Starting a small business takes a very special type of person. Let’s face it; it takes a tremendous amount of courage for anyone to throw away a stable career with job security in order to pursue their dreams.
Usually the new business owner finds herself having to perform all the functions of a business even though she may have little or no experience in these roles. Suddenly she has to develop these new skills awfully quickly.
Anything worth building must be based on strong foundations, so let’s examine the risks and benefits of the various business entities that can be used to set up your business. Once you’re trading it can cause massive headaches if you decide to change from being a sole trader to a close corporation.
The sole proprietor of sole trader
This is the easiest way to set up a business. The business doesn’t need to be registered, and any profits you make become your salary.
But a major problem with being a sole proprietor is that legally, there is no difference between your personal assets and those of the business.
If the business is liquidated because of bad debts you could end up losing your home. To protect yourself from this happening it would be wise to consider placing your personal assets in a trust.
Another problem with sole proprietorships is that any legal agreements fall away in the event of you passing away. If the business is successful, and your child wants to continue with it upon your death, they would need to renegotiate all your agreements with suppliers and customers.
On the up side income tax is a breeze. There are no complex tax issues such as experienced with close corporations and companies.
There are also capital gains tax advantages for the sole trader, who enjoys all the exclusions available to ordinary taxpayers. Furthermore, only 25% of any gain is included for tax purposes. With companies and close corporations, 50% of the gain is included for tax purposes.
Two sole traders can go into partnership, which is very easy to form. A sole trader and a close corporation can also form a partnership. In fact, any form of legal entity can form a partnership as long as no more than 20 entities involved.
A partnership is similar to a sole trader in that the partnership ends when a partner dies, retires, or when a new partner joins. Assets are not owned by the partnership but by the various partners, according to their percentage ownership of the partnership.
Unfortunately, your personal assets are at risk if the partnership is liquidated. A major risk with partnerships is that any partner can enter into an agreement on behalf of the partnership without notifying the other partners.
The different types of partnerships
Basically there are two types of partnerships – ordinary and extraordinary.
Extraordinary partnerships can be divided into “anonymous” and “en commandite”. With these types of partners, their names are never disclosed to any outside parties.
- An “en commandite” partner usually only contributes a fixed sum of money to the partnership so their liability to the partnership is limited to that fixed amount. In return, this partner is entitled to a predetermined share of the profits.
- An “anonymous” partner is responsible for their share of the losses suffered by the partnership. In other words, their share in any loss is not limited as with an “en commandite” partner.
The close corporation or CC
Many business owners feel a lot more comfortable when forming a close corporation (CC), because both a company and a CC are seen as “separate legal entities” to their members or shareholders.
Business owners often erroneously believe that their personal assets are protected in the event of the business being liquidated. While this is partially true, a court will not allow a company or a CC to be used to “justify wrong, protect fraud or defend crime”.
In fact, many sections of the Close Corporation Act deal with the personal liability that can be imposed on the members of a CC.
- In certain cases you will even be required to repay monies paid to you by the CC. An example of this would be when a payment is made to you even though the businesses cash flow can’t afford it.
A major benefit of having a CC is that the business does not end on the death or retirement of any member. It will keep on trading as all legal agreements are between the CC and its customers/suppliers. The CC also owns all the assets, independent of its members.
Membership of a CC is limited to 10 members. It’s important to remember that each member has a responsibility towards the CC. This is known as having a “fiduciary duty”. Why is this so important?
Well, what if the relationship between you and your partner turns sour? They may act in a manner which harms the business or even decide to start a side line business which competes with your CC. You’d be entitled to start legal proceedings against this member and they could be held liable for any loss suffered by the CC.
What to watch out for? Certain CCs are governed by an association agreement. This agreement defines the relationship between each of the members and their roles in the business.
- For instance, by law, any member of the CC may participate in the running of the CC. But only certain members might be allowed to manage and make decisions in the business.
It’s very important that when you join an existing CC, you examine this agreement carefully as you’re automatically bound by it. Without such an agreement in place, anyone can enter into contracts on behalf of the CC which can create even bigger problems.
The private company or (PTY) LTD
The obligations are far more onerous with a company than with a CC. Because a company has directors who are independent of the shareholders, there are strict rules in place which govern their actions. Companies are subject to both the Companies Act and the common law.
A private company must have at least one director and can have between one and 50 members. It’s a separate legal entity from its shareholders and directors and its shareholders and directors are generally not legally liable for its debts.
It’s also important to note that shareholders are only entitled to dividends which may or may not be declared by the company.
Some major differences between a CC and a private company:
- A company can be a shareholder in a private company while only people can be members of a CC
- Shareholders in a private company have no duties towards the company while members of a CC have a fiduciary duty to the CC
- Shareholders are not responsible for the debts of a private company while members of a CC can be held personally liable
- A private company must have an auditor while a CC only needs a bookkeeper.
Considering that a CC offers most of the benefits of a private company with a quarter of the hassle, it doesn’t make much sense for the small business owner to start a private company. Unless of course, there are over 10 partners in your business.
Entering into a partnership can be as difficult as marriage and it makes sense to get all the agreements in place before you decide to commit.