So, you’re looking to start up something official, but which type of legal entity would be best suited to contain the magic? Here’s your options and a bit about each:
A partnership is not a separate legal person or taxpayer. It is a relationship between two or more persons who decide to join forces. A partnership is not registered with the CIPC – instead, a separate legal document, containing all the requirements relating to a partnership and needs to be drawn up between all the relevant parties.
Each partner may contribute money, assets, property, labour, or skills and will be taxed in his own capacity based on his share of the partnership’s profits or losses. Every time a partner joins or leaves the partnership, it effectively means that the partnership is dissolved and a new partnership is formed. The tax implication can potentially be severe since changes to the partnership mean that you must account for capital gains on the dissolvent.
You should also continuously account for the various partners’ contributions to the partnership. SARS does however take a lenient stance on this technicality, but to operate a partnership remains very burdensome from a tax perspective.
Being in a partnership would require you to draw up a partnership agreement. This agreement may include:
- the amount of capital to be invested by each partner;
- the proportion of profits (like drawings) for each partner;
- what happens when a partner becomes ill and can no longer work;
- what happens when a partner dies; and
- control of banking (for example which partner signs the cheques).
A partnership has the following advantages and disadvantages:
- Easy to establish and operate.
- The different skills of partners are combined.
- Each partner has a personal interest in the business.
- Unlimited liability of partners – each partner may be held liable for all the debts of the business. One partner can cause the loss of the partnership’s assets as well as the personal assets of all the partners.
- Authority for decision-making is shared and differences of opinion could slow the process down.
- Not a legal entity.
- A lesser degree of business continuity as the partnership technically dissolves every time a partner joins or leaves the partnership.
The number of partners is restricted to 20 except in the case of certain professional partnerships such as accountants and attorneys
A private company is a separate legal entity and has to be incorporated and registered with CIPC. Private companies have share capital which means that the shareholders can be the same as or different from the directors. Because a company is a separate legal entity, it has a perpetual lifespan and directors do not necessarily take liability for the debts of the company except for in the case of an Incorporated company (Inc.).
The Companies Act of 2008 makes various provisions for companies of different sizes. These provisions include that certain companies must be audited and whilst others do not have this requirement. It goes further by stating that some companies may internally compile their annual financial statements whereas others are not allowed to having to get independent compilations for their financials.
Incorporating and managing a company is a formal and effective way to run a business. Starting out as a sole proprietor is a good start, but as your business grows it is advisable to incorporate a company.
You can incorporate one of three different types of companies:
- Proprietary limited (normal private company)
- Limited (public or listed company)
- Incorporated (directors take responsibility for the debts of the company)
Companies also have certain advantages and disadvantages:
- You may appear a bit more professional.
- Better tax planning opportunities.
- The assets and liabilities of companies are separate from the owners’ assets. This means that if the business goes bankrupt, creditors can only claim assets owned by the company and not the owner’s personal assets owner. If however, the owner signed surety in his/her personal capacity, debt collectors can claim personal assets.
- The lifespan of the business is perpetual.
- The transfer of ownership is easy – you simply sell your shares in the company.
- It is easy to change the directors of a company.
- It is easier to raise capital and expand.
- You have to file an annual return with CIPC each year.
- You also have to prepare annual financial statements, signed by an accountant, which need to be filed with SARS every year.
- Accountancy fees are generally more expensive because you have to adhere to certain minimum standards.
- Depending on the size and shareholding of the company, it may need to be audited.
- In some limited instances, directors may be personally liable for debts of the company.
A sole proprietorship is a business that is owned and operated by an individual and is the simplest form of business entity. A sole proprietor cannot be classified as a legal entity as it has no legal existence separate from its owner. This means that you are the business and the business cannot be separated from you. As there is no separate legal entity, all business income and expenses must be included in the name of the sole proprietor. Therefore your taxable income will be taxed on the sliding scales applicable to individuals.
Only the proprietor has the legal authority to make decisions on behalf of the business as you are not able to appoint any directors. You can however appoint personnel to perform crucial functions to run your business.
Running a business as a sole proprietor has the same implications as would be applicable for any other type of entity because you are still liable for tax. Should you appoint employees, you will be required to register for PAYE, UIF, and SDL. You can also register for VAT if you are trading as a sole proprietor.
There are however definite advantages and disadvantages in operating as a sole proprietor:
- The owner is free to make decisions as he/she pleases.
- Easy to discontinue the business.
- It is an easy way to start a business.
- Simple and cost-effective to set up.
- No company formation fees or formal registration are involved.
- Lower accountancy fees in most instances.
- No need to file annual returns with CIPC.
- You are not obligated to appoint an accounting officer/auditor.
- You don’t have to adhere to the requirements as set out in the Companies Act.
- You are not obligated to compile and submit annual financial statements at the CIPC or SARS that need to be signed off by an accounting officer or auditor.
- Higher personal risk – you are personally responsible for the company’s debts which means that your assets can be at risk.
- Limited ability to raise capital.
- Fewer opportunities for tax planning.
- The owners’ assets (house, motor vehicle, etc.) are not separated from those of the business. This means that should your business become bankrupt, any organization that the business owes money to can claim the owner’s assets to pay the debt.
