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Sole Trader Vs Limited Liability Company - Consideration Of Liability Issues

March 2020

When setting up and operating a business careful thought needs to be given to the ownership structure and potential liability. The two most common ownership structures are “sole traders” and “limited liability companies”.

Sole Trader

A sole trader is a common ownership structure that can be used to operate a small business. The main operator of the business may be one person, supported by a family member such as a spouse. A sole trader can hire staff to help run the business, however, the sole trader will need to register with Inland Revenue as an employer and meet a number of obligations.  

Operating a business may be risky if the right asset protection and insurance is not in place to support the sole trader. The extent of their liability is that they are personally liable for any business debt or loss, including taxes. For debt owing to a creditor, a claim can be made against the personal assets of the sole trader, including funds in bank accounts, and the personal family home. Liability on behalf of the sole trader will end when the sole trader has passed away (and all debt is repaid) unless a Will provides for the business to carry on. 

Should the sole trader cease to operate their business, then there is a statute of limitation of between 6 to 15 years for creditors to make a personal claim, and therefore liability after this time may not apply.

When borrowing funds there may be a linked personal guarantee from the sole trader. When the debt is repaid to the bank, it will remain in place unless the lending organisation agrees in writing for its release. Liability can continue onto the sole trader’s executors and assignors under their Will. 

A sole trader business model can also be harder to sell as a working business compared to a limited liability company asbusinesses, contractors, clients etc. are more likely to work with a limited liability company as their perception is that a company is more professional. A limited liability company can build a good reputation, which makes it more credible to any parties which want to work with your business.

 

Limited Liability Company

The difference between a sole trader and the structure of a limited liability company, is the latter is seen to be a separate legal entity from the shareholders of the company, who are its owners. Liability on behalf of the shareholders of the company is limited to the amount of the debt belonging to it in ratio to the shares held. If the shares haven’t yet been paid for in full there is an element of exposure of liability on the unpaid amount. If the company goes into liquidation, assets sold, creditors paid back first, then shareholders have a right to a share in the funds raised.

As liability can be dependent upon many things, directors can still be held personally liable for the company debt if trading while it is insolvent and if they have given personal guarantees.  

It is important for directors and shareholders to remember to have personal guarantees released in writing when changing lending institutions or retiring from the company. Personal liability on behalf of directors may also apply where the director(s) have not acted in the best interest of the company and/or may have failed to act in accordance with the provisions of the Companies Act.

If the company is acting in the capacity as an independent trustee of a family trust, liability can be disclosed not to be personal and unlimited. It can be limited to an amount equal to the value of the assets of the trust, that are in the hands of that trustee company available to meet the trustee company’s liability from time to time. The relevant time for the purposes of assessing the value of the assets of the trust will be the time of enforcement of any judgment or order against the trust. 

Summary

It is important when entering into business to receive proper legal and accounting advice regarding the ownership structure and consider how much risk and liability you are willing to accept if deciding to become a sole trader, or a director and shareholder of a limited liability company.