1. What are the characteristics of sole proprietorships, partnerships and limited companies? What are the advantages and disadvantages of each type of business?
A sole proprietorship is a business that is run by a single individual who makes all the decisions, although the proprietor may engage employees. The sole proprietor is personally entitled to all of the profits and is responsible for any debts that the company incurs.
Advantages of forming a sole proprietorship
- Sole proprietorship is the simplest and most flexible business structure.
- The sole proprietor has total control and full decision-making power over policies, profits and capital investment.
- It is easy to close down the business.
- Profits from the business will be taxed at the sole proprietor's marginal tax rate, which may be lower than the corporate (limited company) tax rate. Also, business losses can be offset against the other income of the proprietor (for more details on profits tax please go to another topic – Taxation).
Disadvantages of forming a sole proprietorship
- Risks that are taken by the sole proprietor may result in personal bankruptcy.
- The death or prolonged illness of the sole proprietor will lead to the end of the business.
- Due to the limitations of a one-person business, the sole proprietor may not be able to raise additional capital from outside sources to expand the business.
A partnership is the relation which subsists between persons carrying on a business in common with a view of profit. The law relating to partnership is codified under the Partnership Ordinance, Cap. 38.
However the relation between members of any company or association which is (a) registered as a company under any Ordinance relating to the registration of joint-stock companies; or (b) formed or incorporated by or in pursuance of any other Ordinance, or any enactment or instrument is not a partnership within the meaning of the Partnership Ordinance.
Unlike a limited company, each partner in a partnership is personally liable for the acts of the other partners and for all of the debts of the company. On the other hand, all partners are entitled to share in the profits of the company equally unless they agree otherwise.
The transfer of interests in the company to existing or new partners may be carried out in accordance with the Partnership Agreement or other agreement that is entered into by all of the partners. In practice, there is little market for the transfer of the interests of a partnership to public investors.
The name of a partnership can be formed by combining the names (usually the surnames) of the partners. If there are many partners, then they may name the company "XX Company" or "XX & Co". However, they must not include the words "limited" or "company limited",as this is an offence that carries a fine. Note that a partnership can also use a business name or trade name (for example, XX Café) in addition to the partnership name.
It is important for the partners to prepare a Partnership Agreement that contains provisions for profit sharing, control and the settling of managerial and policy disputes. You are strongly recommended to appoint a lawyer to prepare the Partnership Agreement.
Advantages of forming a partnership
- It is easier to raise finance as a partnership than as a sole proprietor.
- Partners pay tax on their share of the partnership profits at their respective marginal tax rates, and their share in the partnership losses can be offset against their other income (for more details on profits tax, please go to another topic – Taxation).
Disadvantages of forming a partnership
- Partners do not have the benefit of limited liability.
- The participation of all the partners is needed for most legal transactions, which can result in disputes among the partners.
- The partnership will be dissolved when a partner dies or becomes bankrupt, unless the Partnership Agreement states otherwise ( section 35 of the Partnership Ordinance).
The characteristics of a company that is limited by shares can be described as follows:
- A limited company has a separate legal status that allows it to enter into contracts, to sue or be sued, to own property and to borrow money in its own name.
- Small and medium-sized businesses are usually run as private limited companies, rather than public limited companies. A private limited company cannot offer shares to the public at large but may have up to 50 shareholders whose right to transfer their shares is limited (section 11 of Cap. 622).
- A private limited company must have a least one director (section 454 of Cap.622). Section 457 restricts corporate directorship by requiring a private company (other than one within the same group as a listed company) to have at least one director who is a natural person.
- Under the New CO, the memorandum of association (“MA”) has been abolished for all companies. For existing companies (i.e. companies formed under the old regime), the conditions in the memorandum are deemed to be contained in the articles of association, except for conditions relating to authorised share capital and par value, which are regarded to be deleted for all purposes (section 98 of the New CO).
- For existing companies (i.e. companies formed under the old regime), the conditions in the memorandum are deemed to be contained in the articles of association, except for conditions relating to authorised share capital and par value, which are regarded to be deleted for all purposes (section 98 of the New CO).
