Financial Accounting for the Hospitality, Tourism, Leisure and Event Sectors PDF

# Chapter 12: The Legal Forms of Organisation ## Learning Outcomes By the end of this chapter, you will be able to: * Compare and contrast the characteristics of the various legal forms of business organisations. * Outline the advantages and disadvantages of each form of legal organisation. * Lis...

# Chapter 12: The Legal Forms of Organisation ## Learning Outcomes By the end of this chapter, you will be able to: * Compare and contrast the characteristics of the various legal forms of business organisations. * Outline the advantages and disadvantages of each form of legal organisation. * List and explain the procedures and requirements associated with the different legal forms of business organisations. * Outline the legal and administrative requirements of Limited Liability company status. ## Introduction One of the first decisions an entrepreneur must make is regarding establishing the legal form of organisation of the business. The type of legal organisation assumed by a business is normally a function of the amount of finance required and the size of the business. Once established, the legal form of organisation affects a business in the following ways: * The taxation requirements of a business * The legal requirements * The audit and financial requirements * The sources of finance available The following types of legal organisation are available to a business: 1. Sole proprietorships 2. Partnerships 3. Limited liability companies 4. Not-for-profit organisations The different legal forms of an organisation were introduced in Chapter 1. This chapter will now go into greater detail on this area focusing on the characteristics, advantages and disadvantages of each. ## Sole Trader Organisations The sole trader legal form of organisation comes into being when an individual sets up in business and starts to trade in his or her own name. The individual is the sole owner of the business. A sole trader can also register a business name such as John Ryan trading as 'Ryan & Sons'. The sole trader option is often adopted by businesses in the hospitality, tourism, leisure and event sectors. ### Advantages The advantages of being a sole trader are as follows: * The simplicity and ease with which one can set up in business. * The lack of legal controls and constraints. However, sole traders do have a legal requirement under tax law (in particular, self assessment, value added tax and PAYE/PRSI regulations) to keep proper books and records for inspection by the Revenue Commissioners. * Privacy, as the accounts of sole proprietorships are not required to be published, unlike the accounts of companies. ### Disadvantages The disadvantages of being a sole trader are as follows: * A sole trader is not protected by limited liability. Limited liability is a type of investment in which the owners or investors cannot lose more than the amount invested if the business fails. In other words, a sole trader has unlimited liability and is personally liable for all the debts of the business. Hence personal assets outside of the business may be lost. * Sourcing finance can be more difficult with only one owner. * The rates of tax on profits for sole traders are higher than for companies, as profits are taxed under income tax rules whereas, for companies, profits are taxed according to corporation tax rules. ## Partnerships A partnership can be described as an association of persons carrying on business in common with a view to making a profit. The agreement between the persons can be in a verbal or written format. Most partnership agreements tend to be written and partners usually draft a 'Deed of Partnership'. The Deed of Partnership would normally contain the following information: * The name of the partnership * The date the partnership commenced * The planned duration of the partnership * The rules governing the retirement or admittance of partners * The capital subscribed and rules regarding the distribution of profits * Cheque signing regulations There are two types of partnerships in Ireland: a general partnership, which is regulated through the Partnership Act of 1890, and limited partnerships, regulated through the Limited Partnerships Act of 1907. In a general partnership, each partner contributes an agreed amount of capital and is an agent of the partnership and thus has full liability for all the debts of the partnership. General partnerships are quite common, especially among professional firms such as solicitors and accountants in Ireland. Under the terms of the Limited Partnership Act of 1907, a limited partnership must consist of at least one general partner who shall be liable for all the debts and obligations of the partnership and at least one limited partner. A limited partner is one who shall not be liable for the debts and obligations of the partnership beyond the amount of capital they invest. Thus, their liability is limited to what they have invested in the business. Limited partners may not take an active role in the running of the business. The number of limited partnerships registered in Ireland is small by comparison to general partnerships. ### Advantages The advantages of