When setting up your business it is essential to choose the right format at the outset to avoid administrative, financial and legal difficulties as your business grows. Each type of business entity has its distinct advantages and disadvantages and before choosing a business structure you will need to consider the nature, size, ownership, tax implications and growth potential of your business.
Other than public companies (which is a company formed to raise funds by offering securities to the public and is listed on the JSE) and state-owned enterprises (SOEs), your options in terms of business entities are as follows:
A sole proprietorship, or sole trader, is the simplest business entity which allows a business owner to operate or trade under his/her name. If you decide to operate as a sole proprietorship, you will not need to set up or register a separate legal entity, although you will need to register with Sars for the applicable taxes. Your sole proprietorship is you, and you are your sole proprietorship, meaning that no separate juristic person exists.
Because of this, it is important to note that in a sole proprietorship there is no separation between your assets and liabilities, and those of the business. Further, you will benefit from all the profits and assets accumulated through your business. This means that you will not enjoy what is referred to as ‘limited liability’ such as directors of a private company enjoy. A sole proprietorship is ideal for a small business where the owner does not anticipate a big turnover and intends to work on his/her own into the future e.g. a service provider.
There are very little administration and very few costs involved in setting up a sole proprietorship. As no registration is required, it is quick to set up. As a sole trader, you also have autonomy over your business.
The sole trader is personally liable for the debts of the business. If the business fails, he can lose all his assets. Because there is only one owner, a sole proprietorship can be limiting if you plan to expand your business in future. Although you can change the business entity at a later stage, it may be difficult to differentiate between what is owned by the business and what is owned by you.
A partnership is a legal form of business similar to that of a sole proprietorship but can have between two and twenty individuals who come together to run a business for the joint benefit of all partners. It is effectively a joint venture between two or more people who have come together to carry out a trade, business or profession, although it is important to note that it is not a separate legal person.
The partnership must be created by agreement, and this agreement should preferably be in writing. Each partner will be taxed on his share of the partnership profits, and each person must contribute in respect of money, property, labour or skills with the common goal of making a profit. In turn, each partner can expect to share in the profits (or losses) of the partnership and, as such, it is best to include a profit-sharing ratio in the partnership agreement. In the case of a general business partnership, the partners are jointly liable for the debts and profits of the venture.
As in the case of a sole proprietorship, two or more people can easily enter into a partnership without having to register a separate legal entity, although it is necessary to enter into a partnership agreement where the duties and responsibilities of each partner are set out. There are no formal auditing requirements in respect of a partnership which can reduce costs somewhat, and it is relatively easy to convert a partnership into a private company if the need arises.
Each partner is personally liable for the debts of the business which means that, if the business fails, the creditors can claim from the assets of each partner – this is known as unlimited liability. Further, every time one partner leaves or a new partner is introduced, the previous partnership ceases to exist and a new one is effectively formed which affects business continuity and planning. Because of the shared responsibility between the partners, decision-making can be slow and ineffective especially where there are multiple partners spread out geographically.
A private company – or (Pty) Ltd – may be founded and managed by anywhere between 1 and 50 people, and takes the form of a separate legal entity. To set up a private company, you will need to register the entity through the Companies and Intellectual Property Commission (CIPC). In terms of legislation, only one shareholder is required in a private company, and shareholding is limited to a maximum of 50 shareholders. The Companies Act of 2008 prohibits private companies from offering securities to the public. As private companies are separate legal entities, they are taxed in their own right and offer shareholders protection against the company’s liabilities, otherwise referred to as limited liability. A private company entity is ideal for more complex businesses which anticipate long-term growth, face higher risks, and anticipate hiring more employees down the line.
A private company is its legal entity which provides the shareholders with limited personal liability if the company cannot pay its debts. It can also make a company seem more professional and attract a higher calibre of clientele as well as investors. The debt is owned by the company and not by the individual shareholders, which offers some protection. As a small business, you can contact Sars to see what special tax rates are offered to small businesses.
Administration and set-up costs are higher and will include annual fees payable to CIPC. If the company is required to be reviewed or audited, this will add costs to the bottom line. Shares cannot be offered to the public and you cannot register on the stock exchange. There are many intricate legal requirements when setting up a private company and it is highly advisable to use a professional.
Personal liability company
A personal liability company is a private company mainly used by associations such as lawyers, engineers and accountants. This type of company must be set up by a Memorandum of Incorporation which must specifically state that the company is a personal liability company and, as such, the name of the company ends in the word ‘Incorporated’. An ‘incorporated’ company means that the directors of the company, as well as previous directors, are jointly and severally liable for any debts and liabilities of the company during their respective periods of office. The owners of a personal liability company are considered separate from the company.
As a director (or past director) of a limited liability company, you will be responsible for any contractual debts and liabilities incurred by the company during your tenure, in other words, debt that was incurred during the company’s order financial and commercial activities. This debt does not include liability for delictual claims or unjustified enrichment claims as these are not contracted liabilities. This type of company is best suited to professionals such as attorneys, doctors and accountants who are statutorily prohibited from enjoying limited liability.
Owners of a personal liability company are free to decide how they want to distribute the profits to the members of the company, and there are no fixed rules as in the case of a private company. There is no limit to the number of shareholders in a personal liability company. Also, personal liability companies are subject to fewer disclosure and transparency requirements than private companies.
A personal liability company must prepare annual financial statements, but they do not need to be audited or lodged with the Commission unless specifically prescribed by legislation. This type of company is prohibited by its Memorandum of Incorporation to offer its shares to the public, and shares cannot be transferred. Directors, both past and present, are jointly and severally liable for the debts and liabilities of the entity, although shareholders enjoy limited liability.
A not-for-profit company needs to be set up in terms of Schedule 1 of the Companies Act and should be set up for either public benefit or an objective relating to cultural, social or group interests. A not-for-profit company will end with the letters ‘NPC’ to indicate its status. An NPC can be incorporated with or without members, but must have at least three directors, and is recognised as a separate legal entity. To form an NPC, the incorporators must draft a memorandum of incorporation (MOI) which must set out at least one non-profit objectives and must comply with the terms of the Companies Act.
Further, an NPC can register with the Department of Social Welfare as an NPO to apply for government funding and/or to obtain a fundraising number. In terms of legislation, the assets and income of an NPC may not be distributed amongst its incorporators, members or directors, other than to provide them with reasonable compensation for services.
An NPC can receive tax-exempt status by applying to Sars in terms of Section 30 of the Income Tax Act. If approved, the NPC will be registered as a Public Benefits Organisation making it very attractive to potential donors because, once registered as a PBO, donations made by donors will be tax-deductible.
A non-profit company is required to comply with ongoing administrative requirements set out in the Companies Act including filing annual returns and the NPO Act which could make it very administratively intensive.