In this legal article, Auckland lawyer Ian Mellett reviews the various entities that are available to you when deciding upon the appropriate operating structure for your New Zealand business.
In a previous article, I discussed the matters that should be considered when deciding to purchase a business. A key aspect in this process is necessarily the choice of the most appropriate purchasing entity. It is important that you obtain the requisite advice from both your lawyer and accountant, as they will be in a position to explain issues such as limited liability protection, tax and succession planning to facilitate an informed decision being made.
There are four main entities that are predominantly used to operate businesses in New Zealand, namely the sole proprietorship, partnership, limited liability company and trading trust. Each of these is discussed briefly below.
Also known as a sole trader, this is a type of business entity that is owned and operated by one individual on his or her own. The key characteristic is that the owner is inseparable from the business, in other words there is no legal distinction between the owner and the business. The owner controls, manages and owns the business, is entitled to all the profits but is also personally liable for all losses, debts and taxes. A sole trader is usually able to establish the business without following any formal or legal process and can employ other people to assist in running the business.
The obvious advantage of a sole proprietorship is that it is easy to start and run, and there is no requirement regarding registration. The major disadvantage is that the business owner/s has unlimited personal liability for all business obligations (including amongst others debts and taxes), which means that personal assets are potentially at risk. Sole traders also often lack credibility in the marketplace, and it is invariably more difficult to sell this type of business.
A partnership is an arrangement where individuals and/or entities agree to co-operate to advance their business interests. Most frequently, a partnership is formed between one or more businesses in which the partners (namely the owners) work collectively to achieve and share any profits or losses. It is recommended that the partnership be established by way of a formal partnership agreement. The partners share responsibility for running the business, share in any profits or losses as stated in the partnership agreement and are liable for any debt within the partnership. The partnership itself does not pay income tax, but instead distributes the partnership income proportionately to the partners who then pay tax on their own respective shares.
The main advantages of a partnership are that no registration is required to commence business, and this entity can provide an effective way to share business operation costs. The disadvantages are that partners may be held liable for debts incurred by the other partners, personal assets are potentially at risk and complications may arise if a partner dies or wishes to leave the partnership.
Limited Liability Company
This entity is by far the most popular and successful form of business structure. A company is a formal and legal entity in its own right, being separate from its shareholders or owners. The protection that a limited liability company affords to its shareholders is the primary reason for selecting this type of operating entity. If the company is unable to pay its debts, the shareholders are not liable for the business debts of the company unless their shares are not fully paid up, or they have given personal guarantees to lenders or creditors, or they are also directors of the company and have traded recklessly. This situation should be contrasted with a sole proprietor or partner who will always be exposed and personally liable for any business debts that cannot be met by the business.
The advantages of a limited liability company are continuity of existence (a company will continue to exist until it is removed from the Companies Office register), transferability of shares (making it easier to sell a company or pass on to others such as children) and marketplace credibility. The disadvantages are that directors need to clearly understand their responsibilities under the companies legislation, and the fact that the limited liability protection can easily be eroded in practice by the requirement to provide personal guarantees to certain lenders or creditors.
Until relatively recently, the choice of business structures in New Zealand was generally limited to the entities discussed above. However, trading trusts have increased in popularity over the last ten to fifteen years and have now emerged as an alternative option to owning and operating a business. Essentially a trading trust is a discretionary trust similar to a family trust, but instead of merely holding investment assets it actively carries on a business and derives business profits.
One of the key advantages of using a trading trust is the flexibility that it provides, particularly with regard to the allocation of business profits to the beneficiaries of the trading trust. Trading trusts are, however, a topic on their own, and I would suggest that anyone interested in utilising this type of business vehicle contact our offices to obtain more detailed information.
It goes without saying that it is critical to “get the structure right upfront”. This is also particularly important in light of the Inland Revenue Department’s stance that a change in operating entity “downstream” has occurred not for commercial but rather for tax (and possible tax avoidance) reasons.
Please feel free to contact Ian Mellett (BComm LLB H Dip Tax) at Auckland law firm Quay Law for more information, or if you have any questions regarding your business or other legal needs please call me on (09) 5232408 or visit our website http://www.quaylaw.co.nzor blog http://www.aucklandlawfirm.co.nzfor more information.