partnerships are as follows: * Simplicity and ease with which one can set up in business * The general lack of legal controls and restrictions compared to limited liability companies * Partners often have a blend of skills and experience, which can help create a more effective organisation. * Partnerships have greater access to capital due to the fact that there is a greater pooling of resources and borrowing capacity. * Privacy, as the accounts of partnerships are not required to be published to the general public but are required for tax purposes ### Disadvantages The disadvantages of partnerships (in addition to the disadvantages of sole proprietorship) are as follows: * Partnerships can be quite unstable and can break up over relatively minor issues. * As in sole traders, partnerships are not protected by limited liability. * Each partnership is liable for the debts of the partnership: 'joint and several' liability. * The life of the partnership can be limited by agreement or by the life of the partners. * Profits are taxed at income tax rates. ## Limited Liability Companies A company is a corporate body, which has a legal existence quite separate from its owners (the shareholders). Limited liability companies can have a perpetual life since ownership is represented by shares that are transferable. This ensures that companies can exist beyond the lives of their original owners. This is unlike sole traders or partnerships where the business ceases to exist on the death of the owners or partners. Many Irish companies have been in existence for over 100 years. Thus, a company is a business entity created by law that is capable of entering into contracts, incurring liabilities and carrying out business. The liability of its owners is limited to what they have invested and what they owe the company. ### Formation of a Company The formation of a limited company is handled by solicitors who draft the necessary legal documents that form its make-up. These documents are then registered with the Companies Registration Office (CRO), whereupon a certificate of incorporation is issued to the company. The company is now registered and can commence trading. ### Types of Companies There are four types of companies to choose from. The most popular are private companies of which there are approximately 160,000 in Ireland in 2011. #### Private Limited Companies A private limited company is a company that has between two and fifty shareholders that have restrictions on the transfer (buying and selling) of their share, but are protected by limited liability. Private companies accounted for 86 per cent of the total number of companies registered in Ireland in 2011. The following are the key characteristics of a private limited company: 1. Between two and fifty shareholders (minimum of two) 2. Business can commence immediately on incorporation. 3. The right of transfer of shares is restricted as there is no market in which to actively trade the shares. 4. The company is prohibited from inviting the public to subscribe for its shares and loan notes. 5. Accounts must be audited each year. Private limited companies whose turnover does not exceed €8.8m and whose total assets do not exceed €4.4m, with employee levels below 50, are exempt from this requirement to have an audit. Many small companies avail of this exemption as it translates directly into a cost-saving. However, some small companies still commission an audit as it can provide some protection against fraud, and financial institutions tend to require audited accounts in assessing finance applications. 6. All companies must file their annual accounts, whether audited or not, with the CRO. This ensures that a company is less private than a sole trader or partnership. Small and medium sized companies can avail of an exemption to file abridged accounts which ensures a lower level of disclosure. These accounts are for public consumption and can be viewed at the CRO or through an on-line search at http://www.cro.ie. 7. Generally private companies are formed to ensure their owners benefit from limited liability. #### Public Limited Companies (PLCs) A public limited company (PLC) is a company that has a minimum of seven shareholders that are protected by limited liability. Shares are freely transferable as they can be traded publicly and are quoted on a stock exchange. PLCs account for nearly 1 per cent of the total number of companies registered in Ireland in 2011.. The following are the key characteristics of PLCs: 1. A minimum of seven shareholders are required for incorporation. Unlike private companies, there is no maximum limit. 2. Shares are freely transferable. In other words, a market exists to buy and sell the shares. 3. Shares and Loan Notes/Debentures of PLCs may be quoted on the stock exchange (subject to permission by the stock exchange authorities). 4. Though incorporated, a PLC cannot commence trading until the CRO issues a trading certificate to commence business. This cannot happen until €38,092 of share capital has been subscribed with 25 per cent (€9,523) paid up. 5. Accounts must be audited each year and a copy filed with the CRO where they are available for public inspection or through an on-line search at www.cro.ie 6. Generally, public companies are significantly larger than private companies (although this is not always the case), and they tend to have more of an international dimension. 