Before starting a business, first consider: if something goes wrong, who will bear the liability?

Many entrepreneurs begin by asking:

“How much money can this project make?”
“How long will it take to recoup the investment?”
“Do I need to register for an ABN?”

From a commercial legal risk-management perspective, however, these are not the most important questions.

The question to consider from day one is:

If the business becomes involved in a dispute, debt, claim or even legal proceedings, who will ultimately bear the liability?

In Australia, the choice of Business Structure affects not only tax arrangements and the operating model, but also directly determines whether the risks of operating the business may extend to personal assets.

In practice, we have seen many entrepreneurs suffer significant losses not from business failure, but because they chose an unsuitable structure at the outset, exposing personal property to business risks.

It is therefore vital to understand the legal consequences of different business structures before registering for an ABN, entering into contracts or commencing operations.

Sole Trader: simple to establish, but the individual bears all the risk

Sole Trader is one of the most common business structures in Australia.

Many freelancers, social media content creators, personal shoppers, consultants and people starting side businesses operate as Sole Traders.

Its advantages are clear:

• simple establishment procedures;
• relatively low registration costs;
• relatively straightforward tax returns;
• flexible business decisions.

From a legal perspective, however, the defining feature of a Sole Trader is that:

there is no legal distinction between the business and the operator personally.

In other words, the operator personally bears the business’s debts, liability for compensation and legal risks.

For example:

• a customer claims compensation because of a problem with a service;
• a supplier seeks payment of an outstanding debt;
• a breach of contract causes loss;
• an accident occurs in the course of business operations.

In these circumstances, a creditor or claimant can generally pursue the operator personally.

This means that personal bank savings, vehicles, property and other assets may all be at risk.

A Sole Trader structure is therefore more suitable for a small, low-risk venture with a relatively simple operating model.

Businesses involving large numbers of customers, greater liability risks or substantial capital investment should be assessed carefully.

Partnership: starting a business together may also mean bearing liability together

A Partnership is a structure used by many couples, family businesses or friends who operate a business together.

The principal advantages of this model are shared resources, joint investment and collaborative decision-making.

However, many entrepreneurs underestimate the legal liability associated with a partnership.

In a general partnership, each partner is responsible not only for their own conduct but, in many circumstances, may also bear legal liability for the business conduct of other partners.

For example:

• a partner signs a contract that carries risks;
• a partner fails to pay a supplier;
• a partner makes an incorrect commitment on behalf of the business;
• an accident occurs or a debt arises in the course of business operations.

A creditor or claimant may not pursue only the person whose conduct was directly involved, but may instead seek recovery from all partners at the same time.

Accordingly, the most important aspect of starting a business in partnership is not mutual trust, but establishing sound legal mechanisms.

A clear and comprehensive Partnership Agreement should generally specify:

• how profits and losses will be allocated;
• each party’s capital contribution;
• who has authority to sign contracts;
• how debts will be borne;
• the decision-making mechanism for significant matters;
• arrangements for a partner’s exit;
• the dispute-resolution mechanism.

In practice, many commercial disputes arise not from market competition, but from a lack of clear agreements at the outset of the business.

Company (Pty Ltd): an important tool for separating risk

As a business expands, more and more enterprises choose to establish a Pty Ltd company.

The principal legal advantage of a company structure is that:

the company is a Separate Legal Entity.

A company can:

• enter into contracts in its own name;
• hold assets;
• employ staff;
• incur debts;
• participate in litigation.

In principle, company debts and shareholders’ personal assets are separate from one another.

This is also an important reason why many businesses choose a company structure.

It must, however, be emphasised that:

limited liability does not mean complete immunity from liability.

If a director:

• continues to incur debt despite knowing that the company cannot pay its debts;
• breaches the director’s statutory duties;
• engages in fraud or dishonest conduct;
• provides a personal guarantee for company debts;

the company’s protective layer may not prevent the relevant liability from ultimately falling on the individual.

The true purpose of a company structure is therefore not to “avoid liability”, but to separate risks and manage liability while operating lawfully and in compliance with applicable obligations. A company structure generally offers greater advantages for the following types of business:

• the building and engineering industries;
• the hospitality and retail industries;
• education and training providers;
• e-commerce and brand-management businesses;
• businesses employing larger numbers of staff;
• businesses that need to enter into long-term leases or major commercial contracts.

Trust: a tool for asset protection and wealth planning

A Trust is a legal structure widely used in Australian business and asset planning.

Rather than being a type of operating entity, a Trust is better understood as an asset-management arrangement.

In appropriate circumstances, a Trust may be used for:

• family wealth planning;
• asset protection;
• income-distribution arrangements;
• tax planning;
• designing a corporate shareholding structure.

Trusts are therefore commonly used for:

• family businesses;
• holding investment assets;
• property investment portfolios;
• multigenerational wealth-transfer arrangements.

At the same time, however, the costs of establishing and maintaining a Trust are generally higher than for other structures.

Its operation requires:

• a comprehensive Trust Deed;
• ongoing legal and accounting compliance management;
• more complex tax-return requirements.

A Trust may not be the most cost-effective choice for a small side business that is just starting out. For business owners who have already accumulated assets and need long-term risk management and wealth planning, however, a Trust can be of considerable value.

A common misconception: registering a Business Name does not mean establishing a company

In practice, we often encounter entrepreneurs who believe:

“I have registered a Business Name, so I have a company.”

In fact, these are two entirely different legal concepts.

A Business Name is simply a trading name. Its function is similar to a brand name or shopfront name used by a business.

For example:

“Lucky Dragon”
“ABC Construction”
“Sydney Education Centre”

These are merely trading names.

A Business Name does not itself create a separate legal personality or automatically provide limited-liability protection.

If the operator is a Sole Trader, the operator personally remains liable regardless of the name displayed by the business.

In other words: a Business Name is merely the sign on the door, while the Business Structure is what actually bears legal liability.

NS Legal’s conclusion: managing the most important risks of starting a business begins with choosing a structure

Many entrepreneurs devote considerable time to marketing, developing a customer base and forecasting profits.

These matters are, of course, important.

From the perspective of managing legal risk, however, success in business depends not only on how much profit is earned, but also on how much risk can be borne when a problem arises.

A business structure cannot guarantee the success of a business.

However, an appropriate business structure can help an entrepreneur to:

• separate business risks;
• protect personal assets;
• improve the business’s governance and compliance;
• lay the foundations for future financing, expansion and asset planning.

At the outset of a business, focusing on profit is certainly important.

In Australia’s business environment, however, what often warrants more advance planning than profit is this: when a risk materialises, who will ultimately bear the liability?