How to Choose the Best Legal Entity for Your Business?

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Date Created: 27 Aug 2020
Last Update: 9 Nov 2020

You have a detailed business plan and you already acquired the resources needed for your business. Now the question comes down to - what legal entity should you use for your business?

 

Choosing the best legal entity for your business is dependant on your line of business, are you carrying on the business alone or with partners, the potential liabilities relating to your business, tax implications, costs of setting up and maintaining the entity, as well as an understanding of the laws, rules and regulations in your jurisdictions.

 

It is important for budding entrepreneurs to take into account all the relevant factors, evaluate them and make the best decision on the best legal entity that will be the most cost-efficient and help them to grow. This guide is a compilation of the 3 most common types of legal entity used by businesses and the advantages and disadvantages of each type of business structure to help you to choose the best legal entity for your business.

 

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1. Sole Proprietorship

 

If you are running the business on your own, choosing a sole proprietorship as your legal entity is the simplest way to set up. In fact, a sole proprietorship is not even a separate legal entity from the owner. The basic premises is that the business is carried out in the sole owner’s name, which means the owner has total control over how the business operates.

 

Since a sole proprietorship is essentially the same as the owner, it is the simplest way to carry on a business or trade with no special rule to follow. As all the business properties and contracts are under the owner’s name, the owner is personally liable for all liabilities and legal obligations of the business.

 

Advantages

  • Owners get all profits from the business operation
  • The simplest way to establish a business
  • Low start-up costs
  • Less administrative paperwork than other business structures
  • Total control over the business operations

 

Disadvantages

  • Difficult to raise capital
  • Lack of continuity in the company without the owner (in the event of illness, incapacitation or even death of the owner, the business cannot continue)
  • Owner is personally liable for all debts, contractual and tortious liability since there is no separation between the proprietor and the business (unlimited liability)

 

Registration

 

Owners should register their sole proprietorships with the government revenue authority if they fall into the government’s requirements. Most common law countries require registration of business with the relevant tax authority even for sole proprietors carrying on business in the jurisdictions.

 

For example, in the UK, sole traders have to register if any of the following apply:

  • The owner earns more than £1000 from self-employment within the last tax year
  • The owner has to prove that he/ she is self-employed, for example, to claim Tax-Free Childcare
  • The owner wants to make voluntary Class 2 National Insurance payments in order to qualify for benefits

 

Then, UK sole traders have to register with HM Revenue and Customs using any of the ways below:

  • Completing an online form from HM Revenue and Customs
  • Filling in the designated form in hardcopy and sending it to the address stated
  • Phoning HM Revenue and Customs on 0300 200 3310

 

Owners have to keep records of their business’s sales and expenses for their ‘self-assessment’ tax.

 

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2. Partnerships

 

If you are carrying on the business with one or more partners, then you may consider setting up a partnership.  A partnerships is formed when two or more persons carry on a business with a common view of earning profit. Partners have a contract between themselves as to the partnership’s operation and regulation. 

 

The partnership can be formed formally through a partnership deed, or informally through a verbal agreement. Each partner is involved in the business, including capital, property and skill. Therefore, they each share in the profits and losses of the business. The partnership itself is not a legal entity, but the partners are the legal entity. The partners could be both a normal person or a company alongside other partners.

 

Limited Liability and Registration of Partnership

 

General Partnership - There is no limited liability in a general partnership, so partners are jointly and severally liable for each other’s liabilities arising from the partnership business.

 

Limited Partnership - The general partners (who generally manage the partnership) would have unlimited liability with the limited partners (who generally only provide the funding) having limited liability on the liabilities arising from the limited partnership.

 

Limited Liability Partnership - This is similar to a limited company in the sense that the partnership is a separate legal entity on its own and carries limited liability for the partners.

 

Registration of Partnership - For registration, most types of partnerships do not have to register with the Registrar of Companies. However, ‘limited partnerships’ and ‘limited liability partnerships’ have to be registered as they are similar to limited companies. Nevertheless, legal entities carrying on business in a particular jurisdiction are generally required to complete business registration with the tax authority of that jurisdiction. 

 

Click here to read more about limited partnerships and limited liability partnerships.

