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Setting up a business: What to consider when choosing a legal entity

A look at sole proprietorship, partnerships and private companies.

When setting up a business, it’s important to take a long-term view of how you envisage your business growing as this will, to a large extent, determine the type of entity best suited to house your business. In this article, we take a closer look a sole proprietorship, partnerships and private companies, and how to determine which structure is most appropriate for your needs.

Legal personality

At the outset, it is important to understand the nature of the various legal entities as this can affect your personal liability going forward. A sole proprietorship is a business operated by one individual. There is no separation between the owner and the business and, as such, no separate legal entity is formed. Similarly, in the case of a partnership – or unincorporated joint venture – no separate legal entity comes into existence.

On the other hand, when forming a private company, a completely separate legal entity comes into existence that is separate from the persona of the owner or owners. The nature of the business you intend to run will be a significant factor in choosing the best vehicle for your business. For instance, if you intend to set up a home industry with relatively low turnover or work as a sole service provider, such as a nail technician or dietician, then a sole proprietorship would be best suited for your needs.

Registration

A sole proprietorship is the simplest form of business to set up as there are no registration requirements, no costs involved, and you are free to name your business without having to reserve a name through the CIPC. As a sole trader, you are free to operate under your own name or under a trading name. Setting up a partnership, on the other hand, requires that a partnership agreement be entered into and, while a verbal agreement is sufficient to form a partnership, it is always advisable to reduce the agreement to writing.

As in the case of a sole proprietorship, the partnership does not need to be registered with the CIPC, no name needs to be reserved and there are no registration costs involved. The set-up and registration requirements of a private company are the most onerous as the entity must be registered with the Companies and Intellectual Properties Commission (CIPC) and must comply with the Companies Act 71 of 2008. Naturally, there are costs involved in setting up a private company and the name must be reserved and approved by the CIPC.

Contractual requirements

In the case of a sole proprietorship, the owner and the business are one and the same thing meaning that no contract is required. As mentioned above, while a partnership agreement can be verbal or implied, it is advisable to enter into a written agreement.

When registering a private company in South Africa, keep in mind that there must be one director and one incorporator who may be the same person. You will need to set up a memorandum of incorporation (MOI) which sets out the agreements in respect of the management of the business. As the company incorporator, you can choose to use either a standard MOI or customise an MOI for your specific purposes.

If there are two or more shareholders, it may be beneficial to set up a shareholders’ agreement to structure the relationship between the shareholders. When registering your company, you will need to submit your MOI together with your notice of incorporation, which should include details of the incorporators, the number of directors, and the share capital.

Personal liability

In the case of a sole proprietorship and partnership, keep in mind that sole traders and partners are personally liable for the debt of the business meaning that, if the proprietorship or partnership goes insolvent, creditors may attack the personal estate of the sole trader or partner.

A significant benefit of registering a private company is that the assets and liabilities of the company are separated from those of the owners and, as such, the owners enjoy protection against the company’s insolvency provided that they did not sign personal surety for the debts of the business or engage in reckless trading.

Number of owners

As its name suggests, a sole proprietorship can only consist of one owner. On the other hand, a partnership can be formed between 2 people up to a maximum of 20 people. If you start out as a sole proprietor, it is easy to change your entity into a partnership by entering into a partnership agreement if you want to bring additional people into the business, although it may be difficult to separate what is owned by the business and what is owned by the individual when making the transition. A private company structure requires only one owner and permits up to 50 non-employee shareholders.

Funding

While sole proprietorships and partnerships rely largely on loans as a funding method, private companies have the added advantage of being able to sell shares or issue new shares in order to raise capital if required. There are also numerous avenues available for SMEs in South Africa to secure funding and set up more flexible favourable tax structures in respect of small business corporations.

Very often, entrepreneurs with a solid business plan will be able to raise venture capital in order to fund their start-up business and, if this is your intention, a private company would be an appropriate structure.

Tax

As a sole trader, you will need to declare any income earned from your business when filing your personal annual tax returns, and you will be taxed according to the individual income tax scales.

Similarly, in the case of a partnership, each partner must include any profits they personally made when filing their respective personal tax returns and will be taxed on the income as per the individual income tax tables.

A private company, being a separate legal entity, must register with SARS as a taxpayer in its own right, with the company’s tax reference number appearing on its Notice of Incorporation.

Once registered, a private company will be taxed at a flat rate of 27% for the year of assessment ending any date between or on or after 31 March 2023 (this was previously 28%, with dividends tax levied at 20%. A private company may be liable for other taxes, duties and levies such as VAT, PAYE, UIF, Skills Development Levies, and Customs and Excise, depending on the size, nature and turnover of the business.

Administration

Naturally, there are higher costs involved in registering and running a private company and, as such, it is important to conduct a cost-benefit analysis to determine whether the benefits of running such an entity outweigh the costs involved. The ongoing administrative requirements of a private company are set out in the Companies Act, including the filing of annual returns and the preparation of annual financial statements, where applicable.

Business continuity

The life of a sole proprietorship is limited to the life of the sole trader, which means that the business ceases to exist in the event of his/her death. There would be no saleable value to the business other than its assets. In the case of a partnership, keep in mind that the partnership agreement gives rise to the joint venture – meaning that if one partner dies the partnership is dissolved and a new partnership agreement will need to be entered into. As such, business continuity in respect of partnerships can be fairly cumbersome.

A significant advantage of registering a private company is that the entity exists separate from the life of its owners, and the business entity will continue to exist in the event of a shareholder’s death. Further, a private company can be sold – either in part (in the form of shares) or as an entire entity.

  Sole proprietorship Partnership Private company
Registration None None CIPC
Contractual requirements None A partnership agreement which can be verbal, written or implied Memorandum of Association
Legal personality No separate legal structure No separate legal entity Separate legal entity
Number of owners 1 Between 2 and 20 Minimum of 1 and maximum of 50
Type of owners Sole proprietor / sole trader Partners Shareholders
Tax Taxed according to individual income tax scales Each partner is taxed according to individual income tax scales Taxed at a flat rate of 27% (previously 28%) plus dividends tax of 20%
Liability Sole proprietor is personally liable for debt Each partner is personally liable for debt Owners have limited personal liability
Administration Low set-up costs and easy administration Low set-up costs, but administration can be complex when there are changes to the partnership Can be administratively intensive, but the benefits of running a private company may outweigh the costs
Funding Limited access to funding

Difficult to obtain loans

Limited access to funding

Difficult to obtain loans

Easier to apply for loans

Can issue shares or debentures to raise capital

Auditing No auditing requirements No auditing requirements Accounting requirements, and may require auditing
Continuity The business ceases to exist on the death of the sole proprietor Partnership dissolves on the death of a partner, and a new partnership agreement will need to be entered into The business can continue trading on the death of an owner
Sale The sole proprietor can sell the assets of the business The partners can sell the assets of the business The legal entity can be sold
Insolvency The personal assets of the sole proprietor can be seized by creditors The personal assets of the partners can be seized by creditors The company owns its own assets and liabilities, and the owners have limited liability

 

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