“I’ve set up myself as a company so that my personal assets are protected”
This statement is technically correct but setting up a small business under a company structure can sometimes provide a false sense of security. The “protection” has a lot to do with your line of business and what you think you are protecting against.
What are you really protecting?
Protection from creditors
A company is insolvent if it cannot pay its debts when its dueA company is a separate legal entity and debts and liabilities incurred by the company theoretically stop with the company unless as a director, you allowed the company to trade while insolvent. If you do, then as a director you are personally liable.
It is fairly common for banks to request personal guarantees from directors when granting loans, and once you sign a personal guarantee, you are liable for the debt if the company is unable to repay the loans. So there goes your protection, at least from the banks!
Protection from being sued for professional negligence or incompetence
Some business owners believe that a company structure will protect them if they are sued. “Being sued” is extremely broad. What if you are being sued for negligence, malpractice, incompetence, bad advice? This is a grey area that may require legal advice based on your individual circumstances. In my discussions with legal contacts, I found I couldn’t get a straight answer. It was a case of “it depends”. It depends on your line of business and it depends on how highly regulated your industry is. This may be particularly relevant for professionals who provide treatment or advice to clients e.g naturopath. The company structure may not protect you from being sued for advice or treatment gone bad. This is what professional indemnity insurance is for, not a company structure.
Things to consider when deciding to incorporate
Costs & Compliance
It costs a lot more to register and set up a company compared to operating as a sole trader, and there are strict compliance requirements that need to be met. This meets more paperwork and record-keeping! For more information (in Australia), have a look at the ASIC website.
Withdrawing funds from the business
Consider how you will be withdrawing funds from the business. Will you be taking wages, paid a dividend as a shareholder or a combination of both? If you are just starting up your business and aren’t making huge amounts of money, you should note that the company tax rate is 30% with no tax-free threshold which means that every dollar of profit is taxed. From 1 July 2012, the individual tax-free threshold has increased to $18,200 which at face value, means it could be more tax effective to be operating as an individual at lower income levels. Obviously tax is never straightforward and there other things to consider like franking credits, the appropriate balance between distributing and retaining funds in the business and so on. Your accountant should be helping you work through these issues. For more on tax, visit the Australian Tax Office.
A colleague recently related a story about a client who was struggling financially while the business was roaring. Upon investigation, it seemed she had been taking too little in wages because she thought she couldn’t take any more. The amount of wages had been set when she first started the business and had never been reviewed. This is one example of how having extra “layers” can sometimes complicate and confuse, so do seek advice if you are unsure.
Most businesses will head straight to an accountant when they want to set up a company. If your objective is protection, seek legal advice as well. Your situation may be unique and setting up a company may not be the best way to offer the protection that you need.
Ultimately, the decision to incorporate should be a strategic one that balances all the other aspects of business planning – financial, marketing, compliance, not just solely on asset protection for the proprietor. Any business that has the potential to grow and expand will likely reach the point where it makes sense to incorporate e.g to enable the ability in issue shares to attract investment capital. However in the early stages, it is worth doing a cost-benefit analysis to work out whether it’s worthwhile. Is this the best decision at this point in time?
Disclaimer: This post has been written for informational purposes only and without considering your individual circumstances. Before relying on any of the information, please seek professional advice.