Sole Trader or Company: What You Need to Know as an SME Founder

Introduction

When setting up a business, choosing the right structure will be one of the earliest and most important decisions that a founder will make.

The most common business structure in Australia for SMEs is to either operate as a sole trader or through a proprietary limited (ie. Pty Ltd) company.

While the distinction between a company and a sole trader seems straightforward, the legal, financial and practical implications are often underestimated or not properly considered.

This article focuses on what SME founders actually need to consider when setting up their business.

Legal Identity and Liability

The main difference between operating as a sole trader and operating through a company is their legal identity.

A sole trader is not a separate legal entity. Rather, the business and the individual are legally the same. The risk here is that the founder is personally liable for all debts incurred and the obligations of the business.

Comparatively, a company is a separate legal entity. The company can enter into contracts, incur liabilities and be pursued in its own name. In most cases, companies registered with the Australian Securities and Investments Commission (ASIC) limit shareholder liability to the value of their shares.

In practice, this means that if something goes wrong, whether that be a contractual dispute, unpaid debts or a negligence claim, the sole trader’s personal assets (including their home) may be exposed. However, if a company structure is used, this typically provides a layer of protection, with only the company liable for these matters. Despite this, founders should note that directors of companies can still be personally responsible in certain circumstances such as where they have breached their directors’ duties or where the company has been trading while insolvent.

Taxation Considerations

When determining the appropriate structure for your business, you should not only obtain legal advice but accounting advice.

There are several tax considerations that accountants can provide advice on that may impact the structure that founders use for their business.

Setup, Cost and Administration

A key consideration for founders that often impacts the structure chosen is the costs and administration involved.

Sole trader structures are inexpensive and can be established quite easily. In fact, registration with the Australian Business Register to obtain an ABN is typically all that is required.

In comparison, setting up a company involves:

• Registering with ASIC;
• Paying ongoing annual review fees;
• Meeting director obligations and compliance requirements; and
• Ensuring there is structured record keeping.

While setting up a company is considered more complex than setting up a business as a sole trader, the added protections of using a company often outweigh the additional compliance involved and this is something that should be considered by founders from the outset.

Perception and Growth

Commercially, operating through a company is often credited as enhancing businesses’ credibility with clients, suppliers and investors as it is seen to show a level of professionalism.

Setting up a company structure also provides a clear pathway for growing, scaling and/or selling the business as it allows founders to:

• Bring in investors;
• Issue shares; and
• Sell the business.

Practically, sole trader structures are more difficult to scale, transfer or to sell as the business is legally tied to an individual.

Risk Profile

As mentioned throughout this article, a common mistake made by founders is choosing a business structure based solely on the costs involved or the simplicity of setting it up and maintaining it.

However, this should not be the only thing that a founder considers.

Founders should always consider the following when looking at what structure to use for their business:

• The level of commercial risk in the business;
• The likelihood of taking on debt;
• Whether employees will be hired; and
• The risk of exposure to third party claims.

Upon assessing the above, if a founder’s business is classed as high risk, a company structure is often more appropriate to limit liability and to mitigate risk.

Insurance

Irrespective of the structure chosen by a founder, insurance is a critical tool that must not be overlooked.

While a company structure limits liability, it does not eliminate it and as noted above, directors can still face personal exposure and the company itself must meet its own obligations.

Similarly, sole traders rely heavily on insurance as their primary risk and liability mitigation tool, given that they are personally exposed through this structure.

Professional indemnity, public liability and other policies should be considered to complement any business structure.

Restructuring

A founder’s decision regarding the appropriate business structure does not need to be permanent and can change over time.

Many founders start as sole traders and later transition to a company as the business grows. This is a common pathway.

However, founders should still take the time to properly assess the appropriate structure to remove the need to restructure the business given that doing so can trigger:

• Tax consequences (including capital gains tax);
• The need to transfer contracts, assets and employees; and
• Administrative and legal costs.

It is worth getting the structure right early or at least planning ahead for a transition.

Conclusion

There is no one-size-fits-all answer when it comes to business structures. Sole trader structures offer simplicity and low cost, while companies provide scalability and a level of personal protection.

For SME founders, the decision should be driven by risk, growth plans and long-term objectives rather than the costs and difficulty initially involved. Obtaining legal and accounting advice can prevent costly restructuring and ensure the business is set up to succeed from the outset.

Additional resources

Frequently asked questions