 

Partnership Agreement

 

The most common way of creating a partnership is by a written agreement which sets out all the terms and conditions agreed to by the partners. Below are some common terms in a partnership agreement:

  • Equal share in profits, equal contribution towards losses
  • Indemnity to partners from the firm for payments and personal liabilities incurred in the ordinary course of business
  • Entitlement to take part in the management of the business with no remuneration
  • No additional partner without unanimous consent
  • Majority rule on ordinary matters
  • Unanimous decision on change in nature of business
  • Keeping of partnership books at a place of business so to allow every partner to have access to and inspect the books

 

Here are some useful information and document templates below:

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Partners’ Liability to Third-Parties

 

Partner is an agent of the firm and other partners. In general, notice to any partner relating to the partnership business is a notice to the firm. Therefore, acts of each partner in the usual course of business bind the firm and other partners, unless the act is without authority and the person with whom the partner is dealing with knows that the partner has no authority, or does not know or believe the person to be a partner.

 

Below are some common acts which the partners have implied authority to do so in the usual course of business:

  • Lending the firm’s money or borrowing money for the firm
  • Pledging partnership assets to secure partnership debt
  • Draw or accept  bills of exchange
  • Receipt of debts owing to the firm
  • Release of debts and compromise of actions

 

A point to note is when a partner represents himself or knowingly allows himself to be represented as a partner in a transaction, either by verbal or written or by conduct, it would cause the whole partnership to be liable for that transaction. Even when that partner has died, the other partners would still be liable. When the other party in the transaction relied on the partner’s representation, the partners may be sued by the third party who has acted upon the faith of the representation.

 

Partners’ Duties

 

The partners owe duties to each other. They must act in good faith as partnerships are based on the mutual confidence of each partner in the integrity of every other partner. Some acts considered to be in bad faith are:

  • Making a private or secret profit from transactions made through the partnership
  • Competing with the firm by carrying business of the same nature
  • Providing inaccurate accounts

 

Partners’ Rights

 

Below are some common rights of the partners in the partnership:

 

  • Taking part in the management
  • Right to veto a change in the nature of the partnership business
  • Inspecting partnership books
  • Right not to be expelled by majority vote except where expressly agreed between the partners

 

Dissolution of a Partnership

 

Some events which may trigger the dissolution of a partnership are:

 

Subject to the partnership agreement

    • Expiration of a fixed term
    • Completion of a single venture or undertaking or by notice
      • Contractual, similar to a joint venture
    • Death or bankruptcy of a partner

 

By the court

    • A partner is permanently incapable of performance
    • Just and equitable grounds
    • A partner is guilty of conduct which prejudices the business
    • Partnership business can only be carried on at a loss

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3. Companies

 

Whether you are carrying on the business on your own or with other people, you have the option of incorporating a company to keep a separate corporate personality. A company is a separate legal entity (unlike a sole proprietor or a partnership) with limited liability.

 

The company itself is held legally liable for the actions and debts the business incurs. The owners of the company are the shareholders. In general, a company should have directors, company secretary, articles of association and a registered office to own and operate its assets and business.

 

Type of Companies

 

  • Public company limited by shares
  • Private company limited by shares
  • Public unlimited company with a share capital
  • Private unlimited company with a share capital
  • Company limited by guarantee without a share capital

 

Read more about companies limited by shares and unlimited companies here.

 

Companies Limited by Guarantees

  • A common form of companies set up for non-profit purposes
  • Need not to pay any amount upfront
  • Does not have any shares or shareholders
  • Owners are the guarantors who agree to pay a set amount of money for the company’s debts
  • Liability of the shareholders is limited to the amount they undertake in the articles of associations to contribute to the assets in the event that the company is wound up
  • In general, guarantors will not receive profits since the profits will be invested to help promote the company’s objectives

 

Private Companies vs Public Companies

 

Private companies are usually smaller in size and more common. They are generally subject to less restrictive requirements, for example, in accountancy, registration of financial statements and restrictions on loans to directors. Below are some additional characteristics:

  • The company restricts the right to transfer its shares (outright or by way of pre-emption clauses)
  • The company restricts members to no more than 50, not counting employee members
  • The company prohibits invitation to the public to subscribe to company shares or debentures

 

A public company allows its shares to be listed on a stock exchange for the public to freely exchange.

 

Click here for the advantages and disadvantages of setting up a company.

 

Corporate Personality

 

The modern corporate entity includes a separate legal entity and limited liability, which means:

  • The company can have all rights and liabilities in its own name
  • The company can own property and can make contracts
  • The company can sue or be sued, for example, in contract, tort and criminal law
  • The rights, property and liabilities of the company do not belong to the shareholders
  • The rights, property and liabilities of the shareholders do not belong to the company

 

When a company is registered, it has a legal personality and has almost the same rights and powers as a human being. The company’s existence is distinct and separate from that of its shareholders. The company also has perpetual succession until it is wound up.

