A Comprehensive Guide on How to Choose a Legal Structure of A Business.
Choice of the legal structure of a business is one of the vital decisions you need to make at the start up stage. There are different legal structures but you cannot just choose anyone arbitrarily. Your choice of a particular legal structure should be as a result of a quality and informed decision drawn from the knowledge of what you actually want for yourself and for your business. The legal structure of your business has a lot to do with you as a person and your business. You need to sit down and thoroughly evaluate available options and choose the one that best suits your situations. It is called legal structure because whatever business structure you choose has its legal implications. The choice of entity you make will affect your tax situation, risks and liabilities, how you have to keep your books, even how you can pay yourself. I recommend that you involve a practising accountant or a lawyer in this process as they are in a better position to advise you appropriately.
Different Legal Structure of A Business
There are different legal structures which a business can take but I am going to restrict this topic to three commonest structures. They are sole proprietorship, partnership and Limited Liability Company.
This is the structure whereby an individual owns the business by himself without any partners. It is the easiest and cheapest way of structuring a business. As a sole proprietor, you have a full control of the business. All the profits of the business belong to you but at the same time you are personally responsible for all debts and liabilities incurred by the business. This means that if the assets of the business are not sufficient to settle its debts, any of your assets, including your personal assets, can be seized and used to discharge the liability you’ve incurred. This is because legally the business is considered to be an extension of yourself.
Please note that being a sole proprietor does not mean you can’t employ others. You can actually employ as many hands as possible. The main issue here are control, ownership and responsibility for the business.
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The main advantages of sole proprietorship are:
- Full control over the business. You can quickly make decision without waiting for approval from anybody. The fact that the entire profits of the business belong to you is enough motivation to put in your best.
- Low start up costs. The registration costs for sole proprietorship is low.
- Few legal requirements. You are not burdened with much legal requirements as it affects limited liability companies.
- No company income tax. The business is not subjected to double tax. You only pay tax as individuals from the profits you realised from the business. You also have the opportunity to set off taxes/losses against other income.
- The dissolution of the sole proprietorship is very easy.
- You are personally responsible for all the debts and liabilities of your business
- Difficulty of raising money. Capital from your personal savings may not be sufficient to run the business. It is typically more difficult for sole proprietors to raise operating cash or arrange long-term financing because they have fewer assets which can be used as collateral.
- Lack of sufficient skills to run the business. All the decision-making power rests with one individual. Two good heads are better than one.
- This system of business cannot afford large-scale operation.
- Problem of continuity. The death of the owner leads to the death of the business.
If you don’t want to do it alone and be the sole owner and operator of a business, you may wish to legally set up your business as a Partnership. A partnership by definition is simply an association of two or more people (but no more than twenty) formed for the purpose of carrying on a business. A partnership does not have a legal personality of its own. A decision made by one partner automatically makes the other partner responsible as well. Partners in a partnership are collectively responsible for all business debts and profits, and also have full control of the business. Therefore, if the Partnership runs into trouble, the Partners will be held liable for any debts or liabilities of the business.
If you want to consider Partnership, please ensure you involve people you can trust. Michael Eisner from his experience said; “It is rare to find a business partner who is selfless. If you are lucky it happens once in a lifetime”. However, no matter the differences among the Partners, Ariel Sharon’s words seems to be the answer to this: “I believe that Jews and Arabs can live together. It’s not an easy thing but I believe we can reach an agreement”.
Therefore, before going into Partnership, it is always safer to have a lawyer draw your Partnership agreement for you. The specific terms of the agreement will be determined by the partners. This agreement is called Partnership Deed. It usually contains the following information:
- Names and addresses of the firm and each partners
- Nature of a business to be carried on and the location of the business
- Duration of partnership, whether for a fixed period/job or not
- Capital contribution by the each partner
- Profit sharing ratio among the partners
- Interest on capital, if any to be paid to partners
- Drawings and interest on drawings, whether permissible or not
- Loans and advances by partners to the firm
- Whether or not to pay salary or commission to partners who will manage the business
- Rights, duties and responsibilities of managing partner
- Methods of keeping accounts, who and how to audit the accounts.
- The bankers and the maintenance of bank accounts
- The mode of admission and retirement of partners
- How to value the goodwill on admission, retirement and death of a partner
- Method of settlement of accounts on retirement and death of a partner
- Provision for arbitration in case of disputes
- The methods of dissolution of partnership firm
- Settlement of accounts in case of dissolution of the firm
- Easy Formation. Partnerships are relatively easy to establish when compared to limited liability companies.
