Business Organizations: Sole Proprietorships, Partnerships, and Company Limited by Shares - Research Paper Example

Running Head: Business Organizations Table of Contents Table of Contents 1 1.0 Introduction 2 2.0 Sole proprietorship 3 2.1 Legal and Taxation Implications of a sole proprietorship 3 2.1.1 Management and Control 3 2.1.2 Legal formalities at formation 3 2.1.3 Taxation Implication 4 2.1.4 No Separate legal entity 4 2.1.5 Continuity and Transferability 5 3.0 partnerships 5 3.1 Existence of a partnership 6 3. 2 Legal formalities at formation 8 3.5 Partnership agreement 8 3.6 Liability of Partners 9 3.6.1 Consequences of Partner’s acting as agents and on behalf of the partnership 9 4.0 Limited by shares 10 4.1 Set up formalities 11 4.2 Tax Implications 11 4.3 Continuity and transfer of ownership 11 4.4 Management and Control 12 4.5 Member’s liabilities 12 4.6 Piercing the Corporate Veil 12 4.6.1Agency 13 4.6.2 Fraud 14 4.6.3 Sham or Façade 15 4.6.4 Insolvent Trading 15 5.0 Conclusion 16 1.0 Introduction There are a number of business organizations a person can use to conduct business in Australia. Arguably, the most popular forms of business organization in Australia are the Sole proprietorships, Partnerships and Company limited by shares. Choosing to operate under each form has a number of advantages which stem from the legal implications of operating under the particular business type. This essay focuses on the features and implications of choosing to operate a business under each of the three aforementioned business structures. The sole proprietorship, arguably the most simple and common business organization in Australia starts off this discussion. It is noted that the law does not distinguish between a sole trader and his business. Similarly, partners and their firm are one and the same in the eyes of the law. This gives rise to unlimited liability where the personal property of partners and sole traders can be seized by creditors to cover debts incurred by the business. The paper spends considerable time in illustrating how liability resulting from the capacity of a partner(s) to act on behalf of other partners of the firm is a source of conflict in Partnerships. Frequently courts are called upon to define the boundaries and definition of a partnership, to ensure members do not escape liability for debts incurred by the firm when they were partners. In the fourth section, the paper explains the concept of a company limited by shares. It also briefly distinguishes between a public limited company and proprietary company. The paper notes that companies limited by share are fundamentally different from sole proprietorship, as shareholder liability is limited to their capital contribution or share subscription in case of a balance owing. This rises from the fact that an incorporated company is a separate legal entity from its owners. However, the paper notes that courts can remove the limited liability of company in some circumstance. The last section focuses on the circumstances were courts fail to recognize incorporated companies as separate legal entities thus exposing member to liability for the act of the company. 2.0 Sole proprietorship These are the most common and easiest business organizations to form. Sole proprietorship refers to business which is owned and directly controlled by one business owner1. One of the most notable features of sole proprietorship is that they are not separate legal entities from the owner2. A number of legal and taxation implications rise from the fact that the law does not distinguish between a sole trader and his business. 2.1 Legal and Taxation Implications of a sole proprietorship 2.1.1 Management and Control In a sole proprietorship all the business decisions are made by the owner of the company. This means business decision making is easy and fast. This feature of sole proprietorships enables them adapt to a fast changing business environment and impact positively on the company fortunes3. But, on the other hand this is a disadvantage where the owner has limited managerial knowledge or enthusiasm for running the business. 2.1.2 Legal formalities at formation Sole proprietorships virtually have no legal formalities to fulfil before they can start trading. However, where a sole proprietorship operates under a fictitious name other than that of the owner, the business name should be registered4. 2.1.3 Taxation Implication The way sole proprietorships are taxed differs greatly from the way taxation is applied on other business structures. A sole trader pays taxes on all the profits of his business. On the other hand, if the business is making losses the Sole trader is able to offset his business losses with other personal income5. The main disadvantage of this taxation principle is that it taxes the trader for all the profits, regardless of whether these profits are retained by the business. 