7. Generally, public companies are considered the most appropriate type of company to raise capital as they can issue their own shares and loan notes publically. #### Companies Limited by Guarantee In a company limited by guarantee, the members usually do not provide money/capital on its formation but guarantee to pay its debts up to a certain limit in the event that the company goes into liquidation. Usually, the sum is a nominal amount. This method of incorporation is used by nonprofit making organisations such as clubs, charities and societies. Companies limited by guarantee account for 8.5 per cent of the total number of companies registered in Ireland in 2011. #### Unlimited Companies An unlimited company is one which ensures that its member can be personally liable for the debts and liabilities of the business. This liability can be totally unlimited or limited to a certain figure. Although this is a big disadvantage, unlimited companies have the following advantages: 1. The right to reduce issued capital without court permission. A court order is required for limited companies under section 72 of the Companies Act 1963; however, this is not a requirement for unlimited companies. 2. Exemption from filing accounts with CRO (privacy advantage) Unlimited companies account for 2.23 per cent of the total number of companies registered in Ireland in 2011. ## Advantages of Limited Liability Company Status 1. The investor's liability is limited. However, the Companies Act 1990 has somewhat tightened up this area. Now, there will be personal liability for all or part of a company's debts if a director is a party to carrying on the business of the company in a fraudulent or reckless manner, and can become disqualified from becoming a director of another company for five years. Civil and criminal liability is imposed on directors where a company fails to keep proper books of account which the court considers has contributed to the company's inability to pay all of its debts. 2. Companies tend to have greater access to capital. 3. The business continues despite the death or incapacity of the investors/owners. 4. Profits are taxed at the corporation tax rate of 12.5 per cent (2013). This is nearly incentive enough for businesses to incorporate as the profits of sole traders and partnerships are taxed at income tax rates that start at 20 per cent but for self-employed can reach 55 per cent in 2014, when one includes all taxes. ## Disadvantages of Limited Company Status 1. Limited companies are more regulated than either partnerships or sole traders. 2. It is more difficult to withdraw money from a company than it is for a sole trader or partnership. Generally, drawing money from a company has to be by way of a salary or bonus which will be subject to PAYE. With a sole trader/partnership, one can have drawings throughout the year and pay the tax later. Shareholders not directly employed in a company can only receive monies through dividends paid from profits. 3. Once incorporated, companies must file their accounts with the CRO and hence, there is a lack of privacy compared to sole proprietorship and partnership legal forms of organisation. ## Legal Requirements for Limited Companies The main legal requirements are contained in the Companies Acts 1963, the Companies (Amendment) Act 1983, the Companies (Amendment) Act 1986 (which introduced the EC fourth directive to corporate reporting), the Companies Act 1990, the Company Law Enforcement Act 2001 and Companies (Auditing and Accounting) Act 2003, Investment Funds Companies and Miscellaneous Provisions Act 2005 and 2006 and the Companies (Amendment) Acts 2009 and 2012. ## The Administration of Limited Liability Companies The majority of companies in Ireland are small private companies where the shareholders and managers/directors are the same persons. However, in large companies where there are many shareholders, obviously not all can be involved in running the company. Each year at the annual general meeting (AGM), the shareholders can vote and appoint directors to run the company on their behalf. In this case, there is a clear division between the owners and directors/stewards of the company. Each year, the directors report back to the shareholders in terms of their stewardship of the company. Their annual report includes an income statement and statement of financial position. If the company performed well and made profits, then part of those profits can be paid out to the shareholders in the form of dividends. Part or all of the profits can also be retained in the company for further investment and expansion. The annual report also includes a report from the company's auditors. An audit is a legal requirement under the Companies Act 1963 and auditors are employed by the shareholders to report on whether the financial statements in the annual report give a true and fair view of the financial performance of the company. ## Other Types of Legal Organisation The three types of business organisations discussed above (sole