parties if there are problems.
Although you can buy Directors insurance, it is not common for smaller companies and may be expensive.
Because of this exposure to risk, you may wish to think carefully before becoming a director of any business other than your own and even more so if you are not involved with it on a day to day basis and so not entirely familiar with what is going on.
You might get paid to be a director but the potential damage to your wealth and your reputation if things go wrong may simply not be worth it.
Many directors and others whose personal wealth might be at risk in this way, put their assets in the names of a spouse or partner. This is fine unless the relationship goes sour and you face a divorce.
You might think that you are safe if you are not formally a director. However, if you act like a director by having a role in the governance of the business, you can be labelled a ‘shadow director’ and be just as liable as a proper director. This is especially the case if you have a parent, friend or partner as a Director but they have little to do with the running of the company and you effectively pull all the strings behind the company. By the way, if you are planning to use another party as your director, you should be aware that, if your business fails, they can be made bankrupt along with you. This might not be a position you want to put your ageing parents in. The argument that your elderly mother who is the director doesn’t know anything about running a business and therefore is not liable for its debts will no longer stand up. Directors are expected to be competent and they will be treated as though they are.
A firewall is a bit of business slang that means to erect some defence against damage from an outside source causing problems for property of yours. It is often used in reference to computing systems and the need to keep hackers out.
The Operating Entity
At the heart of your business is the operating entity. It makes products or offers services, employs people and runs up bills for the input resources it needs.
This is the riskiest part of your business empire so it makes a lot of sense to quarantine it as much as possible from other parts of your empire.
If you are an operation of any size, your operating entity is likely to be owned by a limited liability company.
If it gets into trouble and has to be sold or becomes bankrupt, you can lose not only the operating part of the business but also all the intellectual property (IP) like brands and domain names plus any previous profits and any capital in the bank accounts of the business. Even moving that money out at the last minute will not save it as, increasingly, insolvency practitioners can claw back last minute payments and where one creditor has been favoured over another.
This suggests two other layers of legal entities you might want to wrap around the operating company.
The Holding Entity
You should consider a ‘holding’ entity to own the valuable assets like profit, capital and IP. This might be another limited liability company or a trust. Its purpose is to quarantine these valuable assets so that, if the operating business should fail or be sold, you don’t lose all the wealth you have accumulated.
The holding entity owns the assets and either leases or rents them to the operating entity under a management contract. Because the assets remain the property of the holding company, they may not be lost if the operating company fails.
In addition, any money advanced to the operating company might be in the form of loans that are secured so that, if it does fail, one of the first claimants to what is left will be the holding company as a secured creditor. Simply giving money to the operating company without a legally constructed secured loan is to put your wealth at more risk than it needs to be. Shareholders are the last to be refunded money if a business collapses so simply owning the shares of the operating entity is not nearly enough to protect your interests.
Another purpose of the holding entity is to allow you to export profits to protect them but without paying more in tax.
It may not be a good idea to leave profits sitting in the operating business. If it fails, you lose them. If a person is injured and they sue, you can lose them.
On the other hand, you probably don’t want to take the profits yourself. One reason might be that you need them to reinvest in the business so they are better in the hands of the holding entity. Secondly, personal income may be taxed at a much higher rate than business income is taxed. Therefore if you took the profits personally you will pay more tax than if they flow to, and are held by, the holding company. You can transfer money out with dividends to share holders but there are rules attached that reduce how flexible this can be. If you also rent or lease holding entity assets to the operating entity, you may have some flexibility over what you can charge.
If you are a director of your operating company – and you probably will be – you can be personally liable for many possible problems with the company including insolvency, failure to pay retirement benefits and other employee entitlements and taxes, negligence leading to injury etc. The penalties can be fines, imprisonment and possibly loss of the right to be a director. If this happens, the government and other parties may try to claim all the assets in the operating company and also all the assets you own personally; which might include the shares in the holding entity. So, to further quarantine the operating company and you from the holding company, you might want third parties to hold the shares and possibly be the directors of the holding entity.
One form of legal structure that lends itself to this is a ‘trust’. The entity is governed by trustees who manage the business in the interests of the trust beneficiaries; which can include you. But it might also include your partner/spouse and any children you have.
