Issue 81, Autumn 2020 Fineprint
Fineprint, Autumn 2020 issue 81
Going out on your own
Company structure or sole trader for business?
You have decided to quit your job, and go out on your own to run your own business. Do you form a company or trade in your own name? We outline some of the pros and cons of these two options to help you make a decision.
Trading through a company
Brown Biscuits Limited: owner Jackie Brown
Brown Biscuits Ltd (BBL) is a separate legal entity. There are some significant advantages of trading through a limited liability company.
- Limited liability: The ‘limited’ in the name of BBL means that Jackie’s obligations as a shareholder are limited to the amount of unpaid share capital. As a shareholder Jackie is not personally liable for BBL’s obligations. In most commercial situations Jackie is protected from personal liability for claims against BBL, such as an employee’s personal grievance claim and claims for breach of contract or negligence. If BBL fails, Jackie is not personally responsible for its debts. However, if Jackie is also a BBL director, there are some major exceptions to these rules, see page 2.
To ensure that the situation is clear, Jackie should describe herself as ‘director/Brown Biscuits Limited’ on anything she signs for BBL. This makes it clear that it is BBL that is signing the document, and that Jackie is not agreeing to accept personal liability.
- Separate entities: BBL is a legal entity which is separate from Jackie Brown. It has its own IRD number and must pay all income tax, GST, ACC levies, wages and so on in relation to its business. BBL will continue to exist until it is wound up, even if Jackie and subsequent shareholders die or sell their shares.
- Flexibility: Trading as BBL gives Jackie the flexibility to have other investors (shareholders) in the business, either at the time BBL is established, or further down the track. Jackie and the shareholders can agree to own differing percentages of the shares in BBL. This means that Jackie can sell part or all of her interest in the business by selling some of her shareholding.
Where there is more than one shareholder in BBL, it is wise to have a shareholders’ agreement and a constitution. These will address matters such as restrictions on share sales to third parties, profit-sharing, dispute resolution and so on.
Companies distribute their profits between shareholders as dividends, usually based on the shareholders’ percentages of the total shares in the company.
Management and ownership are separate. Shareholders are not necessarily directors, for example, if they don’t intend to be involved in running the business. Directors do not have to be shareholders. A director’s remuneration (such as an annual fixed director’s fee) does not need to be tied to the performance of the company.
- Tax: BBL may pay less tax than Jackie. The current company tax rate of 28% is lower than the current top personal tax rate. In a situation where profits are reinvested in BBL, rather than distributed to Jackie, it may be that less tax will be paid overall.
There are obligations and responsibilities on Jackie when trading as BBL, even though BBL is a ‘limited liability’ company Jackie is likely to be a director of BBL as well as a shareholder.
- Complexity: Jackie must comply with the Companies Act
and other legislation such as the Minimum Wage Act, and health and safety legislation. If Jackie breaches her statutory obligations as director, there can be significant legal and tax consequences, and potential personal liability (see below). - Personal liability: Jackie can be personally liable for BBL’s obligations where she has not met her statutory duty as a director. One very important statutory duty is that Jackie must not allow BBL to trade while it is insolvent. If Jackie allows BBL to incur debts when it is unable to pay those debts, she may find herself personally liable for those debts.
In the civil courts, Jackie can be personally liable for BBL’s actions where she has been actively personally involved in the wrongdoing in question, such as fraud, or where she has personally assumed responsibility.
Jackie can also be personally liable for BBL’s debts where she has given a personal guarantee. Lenders, landlords, trade suppliers and other business entities will often require a personal guarantee from Jackie before they are willing to lend, rent, or extend credit to BBL. In addition to a personal guarantee, lenders may require security against Jackie’s personal assets, for example, a mortgage registered against her home, before a loan and/or credit is approved.
- Costs: There are greater set-up costs involved in forming BBL than operating as a sole trader. Due to the legal obligations imposed on companies, there can be greater administrative, legal and accounting costs to run BBL after it has been established.
- Tax: The flat company tax rate of 28% could be a disadvantage if BBL is not making much profit initially, as that rate is higher than the current low-to-mid personal tax rates.
Doing business as a sole trader
Jackie Brown: trading as Brown Biscuits (BB)
Being in business as a sole trader/Brown Biscuits is more straightforward than operating as Brown Biscuits Limited. Jackie’s trading name is just a business name; there is no separate legal entity.
Some advantages of being a sole trader are:
- Less paperwork and costs: BB is one business entity and one taxpayer – BB is Jackie. Jackie does not have to get up to speed with the law and administrative detail that is necessary to run a company. That said, Jackie must still comply with the laws of being in business and employing staff.
- Tax: There is no separate IRD number; all Jackie’s tax (personal and under her trading name of BB) will be paid under her personal name. Also, as we explain above, there may be less tax to pay on BB’s profits as a sole trader rather than as a company.
