Sole Trader Vs Company

This is an age-old question that I get asked a lot, and it makes sense right. It’s easy to start trading in your own name; you just start making sales, paying for advertising, you already have a personal IRD number.

But, in the long-term, trading under your own name (i.e. sole trader) is not going to be the best idea. In some instances, it’s fine, but even then, I would just say what’s the point? Why take that risk?

Sole trader, easy to setup

Again, it’s easy. Simple to set up, your IRD number is already sorted, just get started.

Taxes are simple as well, as you just pay based on the personal tiered tax rate system here in NZ.

The biggest downside, and one that I think people underestimate is that you have no protection to your exposure to business risk. For instance, lets say you’re an electrician contracting to a builder. The wiring job you do is top notch (forgive me, my sparky jargon game is weak) but, something goes wrong with the whole build, the builder is on the verge of insolvency and they’re trying to scrape funds together to survive. They start blaming the sparky for a few small human errors. The liability is significant ($50-$100k). What can you do if you can’t pay?

Not much.

You don’t have the protection of a limited liability company, so you are sued personally. All of your personal assets are exposed; your savings, your share of the family home, your vehicle, tools, even potentially your share of your parents family trust. Everything that you own. If you can’t pay, bankruptcy proceedings may come forth.

I’m not trying to be a scaremonger here, but this is a real possibility, and the example clarifies the reality.

Insurance

Public liability or indemnity insurance can certainly be a help in protecting against this potential exposure. However, insurance companies are flaky at the best of times, and they may become a pain to deal with in the event you need to make a claim. They’re a protection, but not one to be relied upon.

Sole trader, when it’s OK…

If you are in a low-risk industry, or you are contracting to one person in a quasi-employment scenario, you should be ok to trade as a sole trader. Even so, I would suggest you only do this for the short term.

In the long-term, if you’re serious about business, you will most likely begin trading through a company anyway. Along with the other benefits mentioned in this article, a company is more professional to the outside world; to clients, financiers, potential employees.

When you do transition, there’ll be a few costs involved from the accountant; the accountant needs to bring your prior trading into the company, which takes time and has some complexity. These costs are greatly reduced if you start with a company from the outset.

The difference between a sole trader and a company, explained.

Ryan, what’s so good about a damn company?

Right, so first off, it’s a separate legal entity. You are a legal entity, and so is a company, they are two separate entities. Hold onto this point, it’s important, I’ll come back to it in a sec.

It’s also got this thing called ‘Limited Liability’. This means that company shareholders are protected from any future claims from creditors.

Remember the earlier example of the builder trying to attack you for faulty wiring? They’re an example of a creditor, an informal one at that, but a real one. All that is exposed are the assets of the company, not the shareholders personal assets. Another term for this concept is the ‘corporate veil’.

So back to the separate legal entity point. As evidenced by the above, the shareholder is separate to the company. The company has the liability, not the shareholder.

This is also important when it comes to taxes. A company can pay anyone it so pleases. Including it’s shareholders. Often a small company has one shareholder, but to better reflect the true ownership, I recommend some of the shares be sold to your life partner. Both of you can then be awarded a shareholder salary (i.e. what the company is paying you for your work) and overall, you end up with a lower tax bill given the lower marginal personal tax rates.   

My final point on companies is that they can be wound up / struck off. If something doesn’t go to plan, you want to start fresh, the company can be wound up. This is often why a new company is incorporated for a property development or a joint venture. They are undertaking a specific activity that has both commercial and tax consequences and the shareholders want this kept separate from themselves and or their other entities.

Once these ventures have run their course, the company can be struck off to minimise the likelihood of future claims against the company.