The use of a holding entity is complex and you should seek the advice of a professional. Take care when finding a professional as you don’t want to find out down the track that your structure is not very sound.
Go to the article: Choosing Professional Advisors
So, the main purposes of the holding entity are to;
- Quarantine valuable assets from a failure of the operating company and
- To stockpile profits in a lower tax environment than personal income and somewhat safer.
- To insulate your assets from your personal liability
You could also give some thought to a ‘service’ entity either at the outset or down the track somewhat.
These provide services to your operating entity where that is convenient.
For example, you might use them to provide labour that might be shared over several operating entitles. Rather than run several payrolls, it is administratively easier to run one payroll in the service entity and then rent staff out to the operating entities. In fact, since the service business can charge a premium on the labour (make a profit), it is a way of moving money out of the operating entity where it is vulnerable to the service entity where it is less vulnerable but still might be subject to problems relating to employment. Be aware that there may be rules about how much money can be transferred to a service entity.
If the shares of the service entity are owned by the holding entity, it can export its profits to the holding entity and therefore have few assets at risk if the service company gets into trouble.
In some counties, retirement entities can have special protections and lower tax and might therefore be a good firewall.
In Australia, a self managed super fund (SMSF) may be worthwhile considering.
They are designed to store money for your retirement so you don’t get the benefit of any superannuation savings before retirement but the money can work for you. They also have a much lower tax rate (though governments of all persuasions can’t resist fooling around with super so it is hard to know how long that will continue.) They are also one of the (currently) best firewalls around as, even if you go bankrupt, your savings in super can’t be taken away.
For these several reasons, you might want to consider having at least some the shares and/or real estate of some of your entitles held by your super fund. Not only will you pay a lower rate of tax on dividends, you will probably pay a lot less capital gains tax on the sale of your business and the money is locked up safely to fund your retirement.
It may be that you expect to keep your business and pass it on to following generations of your family. Alternatively, you might die or be incapacitated unexpectedly.
For these reasons, you should give thought to succession planning for your business. And you should do this at the outset if possible when you have the most flexibility.
A skilful use of trusts can make this process comparatively straight forward. Failure to plan for this can see your heirs paying a great deal of Capital Gains Tax unnecessarily.
In another section, we will talk more about Exit Strategies. For now, exit planning is planning to sell your business at some future date or at least working out how to take out a big chunk of wealth to help make you comfortable into the distant future.
In many counties there is likely to be a Capital Gains Tax levied on asset sales. This means you are taxed on the difference between what you put in to get the business going and what you will take out. This can be very considerable as you probably start the business on a shoe string and retire wealthy.
There are also presently some handy tax discounts for smaller business that are well worth taking legal advantage of. But you need to consider them when you are starting out so that you can structure yourself to take maximum advantage of them.
For example, in Australia, at the time of writing there are some good discounts if the total assets of the controlling entity has less than $6 million in assets. If you think you might exceed that before you exit, maybe you can have several controlling entities with each of them able fall below the $6 million threshold and therefore get maximum tax advantage.
This is also a complex area and one that changes pretty much each year as governments fool around with the various provisions. To get up to date advice, check with a professional.
Recapping Business Structures
The ideal business structures for your business is a complex topic and definitely needs good professional advice.
You may not want to bother with this when starting up your business but, be warned, it can be quite difficult to do a lot of this later without paying unnecessary taxes to transfer assets into new entities.
Alternatively, not to do it places your wealth at risk.
Though it is complex, not to do it at the outset is foolish and can be expensive downstream.
Much of what we have discussed here relates to tax planning and the liability laws. Rather than setting up a structure and leaving it untouched for 20 years, you would be wise to have your accountant and/or lawyer do a regular check of your structure to ensure it is still serving its purpose or if it should be tuned to compensate for some change in government legislation. Maybe aim to do this at the time you get your annual tax returns back from your accountant so that you remember to do it at least annually.
We consider your business structure to be of a similar importance to that of working out what business to be in when it comes to protecting your wealth now and in the future
Rogerson Kenny Business Accountants (Australia – Sept 14, 2014) – Choosing the Right Business Structure – Company vs Family Trust – Video link