8 Aug 2022
27 Aug 2020
Choosing the right legal structure or entity for your business is extremely important. Unfortunately, it is not a straightforward decision as it depends on a whole host of factors, including your line of business, whether you are conducting business alone (or with partners), potential legal liability, tax implications, costs of setting up and maintenance, as well as jurisdictional laws and regulations. As an entrepreneur, you ought to consider all the relevant factors, evaluate them, and decide on the best legal entity for you.
This guide will introduce you to three of the most common types of legal entities used by businesses, and the advantages and disadvantages of each type of business structure. By the end of this, you will be able to make an informed decision on which legal entity best suits your business needs.
A sole proprietorship is the most common type of entity. If you are running the business on your own, a sole proprietorship is the simplest form of legal entity to set up. The basic premise is that the business is carried out in the sole owner’s name, meaning that the owner has total control over business operations.
Since a sole proprietorship only consists of the owner, it is the simplest way to carry on a business or trade as there are no special rules to follow. All business properties and contracts are under the owner’s name, the owner is personally liable for all liabilities and legal obligations of the business.
The advantages of a Sole Proprietorship include:
Business owners get all profits from the business operation
It is the simplest way to establish a business
Low start-up costs
Less administrative paperwork than other business structures
Complete control over the business operation
The disadvantages of a Sole Proprietorship include:
Difficult to raise capital
No continuity of the company without the owner (in the event of illness, incapacitation or even death of the owner, the business cannot continue)
The owner is personally liable for all debt, contractual and tortious liability since there is no separation between the proprietor and the business (unlimited liability)
Business owners should register their sole proprietorships with the government revenue authority if the government requirements apply to them. Most common law countries require businesses to be registered with the relevant tax authority even for sole proprietors carrying on business in the jurisdictions.
For example, in the UK, sole traders must 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 to qualify for benefits
UK sole traders can register with the 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 must keep records of their business’ sales and expenses for self-assessment tax.
If you are conducting your business with one or more partners, you may consider setting up a partnership. A partnership is formed when two or more people create a business with the common goal of earning profit. Partners establish a contract between themselves that sets out the partnership’s operation and regulations.
The partnership can be formed formally through a partnership deed, or informally through a verbal agreement. The idea behind a partnership is that each partner contributes to the business in the form of capital, property, and skill. As a result of their contributions, they share the profits and losses of the business. Whilst the partnership itself is not a legal entity, the partners themselves are considered legal entities.
General Partnership - There is no limited liability in a general partnership, so partners are jointly and severally liable for all liabilities arising from the partnership business.
Limited Partnership - The general partners (who generally manage the partnership) 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 like a limited company in the sense that the partnership is a separate legal entity itself and individual partners have limited liability.
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’ must be registered as they are similar to limited companies.
Click here to read more about limited partnerships and limited liability partnerships.
The most common way of creating a partnership is through a written agreement that sets out all the terms and conditions the partners agree to. Below are some key terms you would find in the typical 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 rules on ordinary matters
The unanimous decision on change in nature of business
Keeping partnership books at a place of business so as to allow every partner to have access to and inspect the books
Here are some useful information and document templates you can use and customise below:
Partners are agents of the firm. Thus, notice to any partner relating to the partnership business is a notice to the firm. Acts of each partner in the usual course of business bind the firm and other partners unless the act is done without authority and the person whom the partner is dealing with knows that the partner has no authority (or does not know/ believe the person to be a partner).
Below are some common types of things that partners have implied authority to do in the usual course of business:
Lending or borrowing money for the firm
Pledging partnership assets to secure partnership debt
Drawing or accepting bills of exchange
Receipt of debts owing to the firm
Releasing debts and compromising 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, the whole partnership will be liable for that transaction. Even when that partner has died, the other partners remain liable. Thus, when the other party in the transaction relies on the partner’s representation, all the partners may be sued by the third party who has acted upon the faith of the representation.
Partners owe duties to each other. They must act in good faith as partnerships are based on the confidence of each partner in the integrity of every other partner. Some acts that are considered ‘bad faith’ include:
Making a private or secret profit from transactions made through the partnership
Competing with the firm by conducting business of the same nature
Providing inaccurate accounts
Below are common rights that partners have in a partnership:
Taking part in the management
The right to veto a change like the partnership business
Inspecting partnership books
Right to not be expelled by majority vote except when expressly agreed between the partners
Some events which may trigger the dissolution of a partnership are:
Events 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
Through the court/legal system:
A partner is permanently incapable of performance
Just and equitable grounds
A partner is guilty of conduct that prejudices the business
Partnership business can only be carried on at a loss
Whether you own the business on your own or with other people, you have the option of incorporating a company to have a separate corporate personality. A company is a separate legal entity (unlike a sole proprietor or a partnership) with limited liability.
The company itself will be 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, a company secretary, articles of association and a registered office to own and operate its assets and business.
Public company limited by shares
Private company limited by shares
A public unlimited company with a share capital
A private unlimited company with a share capital
Company limited by guarantee without a share capital
You can read more about the specifics of companies limited by shares and unlimited companies here.
Common for companies that have been set up for non-profit purposes
There is no need to pay money upfront
No requirement for shares or shareholders
Owners are guarantors who agree to pay a set amount of money for company debt
Liability of the shareholders is limited to the amount they undertake in the articles of associations to contribute to the assets if 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 are smaller in size and more common. They are generally subject to less restrictive requirements, for example, in accountancy, the registration of financial statements and restrictions on loans to directors. Below are some additional characteristics of private companies:
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
On the contrary, a public company allows its shares to be listed on a stock exchange for the public to freely exchange.
Click here if you are interested in learning more about the advantages and disadvantages of setting up a company.
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 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.
However, shareholders should be aware that there is an exception to the principle of separate corporate personality. Normally, the doctrines of separate legal entities 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 entities 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
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 shares, 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 by passing a special resolution in a general meeting or through 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 benefit from what the minority is deprived of
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 the association recorded in local statutes. The model articles of association are documents 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 alter 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
Directors have a general power to manage, 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.
The 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 retire. Directors can be removed by ordinary resolution of the members and special notice should be given.
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
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 under 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.
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. The 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 entities 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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