2.1.4 No Separate legal entity The law recognizes the business and the sole trader as one legal entity6. This implies that the owner is personally liable for any liabilities accrued in the business operations. If for example, a sole trader borrows money to add stock to his shop, expecting bumper sales in the Christmas period, but instead makes losses, and is unable to repay the loan. The creditors can recover the loan amount against the personal assets of the trader including his house, car or furniture7. This aspect of a sole proprietorship makes the owner vulnerable and may discourage owners from taking entrepreneurial risks or borrowing money to fund business expansion. Furthermore, the personal liability of a sole trader may extend to the actions of his employees 8. A driver employed by a sole proprietorship can cause a fatal traffic accident while delivering products to customers. In such a case the sole trader is responsible for the negligent actions of his worker. This may lead to the owner of the business losing his personal assets for actions that he/she was not aware of. 2.1.5 Continuity and Transferability The continuity of business is one points of reference for lenders and creditors while deciding whether to finance or extend credit to a business. The life of a sole proprietorship is limited and the business ceases to exist when the owner dies9. The owner can also decide to wind up his business at any time. Death of the owner of a sole proprietorship implies that creditors cannot recover their debt, unless the trader had provided personal guarantees for the debt. When a sole trader dies, his business assets become part of his estate. These assets can pass on to heirs according to Australian succession law10. 3.0 partnerships A partnership is defined as a business structure where two or more people engage in business together with the view of making profits. The Partnership Act 1892 (NSW) s 1 defines a partnership as a relationship that ‘exists between persons carrying on a business with a view of making a profit”11. The Corporations Act 2001 (Cth) s 115 limits the number of partners is who can form a partnership to 2012. However, part 2a of the act sets different caps for partnerships in such professions as law, medicine and accountants. In some instances, partners contend the existence of a partnership or their inclusion in a partnership in an effort to escape liability for the actions of the business13. The next section deal with how courts handle claims on the existence of a partnership. 3.1 Existence of a partnership According to Keith Lloyd Fletcher a partnership may exist where the following salient features are presents14: i. Consent; there must be an oral or written agreement between the members to form a partnership. In some case the partnership agreement is implied. ii. Fiduciary Obligation: partners have a duty to other partners to exercise their power and rights in the interest of the partnership. iii. Agency: Each partner can act on behalf of the firm, as the agent of the firm or other partners. The Statutory test of whether a partnership exists depends on the satisfaction of the three limb test found in the definition of a partnership, these limbs are15: i. a business must be carried on; ii. it must be carried on by persons in common; iii. it must be carried on with a view of making a profit. In Smith v Anderson (1880) 15 Ch D 247; [1874-80] All ER Rep 1121; (1880) 43 LT 329; 50 LJ Ch 39 it was held that carrying on a business refers to a business relation established to carry out a series of repetitive act with the intent of making profits16. However, the Partnership Act in s 32 (b) considers relationships entered to for a single adventure as partnerships17. In Krizaic v Ravinder Rohini Pty Ltd (1990) 102 FLR 8 18it was held that a mere agreement to carry on business is not an indicator of existence of a partnership. The second limb of the statutory test requires that the business be carried out in common. This limb requires that business either be carried on either by the partners themselves or on behalf of them19. Partners cannot be assumed to be carrying on business together if they are not acting as principals and proprietors. For instance in Keith Spicer Ltd v Mansell [1970] 1 All ER 462; [1970] 1 WLR 333 it was held that purchase of goods together with the intention of using them in a yet to be formed company is not a partnership20. Lang v James Morrison & Co Ltd (1911) 13 CLR 1 at 11; 17 ALR 530, Griffith CJ says business is carried out on behalf of the partners, only if the person carries on business for himself and as an agent of his partners21. This in effect means a partnership exists even though some partners are not engaged in the day-to-day running on the firm. Furthermore, the law in Checker Taxicab Co Ltd v Stone [1930] NZLR 169 it was ruled that separate but complementary business do not constitute a partnership22. The final limb that has to be satisfied for the existence of a partnership to be established is whether the business relationship is formed with the view of making a profit. This requirement means organizations such as sports clubs and social clubs are not partnerships. The concept of profits is separated from that of product in United Dominions Corp Ltd v Brian Pty Ltd. In the case, it was held that a joint venture to generate a product to be shared out by participants cannot constitute a partnership23. In Cummings v Lewis (FCA, No 668/ 89, 2 August 1991, unreported) it was held that a partnership exist only where jointly earned profits are shared24. 3. 