- More Capital. Two or more partners may be able to contribute more funds. Also their borrowing capacity will increase.
- More brains are available for business ideas and for the solving of problems that a business may encounter. Partners can possess complimentary skills.
- Partners have shared responsibility in the running of the business and each partner can focus on the areas of his strengths and this can lead to better service or management.
- Minimum legal requirements.
- Partnerships have an employment advantage if they offer employees the opportunity to become a partner. This can be used to attract qualified employees.
- Joint responsibility. Business partners are jointly and individually liable for the actions of the other partners.
- Profits must be shared with others. There may be a problem on how to arrive on profits sharing ratios.
- Conflicts and disagreements can occur. Different ideas if not properly addressed can lead to conflict which can cause the Partnership to break up
- Death of a partner may lead to the end of the Partnership.
- Partnerships are also subject to unlimited liability. Partners are personally responsible for the liability of the business.
Limited Liability Company
A limited liability company is a separate legal entity on its own. The company is seen as an artificial body that is separated from the owners; it can sue and can be sued. Unlike sole proprietorship and partnership, owners are not personally responsible for business debts and liabilities of the limited liability company. So, creditors cannot pursue owners’ personal assets to pay business debts unless they have signed a personal guarantee. The liability of the owners (members) of a limited liability company for debts and obligations of the company is limited to their financial investment, that is, the amount of shares held by the owners in the company. Companies and individuals can hold shares in a limited liability company. The company pays a tax on its profits under Company Income Tax Act. And if profits are distributed to shareholders as dividends, the shareholders pay taxes on these profits according to the dividends that they received. This is often referred to as double taxation.
A limited liability company can either be a private limited liability company or a public limited liability company.
Private Limited Liability Company
A private limited liability company may have between two and fifty members. Where two or more persons hold one or more shares in a company jointly, they shall be treated as a single member. A private company shall not, unless authorised by law, invite the public to subscribe for any shares or debentures of the company or deposit money for fixed periods or payable at call, whether or not bearing interest. Also, there is restriction on the transfer of shares in a private limited liability company. This means that the members cannot transfer or sell their shares to another person. The minimum share capital prescribed for private companies is ten thousand naira with a minimum subscription of twenty five percent of the authorised share capital.
Public Limited Liability Company
The law describe Public Limited Liability as any company other than a private company and its memorandum shall state that it is a public company. The minimum membership for public limited liability company is two and there is no upper limit. The minimum share capital prescribed for public companies is five hundred thousand naira with a minimum subscription of twenty five percent of the authorised share capital.
Before you proceed to register a limited liability company, it is advisable that you are aware of all the legal requirements that must be complied with as some of these may become a burden in the future especially when you are not prepared for them. For example, the law requires among others that, in the case of every company, the directors shall in respect of each year of the company; prepare financial statements for the year. This alone has its own financial implications.
Capacity to form a Company
The following individuals do not have capacity to form a company
- An individual less than 18 years of age
- An individual of unsound mind and has been so found by a court in Nigeria or elsewhere
- An undischarged bankrupt
- A person disqualified from being a director of a company under Company and Allied Matters Act.
- A corporate body in liquidation
Please note that a person less than 18 years of age shall not be disqualified if two other persons not disqualified have subscribed to the memorandum.
Advantages of limited liability companies
- Limited Liability: If the company runs into financial problem, the creditors cannot cease personal assets of shareholders. Owners are not held personally responsible for business debts and liabilities.
- Continuity of existence. The members of a company may go on changing from time to time, but that does not affect the continuity of a company as the company is a legal entity on its own
- Forming a limited liability company may help a business to be perceived as a more legitimate business than a sole proprietorship or general partnership.
- With more members, more capital can be raised for the business.
- Easy transferability of shares (for public limited liability companies)
Disadvantages of limited liability companies
- Members cannot sell or transfer their shares to anyone else without the agreement of other shareholders (for private companies)
- The company’s profit is taxed under corporate income tax
- The decision making process is complex.
- The registration and post registration costs are high.
- Administratively demanding dealings with authorities. The law strictly governs the conduct and duties of company directors and officers.
- Problem of double taxation
We have other legal structures such as Cooperative Society, Company limited by guarantee, Unlimited Company and Incorporated Trusteeship but the ones discussed are the most popular legal structure of a business.
Finally, before settling for a particular legal structure, I encourage you to consider other factors affecting the choice of a legal structure of a business.