Sole traders who are considering incorporating their business because of the current economic conditions should carefully examine the advantages and pitfalls before making their decision.
There are many businesses which are carried on as sole traders or partnerships. The owners of these businesses do not enjoy the protection of limited liability which is available to the shareholders of a company with limited liability. There are many reasons why the owners of such businesses decide to trade as sole traders or as partnerships and in the case of some professions they are prohibited from trading via the medium of a limited liability company.
However, in the current challenging economic environment it is probable that many sole traders and partnerships may consider incorporating part of all of their business. This article looks at some of the issues to be considered and pitfalls to be avoided by a person who is proposing to transfer an existing business into a corporate structure.
What is Limited Liability?
In technical terms the legal liability of a shareholder in a private company limited by shares (which is the most common form of company used in Ireland) is to pay the amount, if any, remaining unpaid on his or her shares. There is no general requirement to have any particular amount invested in such a company by way of share capital though in practicality the owner may have to support the company by means of putting in share capital, shareholder loans or giving a personal guarantee to support bank borrowings. The concept of limited liability therefore effectively means shielding the owner from liabilities of the company even though he or she may stand to lose the equity or loans which they may have put into the company.
Many people query the value of limited liability protection in situations where the shareholders are also directors and as such are exposed to personal liability if they are found to be in breach of their common law or statutory duties as directors. It is beyond the scope of this article to examine the question of liability of directors' duties but it should be noted that directors of companies which become insolvent are not automatically exposed to personal liability for the debts of the company. There usually has to be a fairly clear breach of their duties as a director where they knowingly or recklessly caused loss to the company's creditors (e.g. reckless trading).
Some Other Advantages of Incorporation
The ownership of a limited liability company is made up of shares and it is possible to have different classes of shares carrying different rights. This can facilitate easier division of ownership than in a non incorporated business where if the participants are sharing the profits of the business they may find themselves operating as a partnership. Accordingly if a sole owner of an unincorporated business is considering entering into an arrangement involving a sharing of profits of the business he should carefully consider how the arrangement should be structured as he may unwittingly end up in a partnership relationship with that person.
A corporate structure may also make it easier to allow employee participation in the business by way of granting options over shares or by way of non voting shares. It may also be a means of giving children a stake in the business whilst the owner retains control until he is satisfied that the children are ready to take control.
Common Pitfalls Encountered in Incorporating an Existing Business
Before proceeding to transfer an existing business into a company careful consideration needs to be given to the legal, financial and taxation implications of the transfer.
- A careful list of all assets used by the business needs to be prepared and if any such assets are leased or licensed (e.g. premises, equipment, software, trademarks etc.) there may be a need to obtain the consent of a third party before such assets can be used by the company which is intended to carry on the business. Failure to obtain such consent could result in forfeiture of the lease or penalties. It should not be assumed that any necessary consent can be sought retrospectively. In the current economic climate landlords in particular may be reluctant to give consent to the assignment of a lease to a limited liability company and may insist on the business owner providing a personal guarantee of the company's obligation under the lease.
- If there are employees in the business there will be a requirement to consult with those employees pursuant to the transfer of undertaking regulations. Failure to do so can give rise to a liability to compensate the employees concerned.
- Tax advice should be obtained on whether the transfer of the business assets will constitute disposal of assets for capital gains tax purposes and tax issues relating to the cessation of the unincorporated trade and the commencement of the business in the new company (e.g. obtain tax numbers for the company etc.).
- Particular care should be given to potential stamp duty exposure on the transfer of assets into the new corporate structure as there is no relief under the stamp duty legislation on the transfer of assets into a company even where the company is owned by the same person(s) as owned the unincorporated business and in the same proportions. It is frequently overlooked that the transfer of the goodwill of a business attracts stamp duty. It is usually possible to mitigate the level of stamp duty liability if sufficient attention is given to the structuring of the transfer of the business.
- As insurance policies are not assignable, arrangements should be made in advance of the date of the proposed transfer for insurance cover to be taken out in the name of the new company.
- Similarly, many licences or accreditations held by a business from a government or regulatory agency are usually not assignable and the new company may need to apply for such licence or accreditation. In some cases such licences or accreditations may be essential to the company's ability to carry on business and should be sought well in advance of the date for the proposed transfer.
- Customers and suppliers of the business may need to be notified of the transfer of the business to the new company and the VAT number of the new company.
- Operating via a company also brings with it new obligations. The company will have certain compliance requirements such as to submit an annual return and accounts to the Companies Registration Office annually. In addition a business operating as a limited liability company must set out certain details such as its corporate name, registered office, details of directors etc. on its stationery and invoices and on its emails. There is also a range of common law and statutory duties imposed on the directors of the company and some of these will restrict the ability of the shareholders or directors to use the assets of the company for their own benefit. For example there are strict limits on the granting of loans by a company in favour of, or guaranteeing or providing security over company assets for the personal debts of, a director (and/or certain persons or companies connected with a director). Breach of such duties can result in criminal and/or civil liability and compliance with a range of directors' duties is monitored and enforced by the Office of the Director of Corporate Enforcement (ODCE).
- If, after the transfer of the business to the new company, there is going to be more than one shareholder owning the shares in the company, then careful consideration should be given to putting in place a shareholders' agreement between the shareholders and putting in place articles of association which are appropriate to a multi shareholder situation. It is very common to find that the articles of association which were adopted upon incorporation of a company remain in place for a long period. In general these articles of association are only suitable for a company which is owned by one person and do not adequately cover what should happen in the event that one shareholder wishes to transfer his shares or indeed on the death of a shareholder. Disputes between shareholders can be very difficult and costly to resolve but if a suitably drafted shareholders' agreement is in place it may well deal with the situation or at a minimum provide a mechanism for dealing with the dispute which reduces the risk of expensive and distracting litigation.
In the current economic climate many owners of unincorporated business may be examining the pros and cons of transferring their business into and running their business through a limited liability company. If so, they should give careful consideration to the legal and taxation implications of doing so in conjunction with their professional advisers.
This article by Emmet Scully was first published in Accountancy Ireland, February 2010, Volume 42 (1).