 

Piercing the Corporate Veil

 

However, shareholders should be aware that there is an exception to the principle of separate corporate personality. Normally, the doctrines of separate legal entity and limited liability will shield a company’s shareholders from being sued by the company’s creditors.

 

The exception to the doctrine is called piercing the corporate veil. When the doctrines of separate entity and limited liability are abused, the corporate veil may be lifted to render the rights or liabilities of the company as those of the persons behind the company. Shareholders or directors may be required to pay the outstanding debts of the company to the creditors.

 

This exception only applies under limited circumstances, below are some examples:

  • A shareholder’s absolute control over the company
  • Some exceptional circumstances eg. impropriety/ improper motive

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Company Constitution

 

There are generally two documents required to set up a company: a memorandum of association and articles of association.

 

A memorandum of association is a document stating that the founding shareholders or guarantors agree to become members of the company.

 

Here is a document for the Written Resolutions of Sole Member/ Members/ Shareholders- Memorandum of Association Amendment.

 

The articles of association are a company’s internal rules or by-laws. They outline the company’s operation and shareholders’ rights. The rules include issues such as the rights attached to each class of share, the quorum for meetings and the transfer of shares.

 

Here are some document templates for articles of association:

 

The articles of association may be amended by the shareholders passing a special resolution in a general meeting or a written resolution. There are certain restrictions under local statutes and common law. Below are some common law constraints:

  • The alterations must be bona fide for the benefit of the company as a whole
  • Unfair discrimination test: alterations are invalid if the majority shareholders are benefitted by what the minority is deprived
  • Alterations regarding compulsory share buy-backs may be invalid unless they are for proper purposes and are fair in the circumstances

 

Here are some document templates for the written resolutions related to articles of association:

 

There may be model articles of association recorded in local statutes. The model articles of association is a document containing the default articles. For example, there are three versions of the model articles in the UK for private companies limited by shares, private companies limited by guarantee and public limited companies. The model articles are automatically applied to the company upon incorporation unless the company chooses to tailor the articles.

 

The provisions in the model articles of association generally include:

  • Members’ liability- the limit of members’ financial liability
  • Meetings arrangement- general meetings’ organisation and voting arrangement
  • Administration- company records inspection and directors’ indemnity
  • Shares- rights attached to shares, transfer of shares and dividends
  • Directors- rights and responsibilities and appointment

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Directors

 

Directors have a general power of management subject to the ultimate control of the members. There are executive and non-executive directors. Executive directors are full-time employees of the company. Non-executive directors are not involved with the company on a full-time basis.

 

First directors of the company are named when the company is incorporated. Subsequent appointment, rotation and removal of directors are governed by articles of association. In general, directors hold their office until the next annual general meeting, at which point they are either re-elected by ordinary resolution or they retire. Directors can be removed by ordinary resolution of the members and special notice should be given.

 

Directors’ Duties

 

Directors owe fiduciary duties and duties of care to the company.

 

Below are some fiduciary duties the directors owe to the company:

  • Duty to act in good faith in the interest of the company
  • Duty to exercise powers for proper purposes
  • Duty to avoid conflict of interests

 

With regards to the duties of care, the directors owe the duty to exercise reasonable care, skill and diligence. Below are some breaches of such duty:

  • Inadequate risk management
  • Signing inaccurate documents
  • Approving inaccurate financial statement

 

Corporate Dissolution and Insolvency

 

There are three modes of winding up- members’ voluntary winding up, creditors’ voluntary winding up and winding up by the court.

 

For voluntary winding up, it is resolved by special resolution. Upon the date of the passing of the special resolution, the voluntary winding up commences.

 

Regarding winding up by the court, here are some circumstances which the court may order the company to be wound up:

  • The company suspends its business for a whole year
  • The company has no members
  • The company is unable to pay its debts
  • It is just and equitable that the company should be wound up

 

After final affairs are wound up, the company is dissolved. Any property left in the company is vested in the government.

 

Choosing the Best Legal Entity for Your Business

 

You can choose the best legal entity for your business based on a variety of factors, such as the procedures, rights and responsibilities of the owners and business dissolution. It is best to analyse the advantages and disadvantages of each type of legal entity. A right legal structure can take your business further - it may make very little difference initially, but it matters a lot if your business grows to a certain size later on.

 

Please note that this is a guide on the general position of different types of legal entity under common law. This does not constitute legal advice. As each jurisdiction may be different, you may want to speak to your local lawyer.

 

 

 

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