- Companies to be incorporated under the New CO are required to have certain mandatory articles of association. For instance, the company name (section 81 of the New CO); details of the liabilities or contributions of the members(sections 83 and 84 of the New CO).
- Company directors must declare any actual or potential conflicts of interest in relation to the company to the board of directors. Nevertheless, company directors should try to avoid dealings which might have conflicts of interest in relation to their company.
- A limited company must keep minutes of the proceedings of all general meetings and meetings of the board of directors at its registered office.
- Certain companies are allowed to prepare simplified financial and directors’ reports. Companies which are qualified for simplified reporting are referred to in the New CO as companies “falling within the reporting exemption”. Sections 359 to 366 and Schedule 3 set out the qualifying conditions for companies to prepare simplified financial and directors’ reports.
- A limited company must not be registered without “limited” as the last word of their English name or “有限公司” of their Chinese name (section 102 of the New CO). However, the Registrar, may, by licence, exercise power to dispense with the use of the word “limited” or “有限公司” (section 102 of the New CO).
- It is prudent to prepare a Shareholders Agreement that covers the disposal or transmission of shares, the settling of managerial and policy disputes and the protection of interests of minority shareholders. You should appoint a lawyer to prepare this Agreement.
Advantages of forming a limited company
- The most obvious advantage is that the liability of the shareholders for the company's debts is limited to the amount of their respective shareholding. The liability of the company as a whole is limited to its aggregate issued share capital and its assets.
- An individual can be both sole shareholder and sole director, and hence have total control and full decision-making power over the company's policies and profits.
- It is easy to transfer the interests of the business by transferring shares to existing or new shareholders without interfering with the corporate structure by signing an instrument of transfer and a bought and sold note (based on the latest audited balance sheet and management accounts) on which the requisite stamp duty has been assessed and paid, provided that the approval of the company is obtained and the relevant rules that are set out in the company's Articles of Association are followed.
- The continuity of the business is not affected by the death, bankruptcy, retirement or mental disorder of any shareholder.
Disadvantages of forming a limited company
- A limited company must pay profits tax at the corporate rate, which is higher than the rate for individuals paid by sole proprietors and partnerships (for more details on profits tax, please go to another topic – Taxation).
- Shareholders cannot withdraw their capital at will from the company (unless they sell their shares to others).
- The transfer of shares in a private limited company may be restricted by the right of pre-emption (if any) in the Shareholders Agreement, which states that the existing shareholders must be given the first option to buy shares. The Companies Ordinance also gives the board of directors the right to veto potential new shareholders unless the directors do so in bad faith.
- Due to the nature of limited liability, many creditors of private limited companies will ask for personal guarantees or bank guarantees from shareholders or directors of such companies, and those shareholders/directors will then have to bear the debt personally if the company is unable to pay it.
- It is obligatory to publicly disclose the company’s Articles of Association, registered office address, details of shareholders, directors….at the Companies Registry.
- In order to protect personal data, the New CO introduces the concepts of “withheld information” and “protected information” [Note: The provisions relating to “withheld information” and “protected information” have not yet come into effect. Check with the Companies Registry for latest updates].
- Section 49 allows the Registrar to withhold from public inspection the usual residential address of a current or former director or a current or former company secretary and the full ID number of any person in specified categories of documents which have been registered with the CR upon application by the persons concerned (“withheld information”).
- Section 54 provides that the usual residential address of a director and the full ID number of any person in specified categories of documents registered with the CR after commencement of the New CO will not be made available for public inspection (“protected information”).
- The director’s correspondence address and the partial ID number of the person will be shown on the Companies Register for public inspection.
- There are prolonged and costly procedures for dissolving a limited company after the business has ceased or if it fails (further details can be found in the Bankruptcy and Winding-up topic).
- Potential conflicts of interest may arise among the company, its shareholders and its directors.
- Minority shareholders may not have effective involvement in or control over decision-making or management.
- A company director may have to take personal liability for a contract that is drawn up in the company's name but subsequently proves not to be enforceable against the company (if a potential director signed a contract before the date of formal incorporation of the company, for example). Directors may also be personally liable for claims if they act negligently in the performance of their job duties.