traders, partnerships and limited companies) are primarily the business organisations that are established for the purpose of making a profit (see Table 12.2). However, there are organisations that are established to achieve some goal or goals other than making a profit. These companies are frequently referred to as 'not-for-profit organisations'. This does not mean that the companies in question never make a profit. It simply means that the making of a profit is not their primary goal. Examples would include the following: 1. Co-operatives 2. State-sponsored enterprises 3. Charities ## Tourism State-Sponsored Enterprises Fáilte Ireland, the National Tourism Development Authority, was established under the Tourism Development Authority Act, 2003. It brings together and builds on the functions previously discharged by Bord Fáilte and CERT. Fáilte Ireland provides strategic support to develop and sustain Ireland as a high-quality and competitive tourist destination. Its mission is 'to increase the contribution of tourism to the economy by facilitating the development of a competitive and profitable tourism industry'. Fáilte Ireland works in strategic partnership with tourism interests to support the industry's efforts to be more competitive and more profitable and to help individual enterprises to improve their performance. ## Table 12.2: Comparison of Ownership Classification | Ownership | Sole proprietorships | Partnerships | Limited liability companies | |:--:|:--:|:--:|:--:| | | 1 person | 2-20 | Private: 2-50 Public: minimum 7 but no maximum limit | | Set up costs | minimal | minimal | Legal fees and stamp duty apply | | Financial | No restriction on distribution of profit or cash withdrawal | Profits distributed in agreed proportions | Distribution of profits Restricted under company law | | | No legal requirement to prepare accounts except under tax law | No legal requirement to prepare accounts except under tax law | Accounts must be prepared and registered with the CRO | | | No audit fees | No audit fees | Audit fees | | | *No limited liability* | *No limited liability except for limited partners under the LPA 1907* | *Limited liability* | | Legal | No real legal restrictions except tax law | Restricted under Partnership Acts | Restricted under companies acts and accounting regulations | | Taxation | Profits taxed at income tax rates. | Profits taxed at the income tax rates. | Profits taxed at corporation tax rates. | ## Summary Establishing the legal form of organisation is one of the first decisions an entrepreneur must make. Hence, a knowledge of the financial, legal and taxation aspects relating to this decision is very important. Generally, small, one-person businesses begin as a sole proprietorship and, as they develop and grow, they choose a limited liability company format. This is normally in the form of a private company and, as the business expands and requires new sources of capital, it may need to develop into a public limited company. The following main information points are covered in this chapter: * The legal form of organisation affects the taxation, legal, audit and financial requirements of a business. ## The sole trader legal form of organisation comes into being when an individual sets up in business and starts to trade in his or her own name. The individual is the sole owner of the business. * The advantages of sole proprietorship status are privacy, lack of regulation, simplicity and ease in set up. Its disadvantages include unlimited liability for the owner and difficulty sourcing finance. ## A partnership can be described as an association of persons carrying on business in common with a view to making a profit. The agreement between the persons can be in a verbal or written format. ## A limited company is a business entity created by law that is capable of entering into contracts, incurring liabilities and carrying out business. The liability of its owners is limited to what they have invested in the company. * The formation of a limited company is handled by solicitors who draft the necessary legal documents that are then registered with the company's registrar before trading can take place. The main documents are known as the memorandum and articles of association. * The majority of companies in Ireland are small private companies, where the shareholders and managers/directors are the same persons. However, in large companies where there are many shareholders, obviously not all can be involved in running the company. * Each year at the AGM, the shareholders can vote and appoint directors to run the company on their behalf. In this case, there is a clear division between the owners and directors/stewards of the company. At each AGM, the directors report back to the shareholders on their stewardship of the company. * All companies (except those under a certain size) are legally required to have their accounts audited. * The main advantage of limited liability company status is actual limited liability, greater access to capital, perpetual life and profits taxed at corporation tax rates. Its main disadvantage include high level of regulation and lack of privacy as the accounts of all companies are available for public inspection.