2 Legal formalities at formation Like sole proprietorships partnership have virtually no legal requirement for formation. However, the legal capacity of a partner to enter into the partnership association has to be considered25. Surprisingly, minors are allowed to be partners in this business structure. However, underage partners do not attract liability for partnerships past transactions. As seen in Whundo Copper Syndicate v Ferrari [1962] WAR 24 some contracts of partnership are not binding on minor partners26. In some special cases, the formation of a partnership requires a written agreement27. In addition if partnerships use a name separate from their own names, they are required to register the business name. Business Names Registration Act 2011 (cth) section 181 makes it illegal for a partnership to operate under a name that is not registered unless the name constitutes of all the names of the partners28. 3.5 Partnership agreement A partnership agreement records the terms of association between partners and also specify all the other relevant aspects of the business29. In the absence of this agreement all matters of partnership are decided under the partnership act of the relevant state or territory. Statute law reflects the principle of equal share of profits, losses and liability in the absence of a partnership agreement30. 3.6 Liability of Partners According to Eugene and Vemuri, the liability of participants in a partnership is unlimited. This rises from the fact that a partnership is not a separate legal entity from its owners31. Section 12 (1) of the Partnership Act 1892 (NSW), holds partners jointly and severally liable to loss suffered by people dealing with the business. This means partners can be jointly or separately sued for the liability of the firm. This makes partners more vulnerable to liability than sole traders as they are responsible for liability that they may not be aware of or played any part in incurring as occurred in Walker v European Electronics Pty Ltd (in liq) (1990) 23 NSWLR 132. On the other hand section 9 (1) makes all partners jointly liable for all debts and contractual obligations of the firm. 3.6.1 Consequences of Partner’s acting as agents and on behalf of the partnership Section 5 (1) of the Parnership Act 1892 (NSW) gives virtually unlimited authority for a partner to enter into contracts with outsiders. However, in some cases though a partnership may fail to be bound by a contract made by a contracting partner. According to Section 5 (1) a firm is not bound by a contract made by a partner if: i) the partner has no authority to act for the firm, ii) if the outsider is aware the partner has no authority or is not a partner of the firm33. Despite these exemptions, the partnership may still be bound by a contracts made without the consent of all partners as seen in Young v Lamb (2001) 10 BPR 18,553; [2001] ANZ ConvR 629; [2001] NSWCA 22534. In this case it was found that the partner had the actual authority of the firm even though he exercised a lease without their knowledge. 4.0 Limited by shares A company limited by shares is one of the organizations that individuals can join to run a business in Australia. The name; Company limited by shares is reference to the fact that the shareholders liability is limited to the capital contribution in the company35. If a company is unable to settle its debt obligation the personal assets of its shareholders or directors is not affected. A company limited by shares is distinguished from a company limited by guarantee as the later is funded by the guarantees of shareholders or directors36. A company is different from partnerships and sole proprietorship as it is recognized by the law as separate legal entity from its shareholder37. There are two variation of the company limited by shares business structure; public company and private company38. In a public company the shares of the company are owned by the public at large. Public company is listed at the stock exchange in their home country39. Unlike in a partnership, the number of members is not limited. A public company has at its disposal unlimited ways to raise revenue for its operations including issuing debentures, rights offers or borrowing. The liability of members of a public company is limited to their share capital or any balance on share capital. A public company is denoted by the word limited or Ltd after its name40. The proprietary or private limited company is another type of business organization whose member’s liability is limited to their share capital. A proprietary company restricts the transfer of ownership and as thus does not offer its shares at the stock exchange. The number of members who can own a proprietary company is limited to 50 shares by section 45A (1) of the Corporations Act41. Section 113 (3) of the Act prevents proprietary companies from raising capital by issue of prospectus, profile statement or information statement42. A proprietary company is denoted by the word “pty limited” or “Pty ltd” at the end of its name43. 4.1 Set up formalities A company has to comply with a number of legal formalities before being set up. These include the preparation of a constitution and registration with the ASIC44. 4.2 Tax Implications The owners of a limited company have a distinct advantage when it comes to sharing business profits. Unlike partners and sole traders, all the company’s profits are not assessed for income tax. In contrast, only dividends paid out to members are assessed for tax as part of the shareholders income45. 