Incorporation – the benefits In this article Jim Finn, BL, High Court Examiner in the Courts Service, discusses some of the benefits and possible drawbacks of forming a company or remaining as a sole trader. The company as a separate legal person For anyone involved in managing his/her own business, one of the key decision is whether or not to incorporate- in other words, should they carry on business as sole trader, form a partnership or form a limited company? This article will focus mainly on sole traders and limited companies, as Partnership Law is not on the F1 Business Laws syllabus. In 1892, Mr Aron Salomon faced that very choice. He was a sole trader who ran a successful business making leather boots. Members of his family wanted to share in his business and he was interested in expanding. He decided to form Salomon & Company Limited…. and the rest is legal history. He sold the business to the new company and he secured part of the purchase price by a debenture creating a floating charge over the assets of the company. Mr Salomon remained the main share holder and driving force of the new company. Unfortunately, the business later fell on hard times and the company went into liquidation. The company’s debts were greater than its assets – if Mr Salomon’s debenture was to be paid, then the trade creditors of the company would not be paid. The company’s liquidator argued that the company was merely Mr Salomon’s agent or nominee and therefore that he was liable for the company’s debts. When the case reached the House of Lords, that court set out in very clear terms that a company is a different legal entity from its members, even if after incorporation the business remains the same and the same persons receive the profits. For the parties in the case, this meant that Mr Salomon’s debentures were given priority and he was not personally liable for the company’s debts. Of course, the decision had far reaching consequences and the principle that a company is a legal entity separate from its members means that forming a company has several benefits for any person in business The Benefits
Limited liability As a company is a legal person distinct from its members, it follows that the debts of the company are not the debts of those members. Therefore one very important benefit of incorporating is that the members of a company are not personally liable for the company’s debts. In the case of company limited by shares, a member is only liable up to the value of the shares held by him/her insofar as this amount has not already been paid. In contrast, a sole trader is liable to pay the debts of his/her business out of his/her assets and being unable to pay business debts can lead to bankruptcy.
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Ownership of company property The notion of the separate legal person means that the company’s property is separate and identifiable from the property of the members. Members cannot claim ownership rights in the assets of the company. Flexibility in transferring shares Incorporation results in flexibility when transferring shares of the company. When there is a change in membership of a company, the shares are transferred to the new member(s) and the company’s assets and liabilities remain unaffected. This flexibility does not apply when transferring the interests of sole traders or partners. For example, when a sole trader sells his/her business, he/she does not necessarily transfer debts and obligations to the new owner(s) as these may well be personal debts. Perpetual succession This means that a company will remain in existence even where members die, or become incapacitated or bankrupt. A change in membership does not affect the status of the company. A company can sue or be sued in its own name. Because the company is not the agent of its shareholders, any action to enforce its rights is taken in the name of the company, not by all of its members. Where a company has a legal obligation, any resulting action is taken against the company and not against all or any of its members. Ability to borrow or attract investment The structure of a company is well suited to raising capital. An investor can be offered shares as an incentive. A financial institution can secure a loan to a company by way of a floating charge over the assets of a company. A floating charge has attractions for the company (more flexible than a fixed charge on a specific asset) and for the financial institution (priority over unsecured creditors). Taxation There can be tax benefits to forming a company. The income and capital gains of a company are subject to Corporation Tax. For a business that makes a profit, Corporation Tax rates are more attractive than the Income Tax that would apply to a sole trader. Furthermore, through good financial management the tax liabilities of a company can be minimised, for example if the company makes pension contributions or if the company pays benefits-in-kind. Possible drawbacks to Incorporation For most, the benefits of incorporation will outweigh the drawbacks. The main deterrent to forming a company is that a number of formalities need to be complied with. For example certain documents, including the memorandum and articles of association, must be filed with the Companies Registration Office (CRO). There must be at least two directors, one of whom must be Irish resident.
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Of course, compliance with company legislation is an ongoing requirement, not just at the start-up of a company. For example, Annual Returns must be made to the Companies Registration Office (CRO). While compliance with the legislation can involve expense, non compliance can have very serious consequences for the company, including penalties and even prosecution. For example, failure to file an Annual Return can result in financial penalty, prosecution or the company being struck off the register of companies. Furthermore, non-compliance can have consequences for individual directors, including fines and in extreme cases disqualification from acting as a director. Conclusion For many in business, including those involved in small businesses there are numerous benefits to forming a company. Of course there are legal limits on the privileges arising from incorporation, including the concept of limited liability. For example, directors involved in fraudulent trading can be made personally liable for company losses that arise. Nonetheless, the fact that an incorporated company is a separate legal entity and the notion of limited liability, in particular, mean that the benefits of forming a company usually outweigh the drawbacks.
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