Commercial Law: New Business – How to Pick the Right Legal Entity for It
“Owning one’s own business is an adventure – enjoy it every step of the way.” (From the SME Toolkit article referenced below)
First, three questions to ask yourself…
If you dream of going into business for your own account in 2023, ask yourself these questions before you get started –
- Am I an entrepreneur? You have an amazing idea, you can’t wait to launch your new business, success and wealth beckon! But wait a second – are you really suited for the hurly-burly of entrepreneurship? It can be hugely rewarding, not just in the financial sense but also in terms of lifestyle and life satisfaction. But it also carries far more risk than the classic “9 to 5 employee” option, so think long and hard before choosing. There are many online quizzes to help you decide – try for example DeLuxe’s “Quiz: Are you ready to start your own business?” here.
- What’s my plan? Without a plan you sail rudderless through some very treacherous and shark-infested waters. Start-up failure rates are high, but luckily there is plenty of advice available to help you plan your course. Read for example the Business Partners “Ten Simple Rules For a Successful Start-up” on SME Toolkit.
- What legal entity should I use to trade? Don’t make the rookie mistake of setting sail in just any old boat. Starting off in the wrong entity and then having to change mid-stream will mean a lot of unnecessary expense, hassle and risk. Rather plan long term – ask yourself where you want your business to be in 5 or 10 years, how big it will be, what your exit plan will be and so on.
We set out below some brief thoughts on the various alternatives available to you, but upfront professional advice, specific to your particular needs and circumstances, is a real no-brainer here.
So, what are your choices?
…and four business vehicles to choose from
You have four main options –
- A sole proprietorship (“sole trader”). You are the business, trading for your own personal profit and loss, perhaps under a trading name such as “Syd Smith trading as ‘Syds Plumbing’”.
- A partnership of 2 to 20 individuals or entities, pooling resources to carry on a trade, business or profession for a share of the profits.
- A private company (“Pty Ltd”) with any number of shareholders. Controlled and administered by directors.
- A trust (number of trustees and beneficiaries not restricted). There are various types of trust, with trustees controlling and managing trust assets and/or trading for the benefit of beneficiaries.
Note that you might be advised to combine one or more of these entities in a corporate structure, and that there are other specialised types of entity available to, for example, non-profit organisations (charities etc), professionals (lawyers, accountants, doctors etc) and the like.
The pros and the cons of each
Have a look at the illustrative table below for a summary of the advantages and disadvantages of each of these options.
“Trading entities – Advantages and Disadvantages”
| Trading entity | Advantages | Disadvantages |
| Sole trader/proprietorship | Low cost, simple, quick and easy to set up, administer and exit.
A good option therefore for an initial phase of testing the waters with your “Awesome Idea” before incurring substantial cost.
Low administrative burden.
You are your own boss in every way, and you keep all the profits.
A good long-term choice for many small businesses not expected to grow significantly.
Tax and estate planning aspects are important but a mixed bag – see discussion below. |
Risk – you are personally liable for all business debts. Not just trading debts, but also things like damages and warranty claims, claims from staff, landlords, banks and so on. Creditors can and will attack all your assets so expect sleepless nights if an important asset like your family house is in your name.
Business funding can be vital for survival and expansion, but most lenders have less appetite for lending to sole traders than to formalised corporate structures.
You are a lone wolf with no one else to share the burdens of management and decision making. |
| Partnership | Relatively quick and easy to set up. Not required by law but very strongly recommended – a full partnership agreement.
Low administrative burden.
No more “lone wolf” – you have partners to share in decision-making, to provide access to funding and assets, and to pool skills and workload with.
Again, tax and estate planning aspects are important but a mixed bag – see discussion below. |
Maximum of 20 partners – probably enough for most types of business, but not all.
Loss of control – you are no longer the sole decision maker so make sure you share a common vision with all your partners.
Ceases to exist on exit, insolvency or death of any partner.
A big risk – you are personally liable for all partnership debts, agreements and obligations, and for everything any partner does in the business. Make sure you can trust all of your partners implicitly! |
| Private company | You can have any number of owners (shareholders).
The company is a separate legal entity so will survive your death or personal insolvency, hence often recommended as an estate planning and asset protection tool (more on that below).
Lives on through changes of ownership, directorship and management.
Directors have only limited risk of personal liability for company debts and obligations. Shareholders’ risk is generally even lower.
Funding is generally more easily available to a corporate than to an individual or partnership.
Useful to house both small and large businesses, so could be a good choice if you start small but anticipate growth.
Also, potentially a good “exit strategy” choice – grow the business, sell your shares, on to your next venture.
Again, tax and estate planning aspects are important but a mixed bag – see discussion below. |
Formation, administration, and termination all involve more formality, red tape, paperwork, cost and delay than the alternatives.
Directors failing to live up to the high standards of conduct required by the Companies Act face penalties, sanctions and personal liability.
Shareholders can also be personally at risk, particularly for certain tax liabilities.
|
| Trust | Any number of trustees and beneficiaries, from one upwards.
Another commonly recommended estate planning and asset protection tool as it survives death, insolvency and removal/resignation of trustees.
Trading and liability risks lie with the trust, not with trustees personally.
As with companies, it may be easier to raise funding than it will be for an individual or partnership.
Also, a possible “exit strategy” winner.
Again, tax and estate planning aspects are important but a mixed bag – see discussion below. |
Formation, administration, and termination may require a bit less formality, red tape, paperwork, cost and delay than a private company.
Strong fiduciary duties towards beneficiaries, and the principle that trustees cannot treat the trust as their alter ego, require careful management to avoid trustee personal liability.
|
Don’t forget the tax and estate planning implications!
Each of your choices carries with it a mixed bag of positives and negatives when it comes to both tax and estate planning implications. For an overview, have a look at SARS’ “Starting a business and tax” webpage, with a link to its “Tax Guide for Small Businesses” PDF.
That Guide is 102 pages long, and unless you are comfortable with the complexities involved, professional advice specific to your circumstances is again essential.
In a nutshell –
- Estate planning: You may be advised to use companies and trusts for tax-efficient and practical transfer of wealth to future generations, as well as for asset protection from creditors both before and after you die. Both companies and trusts are “perpetual” in the sense that they survive changes in directors/trustees (resignation, removal, retirement, insolvency, death etc), with potential multi-generational savings in estate duty and avoidance of the cost and delays inherent in deceased estate administration.
- Tax efficiency: Sole traders and partners are taxed at individual rates; trusts other than special trusts at a flat rate of 45%; companies at a flat rate of 27% (27% for years of assessment ending on 31 March 2023 and later, previously 28%) with 20% dividends tax when you take profits out. There are a host of other factors to take into account here, including aspects such as Capital Gains Tax inclusion rates, exclusions, exemptions, small business breaks and the “trust conduit principle” all being highly relevant to the ultimate question – will you be better off being taxed as an individual or will some form of corporate and/or trust structure be more tax efficient for you?
Take that professional advice!
For any assistance or guidance please contact Company Services and Commercial Services
This article is for general information purposes and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact us At DKVG Attorneys for specific and detailed advice.