- Going solo: As Jackie does not own the business with anyone else, there is less likelihood of friction and disputes in the running of the business.
There are some disadvantages of running the business of BB as a sole trader:
- Unlimited liability: Jackie’s personal liability is unlimited. Her assets, including her home and other assets and bank accounts, are all vulnerable to claims arising from her business.
- Sole responsibility: Jackie doesn’t share the responsibility with anyone else. There is no one with a stake in the business Jackie can rely on or share ideas with.
Partnership is another ownership option
Another option for shared business ownership, apart from a company, is to form a partnership. This may be with a formal partnership agreement (recommended) or by a verbal agreement with the people you are in business with. In a partnership, Jackie is personally liable (as will be the other partners) for all the partnership’s obligations.
Changing your trading entity
Jackie could begin as a sole trader (BB) or in a partnership and, when the business grows, later form BBL. As BBL is a new legal entity, it must make new contracts with BB’s clients, suppliers, employees and so on. BBL does not automatically take on BB’s contracts and liabilities. Jackie or her other partners remain personally liable for any obligations incurred before BBL was formed.
Get advice before you start
Depending on your situation, there can be legal, financial and tax pros and cons for operating as a sole trader, establishing a company or forming a partnership. We have only scratched the surface in this article; there is more general information at www.business.govt.nz
You will, however, need tailor-made advice that suits your personal circumstances. Talk with us and your accountant to work out which option best suits your business and personal needs; we are happy to help.
How are enforceable penalties set out in contracts?
Contracts are commonplace in business and life. A well-drafted contract can provide certainty and clarity for businesses and others by creating legal obligations for each party to do what they say they will. But what if a party to a contract doesn’t do what they promised they would? Are you allowed to penalize that party for not fulfilling their obligations under the contract? We will explore the enforceability of so-called ‘penalty clauses’ in light of a recent decision in the Court of Appeal[1].
What is a penalty clause?
It is common for businesses to try to reduce their risk of suffering a loss under a contract. One way businesses try to minimise their risk is by including a clause in the contract that requires money to be paid to them to compensate for loss if the other party doesn’t do what they promise.
In the past, such a clause has been considered a ‘penalty’ clause if the amount claimed is far more than the loss that is likely to be suffered from a breach of the contract. A disproportionately large amount could be seen as a punishment for breaching the contract, rather than a deterrent.
For example, you might enter into a contract to supply 400 apples to a food truck owner by 31 October so she can sell them as candy apples at a festival. The contract includes a clause that requires you to pay the owner $20 for every apple that you do not supply. The food truck owner intends to only make $1 of profit per apple sold. The $20 per apple is far more than the foreseeable loss of $1 per apple and is likely to be considered a penalty.
In the past, the courts have only been willing to enforce such clauses if the amount claimed was a reasonable (our italics) estimate to compensate for any foreseeable loss when the contract was signed. If the amount claimed was far more than the foreseeable loss, then the court would view this as a punishment for breaching the contract and would not enforce it.
The Honey Bees Preschool case
The late 2019 Court of Appeal decision in 127 Hobson Street Ltd v Honey Bees Preschool Ltd clarified the law relating to penalty clauses. The case involved the lease of the fifth floor of a central Auckland commercial building to a childcare provider, Honey Bees Preschool Ltd. The building only had one lift that serviced the whole building.
Part of the agreement between the preschool and the landlord required the landlord to install a second lift in the existing empty lift shaft. The agreement also stated that, if the lift was not installed by a certain date, the landlord would cover the remaining rent and outgoings for three years and five months, until the initial lease term ended. The lift was not installed by the due date so Honey Bees issued court proceedings.
In the Honey Bees case the court created a new approach by looking at whether there was a legitimate business interest, and whether the amount claimed was out of proportion to the protection of that legitimate business interest.
Legitimate business interest confirmed
The court stated that monetary loss was not necessarily the only legitimate business interest that could be protected –there may have been other business risks. In the Honey Bees case the preschool needed the second lift to obtain a consent to increase the number of children enrolled, otherwise their business was not viable. This was considered a legitimate business interest.
In our candy apples example, the food truck owner may not be allowed back to any future festivals if she does not have 400 apples. The court may consider this to be a legitimate business interest that may justify a greater amount of compensation than just $1 per apple.
This Court of Appeal ruling provides businesses and others with greater freedom to enter into contracts that require a larger amount of compensation for a breach than might previously have been enforced by the courts. The compensation amount under the contract, however, still needs to be proportionate to the legitimate business interest. In our candy apple example above, $20 per apple would still likely be disproportionate and not enforceable.
The Honey Bees decision has been appealed to the Supreme Court; we will report on its outcome.
If you are considering including a penalty clause in your contracts, or would like to know whether any penalty clauses in existing contracts are enforceable, do talk with us.
[1] 127 Hobson Street Ltd v Honey Bees Preschool Ltd [2019] NZCA 122.