4.3 Continuity and transfer of ownership While sole proprietorships and partnership come to an end when the owner or partner dies, the life of a company is not limited to the life of its members. From the perspective of lenders and creditors this is a profound advantage while dealing with companies as they can recover their debts regardless of whether the shareholders are alive or dead46. In public companies shareholding is easily transferable and trade in a public company shares occurs on a daily basis47. On the other hand, transfer of ownership in proprietary companies requires the consent of the other shareholders. 4.4 Management and Control Management and control in partnership rests with elected representatives of shareholders, referred to as directors48. 4.5 Member’s liabilities One of the largest advantages to operating a business through a company is the fact that members have limited liability. As seen earlier a shareholders liability does not go beyond any uncalled capital on the share subscription. However, in proprietary companies owners and directors are usually required to give personal guarantees to secure financing, negating the principle of limited liability49. However, in some case courts have ruled to lift the limited liability of company shareholder and extend the liabilities of company to its members and directors also referred to as “lifting or piercing the corporate veil50. In the next section the paper analyzes situation where courts have lifted the corporate veil and exposed members to liabilities for the company’s actions. 4.6 Piercing the Corporate Veil Section 119, 124, 601AA-601 DDD of Corporation Act 2001 (cth) recognizes the separate existence of a company distinct from its owner, directors, operators and employees51. Similarly, Salomon v A Salomon & Co Ltd [1897] AC 22 the House of Lords reaffirmed that the company is a separate legal entity from its shareholder52. Recently, courts are increasingly overlooking the limited liability of companies in cases of fraud, torts or criminal activities. In some cases, courts have held parent company responsible for liability incurred by their subsidiaries. In Dennis Willcox Pty Ltd v Federal Commissioner of Taxation, the conditions under which the corporate veil may be pierced were set53. The court advised that the legal personality of company can be set aside if the use or creation of a company is aimed at evading a legal or fiduciary obligation, or enable a fraud to be committed. Ramsay and Noakes categorize these circumstances into54: i. agency; ii. fraud; iii. sham or façade; iv. Insolvent trading 4.6.1Agency It can be argued that the shareholder’s of a company have some amount of control over a company, and thus the company can be said to be an agent of the shareholder55. It follows then that the actions of the company are by extension the action of shareholders. This argument was used by Bray CJ to pierce the corporate veil in Brewarrana v Commissioner of Highways (1973) 4 SASR 476, at 48056. However, in Balmedie Pty Ltd v Nicola Russo this argument was rejected and it was pointed out that a company is not an agent of shareholders merely because they are its shareholders57. The agency argument for piercing the corporate veil is weak as seen in Briggs v James Hardie & Co Pty Ltd (1989) 16 NSWLR 54958. In this case, the court found it hard to extend tort liability to the shareholder as it proved hard to prove foreseeability and causal nexus. Similarly, in The Electric Light and Power Supply Corporation Limited v Cormack, Rich AJ argued against piercing the corporate veil on agency grounds59. Rich AJ argued the company did not breach the exclusive power supply contact between the plaintiff and the defendant. According to Rich AJ the contract was between the plaintiff and defendant, and did not extend to the one-man company formed by the defendant as this was a separate legal entity. The company could not therefore be taken to be an agent of the defendant. 4.6.2 Fraud This refers to a situation where a company is formed to evade some contractual obligation. However, the fraud as an argument for piercing the corporate veil is also a weak argument as shown in Re Edelsten ex parte Donnelly60. In this case, the plaintiff argued that VIP group of companies had acquired title to property owned by Edelsten, prior to Edelsten being declared bankrupt. The plaintiff claimed this was a move to defeat creditors, by making sure the property would not be acquired by the bankruptcy trust. This argument was defeated as it was impossible to ascertain if the property acquired by the company belonged to Dr Edelsten. Furthermore, the VIP group of company could not be characterized as a “sham” a condition needed to pierce the corporate veil in cases of fraud61. On the other hand, the courts pierced the corporate veil in the Re Neo where a company formed the same day purported to sponsor a Visa application for a foreign immigrant62. The Immigration tribunal held the company was a façade used to try and circumvent Australian immigration law. 4.6.3 Sham or Façade A sham refers to a situation where a company is formed to “mask: or hide