Choosing a legal entity for your business

One of the first and most important decisions an entrepreneur has to make is what type of legal entity to register his business under. There are many factors to consider and all the pros and cons must be weighed, as the wrong choice could be a costly mistake.

“The business format will depend very much on the nature and size of the business, and should suit the entrepreneur’s individual needs,” says Nazeem Martin, MD of Business Partners, South Africa’s leading financier of Small and Medium Enterprises. “This is one decision that should not be made without the advice of experts in the field of small business ownership”.

Some forms of enterprise must be registered with the Registrar of Companies, and need to meet certain legal requirements, while other entities simply need to be given a name and can then start operating immediately.

When deciding on a business format, “try to think as far ahead into the future of your business as is practical, since selecting an inappropriate entity can have serious long-term consequences,” Martin says. “There are also tax implications for the type of business you register, again illustrating the need for specialist advice, such as the expertise provided by the Business Partners Technical Assistance, Mentorship and Consulting Services division.”

This value-add offering is part of the broader portfolio of Business Partners’ services to SMEs. The know-how, skills and wisdom of senior business and professional people are harnessed and matched to the needs of entrepreneurs who contact Business Partners for assistance.

“The Business Partners Mentors Programme, for instance, is based on a widely accepted principle that mentorship can achieve success in the underlying viability of a business,” explains Martin. “While it’s normally well-established businesses that enlist the services of a mentor, there’s no reason why a would-be entrepreneur can’t ask for the professional guidance needed to set up his business.”

There are various types of business formats suited to the SME sector, each with its own distinct characteristics. Martin gives a brief breakdown of each one:

Sole Proprietorship

Where there is only one owner, this is the simplest kind of independent business, as it does not need to be registered as a legal entity. This makes a sole proprietorship the ideal choice for a professional in private practice, a guest house owner, or the owner of a small craft business, for example.

On the other hand, there is no distinction between the business and the owner, which means that the owner is fully responsible for all debts and liabilities incurred by the business.

A Partnership

To put is simply, a Partnership is an association of 2-20 people who are contractually bound to operate a joint, profit-generating business. Each partner contributes money, goods or services to a fund, agreeing that profits will be shared between the partners as per their contract.

A Partnership is quite inexpensive to set up, as it does not have to be registered at the Registrar of Companies. There are a few different types of partnership agreements, but for the purposes of this article, let’s look at the characteristics of a partnership in general:

  • Each partner must make a contribution to the Partnership
  • It does not have a juristic personality separate from the partners. Each partner can bind the Partnership
  • If the Partnership’s estate is sequestrated, the estates of the partners can follow unless the partners undertake to pay the debts of the Partnership
  • On dissolution, the profits and net assets are usually distributed amongst the partners
  • The life of the Partnership is not separate from the lives of the partners (so if one partner dies, leaves or is declared personally insolvent, the Partnership becomes null and void)
  • On dissolution, the assets are liquidated, creditors are paid and partners must stand in for any shortfall
  • The Partnership is not a “person” for tax purposes and not taxed as a company would be
  • There are no statuary audit requirements

These points can be seen as advantageous or not, depending on the needs and circumstances of the owners. Once again, entrepreneurs need to seek professional guidance on registering and running a partnership according to the legal requirements.

Private Company

“Despite the complex nature of setting up and running this type of business, a Private Company can be a good choice for medium-sized enterprises with up to fifty shareholders,” says Martin.

“The most obvious advantage is that the law sees the company as its own legal entity, so shareholders are not personally liable for its debt.”

Among other things, a Private Company:

  • Must reserve and register the company name with CIPRO
  • Must have strict laws governing the duties and responsibilities of the company’s directors and officers
  • Must have a Memorandum of Agreement defining the company’s nature and purpose
  • Must hold an Annual General Meeting and issue annual audited financial statements
  • Must have registered Articles of Association

A Business Trust

A highly under-rated form of legal entity is the Business Trust – a legal entity where the trustee uses the trust assets to do business in order to benefit the beneficiary. Choosing to set up his business within the legal framework of a business trust affords the entrepreneur certain protections and advantages that other legal entities do not.

For example:

  • The assets of the trust belong to the trust alone, which means that creditors can not claim against the trustee’s personal assets
  • The costs associated with running a business trust are less, as it is not legally required to hire an auditor, disclose financial statements, pay annual fees to the Registrar, etc.
  • Taxes related to trusts are less complicated
  • It is relative easy and inexpensive to dissolve a business trust

“An attorney with specialist knowledge in this area can explain all the pros and cons in detail, should the would-be business owner deem this the most viable option. Legal documents should also be drawn up in the best interest of the trustee.”

Combination of legal entities

It is even possible to structure a business in a way that reaps the benefits of two different legal entities, such as running the business as a private company, but setting up a family trust that owns the shares in the company.

This can save the entrepreneur huge amounts of money in estate duty, because the value of the shares in the company appreciates in the hands of the trust. But this kind of financial engineering needs to be done and managed by professionals.

These formats clearly apply to very different types of business, and the choice between them is usually determined by the nature of the venture and its short- to medium-term goals. Other aspects include the source of finance; the costs associated with the administration of the business, processes that apply should the owner die or go insolvent, and so on.

“The average entrepreneur can’t wait to start living the dream of having his own business,” Martin finishes off by saying. “But informed choices made from the very beginning and the relevant support throughout the life of the business can ensure that this dream doesn’t turn into a legal or tax nightmare. The Business Partners Technical Assistance, Mentorship and Consulting Services division is aligned to this kind of thinking.”