- Perceived to be informal compared to a company and might therefore have difficulty to get on vendor lists of bigger companies.
- Cannot take part in the Small Corporation Tax regime as you have to trade as Company.
A trust is a legal contract that is lodged with the master of the high court. Upon the lodgement, the registrar will issue the trustees with a registration number for the trust. The following persons are party to a trust:
- the donor;
- the trustees; and
- the beneficiaries;
Without these three parties, a trust cannot be formed or be valid. The trustees are appointed by the donor, who undertakes to manage the trust in accordance with the trust deed and to the benefit of the beneficiaries.
Trusts are usually referred to as a family, personal, or business trusts. But, in actual fact no such difference exists as the only difference between these types of trusts is the wording of the trust deed.
Inter Vivos (living trust)
An inter vivos trust is formed by the donor during his or her life. An inter vivos trust is used by the donor to actively manage certain affairs which he/she deem to be best handled in the structure of a trust.
One such example may be to limit the capital appreciation of an asset in your own name and ensure that it is not included in your estate. If you for instance bought an investment property in the name of a trust, the property will never form part of your estate and you will not pay any estate duties on it.
Inter Vivos trusts are also used to lessen the risk of entrepreneurs. As entrepreneurs are usually required to sign surety, the only way to ensure that your assets are not at risk is to register them in a trust or to have the assets or shares you own in a company vest in a trust ensuring they are not part of your risk profile.
Mortis causa trust
A Mortis causa trust is formed at death. Should your last will state that certain assets should be transferred to a trust upon death, your attorney will ensure that a trust is formed and the indicted assets are legally transferred. The trust deed will then be worded to ensure that your last will be reflected. The trustees will also act in accordance with the trust deed to ensure that your will is being adhered to.
A trust is not a flexible legal structure and it is not advisable to use when doing business but rather to form part of a holding structure. If for instance, you want to use a trust to operate a business, all trustees must always sign the relevant documents as compared to a company where you can only have one representative signing. Another issue to consider is the fact that once you have nominated your beneficiaries and at least one distribution has been made to them, you will not be allowed to alter or change these beneficiaries. If you alter the beneficiaries you can adversely affect their rights.
The trustees are appointed by the donor and must accept their appointment by signing the relevant documentation. Trustees have a huge obligation as they should ensure that the trust is dealt with in accordance with the trust deed and to the benefit of the beneficiaries.
It is advised that at least two trustees should be appointed with one being independent of the structure. One of the trustees can be you (the donor), but if you are the only trustee, the whole purpose thereof is void as this structure will simply be seen as an extension of you. Section 3(d) of the Estate Duty Act indicates that any assets which you were competent to dispose of immediately prior to your death should be included in your estate. This can be avoided should you have at least two trustees appointed.
Trustees can resign at any stage by simply tendering their resignation to the master of the high court. A new trustee must then be appointed in accordance with the trust deed. Great care should be taken when trustees are appointed as you (the donor) are effectively relinquishing control of your assets to the trust which is now managed by the trustees.
For taxation purposes there are three parties to a trust, namely:
- the donor;
- the trust; and
- the beneficiaries.
The Income Tax Act is written in such a way as to firstly tax the donor, secondly the beneficiaries, and thirdly (if neither the donor nor the beneficiaries were taxed) the trust. The tax rate applied to a trust is 40% compared to the rates applicable to the donor or beneficiaries which can vary depending on the tax scales where these individuals are.
Section 7 of the Act also has various anti-avoidance rules applicable to a trust. The trust deed, as well as sections 7 and 25 of the Act, should be carefully considered when dealing with the taxes of a trust.
Interest-free loans to a trust
It is common practice to form a trust and loan money to that trust on an interest-free loan account. The individual loaning the money to the trust, therefore, has a loan receivable in his accounts were as the trust has a loan payable (liability). The trust can use the money at its discretion. As time passes, the individual who loaned the money to the trust will annually donate a portion of the debt to the trust thereby reducing the liability to the trust.
The concept of an interest-free loan and its tax consequences has been challenged in court. The outcome is that section 7C was introduced into the Act resulting in loans being required to be interest-bearing, bar certain exemptions. The lender will therefore have to calculate deemed interest received based on the interest rates provided by SARS and include this amount in his/her tax return as gross income. The trust on the other hand has the risk of not being allowed the deduction of paying deemed interest as this amount was not actually incurred.
If a beneficiary has vesting rights in the trust assets or income, it means that he or she must receive whatever is indicated in the trust deed. If the trust deed for instance indicates that you should receive R5 000 every month, then the trustees must adhere to this and ensure that you receive your money every month.
If you have a vesting right, you will be taxed on this amount whether or not you actually receive it. The actual receipt of the money is irrelevant.
A discretionary right simply means that the trustees may distribute a certain amount (determined at their discretion) to you. This distribution is not based on any obligation placed on them by the trust deed. The trust deed may for instance indicate that you need a living allowance. If the trustees agree that your living allowance should be R2 000, then this is what you will receive.
If you have a discretionary right, you will only be taxed on the amounts you actually received from the trust.
Therefore, unless there is a very specific reason why you require vesting rights as part of your trust deed you should rather revert to a discretionary trust deed.