the real intentions of its shareholders. As seen in Donnelly v Edelsten (1994) 13 ACSR 196 (FC, Neaves, Ryan and Lee JJ), courts use the reference “façade” or “sham” to identify situations where corporate form are used to escape legal and contractual obligations63. Courts are more likely to pierce the corporate veil if plaintiffs are able to sustain the sham argument as seen in Sharrment Pty Ltd v Official Trustee in Bankruptcy64. However, some commentators argue the “sham” argument has been overused by court to defeat the socially useful principle of recognizing a company as separate legal entity. Windeyer J, in Peate v Federal Commissioner of Taxation faults the characterization of a company as a sham, arguing that a company is a reality as long as it is not been deregistered by the ASIC and continues to keep proper records65. 4.6.4 Insolvent Trading As seen in Credit Corporation Australia Pty Ltd v Atkins (1990) 17 ACLC 756; 30 ACSR 727, courts can pierce the corporate veil and find directors directly liable for a company’s debt incurred through insolvent trading66. Section 588M provides an avenue for the corporate veil to be pierced, if directors breach their duty to prevent insolvent trading67. 5.0 Conclusion The limited liability of a business organization is one of the greatest factors that may influence a person’s decision to make an investment. However, other important factors include the level of control over management and taxation implications. In this paper, the sole proprietorship offers the owner direct and most effective control over his business. However, a sole trader is the most vulnerable to liability incurred in the cause of running his business. In contrast, in companies limited by shares a shareholder liability is limited to his share subscription in the company, but he has little control over the management of the company. Indeed, responsibility for liability is the major theme when it comes to comparing the three business forms. In the discussion on partnerships, personal liability for the debts of the partnership was found to be the cause of many court disputes. Normally, partners are equally responsible for any obligation and debts incurred by any partner in the cause of running their firm. It can then be presumed that companies limited by shares are the most advantageous forms of business organization. However, court can remove the limited liability protection company shareholders. The discussion in the last section discusses the circumstance where shareholders are exposed to unlimited liability arising from the actions of their company. Just like partners and sole traders, shareholder of a company may be exposed to unlimited liability arising from their interest in a business. This calls for caution and diligence in running the affairs of any business organization be it a sole proprietorship, a partnership or a company. Bibliography A. Articles/ Books/ Reports Bennett, Rebekah, and Susan Dann. "The changing experience of Australian female entrepreneurs (2000) 7 (2) Gender, Work & Organization 75-8 Fletcher, Keith Lloyd, The Law of Partnership in Australia & New Zealand (LBC information services, 2000) Harris, Ron. Industrializing English law: entrepreneurship and business organization, 1720-1844 (Cambridge University Press, 2000). J Farrar, ‘Fraud, Fairness and Piercing the Corporate Veil’ (1990) 16 Canadian Business Law Journal 474, 478. 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Brayshaw, R.E., Financial Management and Decision Making (International Thomson Business Press, 1999) B. Cases Smith v Anderson (1880) 15 Ch D 247; [1874-80] All ER Rep 1121; (1880) 43 LT 329; 50 LJ Ch 39 Partnership Act 1892 (NSW)s 32(b) United Dominions Corp Ltd v Brian Pty Ltd (1985) 157 CLR 1 Krizaic v Ravinder Rohini Pty Ltd (1990) 102 FLR 8 Keith Spicer Ltd v Mansell [1970] 1 All ER 462; [1970] 1 WLR 333 Lang v James Morrison & Co Ltd (1911) 13 CLR 1 at 11; 17 ALR 530, Checker Taxicab Co Ltd v Stone [1930] NZLR 169 Cummings v Lewis (FCA, No 668/ 89, 2 August 1991, unreported) Whundo Copper Syndicate v Ferrari [1962] WAR 24 Walker v European Electronics Pty Ltd (in liq) (1990) 23 NSWLR 1 Young v Lamb (2001) 10 BPR 18,553; [2001] ANZ ConvR 629; [2001] NSWCA 225 Dennis Willcox Pty Ltd v Federal Commissioner of Taxation (1988) 79 ALR 267 (FC, Woodward, Jenkinson and Foster JJ). Brewarrana v Commissioner of Highways (1973) 4 SASR 476, at 480 Balmedie Pty Ltd v Nicola Russo (Unreported, Ryan, Whitlam and Goldberg JJ, Federal Court, 21 August 1998). Briggs v James Hardie & Co Pty Ltd (1989) 16 NSWLR 549 The Electric Light and Power Supply Corporation Limited v Cormack (1911) 11 NSWSR 350 (SCNSW, Rich AJ) Re Edelsten ex parte Donnelly (Unreported, Federal Court, Northrop J, 11 September 1992) Re Neo (Unreported, Immigration Review Tribunal, Metledge M, 30 July 19970 Donnelly v Edelsten (1994) 13 ACSR 196 (FC, Neaves, Ryan and Lee JJ) Sharrment Pty Ltd v Official Trustee in Bankruptcy (1988) 82 ALR 530 (FC, Lockhart, Beaumont and Foster JJ) Peate v Federal Commissioner of Taxation (1964) 111 CLR 443. Credit Corporation Australia Pty Ltd v Atkins (1990) 17 ACLC 756; 30 ACSR 727, C. Legislation Business Names Registration Act 2011 (cth) s 181 Partnership Act 1892 (NSW) s 1 The Corporations Act 2001 (Cth) s 115 Read More