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 business 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) and the Limited Partnerships Ordinance (Cap. 37) which stipulate that the rules of equity and common law applicable to partnerships shall continue in force except so far as they are inconsistent with the express provisions of such Ordinance.
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.
In broad terms, there are two types of partnership: general partnership and limited partnership. There is however a third type of partnership called limited liability partnership under the Legal Practitioners Ordinance (Cap.159), which is available only to law firms in Hong Kong.
Each partner in a general partnership is personally liable for all the debts and obligations of the partnership.
Each partner can bind the partnership and is responsible for the acts of other partners taken in the ordinary course of business.
All partners are entitled to share in the profits of the partnership equally unless they agree otherwise.
A general partnership is not a separate legal entity from its partners and cannot acquire rights, incur obligations or hold properties in its own right.
A limited partnership must consist of at least one general partner and one limited partner.
A general partner is a partner who is personally liable for all the debts and obligations of the limited partnership.
A limited partner is a partner who at the time of entering into the limited partnership contributes a sum or sums as capital or property valued at a stated amount and is not liable for the debts and obligations of the limited partnership beyond the amount so contributed. Limited partners shall not, during the life of the partnership, draw out or receive back any part of their contribution and if they do, they become liable for the debts and obligations of the partnership up to the amount so drawn or received back.
A limited partner has no power to bind the partnership and must not take part in the management of the partnership business. If a limited partner takes part in managing the partnership business, he or she shall be liable for all the debts and obligations of the partnership incurred while taking part in the management.
A limited partnership must be registered as such with the Registrar of Companies in accordance with the Limited Partnerships Ordinance (Cap. 37). Until it has been so registered, the partnership will be deemed as a general partnership and every limited partner shall be deemed as a general partner.
A limited partnership is required to notify the Registrar of Companies and where applicable to advertise in the Gazette if there are certain changes during the life of the partnership such as change of partnership name, principal place of address or the nature of the business or the partners (sections 8 and 9 of the Limited Partnerships Ordinance).
Like a general partnership, a limited partnership is not a legal entity.
Limited liability partnership
Only law firms in Hong Kong may choose to operate in the form of a limited liability partnership (“LLP”).
According to the Legal Practitioners Ordinance (Cap. 159), an innocent partner of an LLP will not be personally liable for the debts, obligations and liabilities of the LLP that arise from the provision of professional services by the LLP and as a result of the default of another partner, an employee, agent or representative of the LLP.
This protection for LLP partners is however limited as follows:
- it does not protect a partner for his or her own default and/or the default of those employees, agents or representatives that he or she directly supervised at the time of default;
- it does not protect a partner who knew the default at the time of its occurrence and failed to exercise reasonable care to prevent its occurrence; and
- it does not protect a partner’s interest in the partnership property from claims against the LLP.
The protection for LLP partners applies only if the law firm had complied with the following conditions at the time of the default:
- the law firm was an LLP;
- the law firm had maintained a top-up insurance policy as required under the Legal Practitioners Ordinance (Cap. 159);
- the client, at the time of the default, knew or ought reasonably to have known that the law firm was an LLP; and
- the law firm had informed the client of the identity of at least one partner who was responsible for the overall supervision for the relevant matter within 21 days the firm accepted instructions on the matter and had, throughout the time that the matter was handled by the firm, kept the client informed of the identity of at least one overall supervising partner for the matter.
Subject to certain exceptions and conditions in the Legal Practitioners Ordinance (Cap. 159), if an LLP is unable to meet its debts, obligations and liabilities or the value of the remaining partnership property is less than the LLP’s debts, obligations and liabilities immediately after the LLP has made a distribution of its partnership property, the recipient(s) of that distribution may be liable to pay some or all (as the case may be) of the distribution back to the LLP.
Every partner remains liable for the LLP‘s ordinary business obligations such as office rent and staff salaries.
LLPs are not governed by the Limited Partnerships Ordinance but are subject to the Legal Practitioners Ordinance (Cap. 159) and its subsidiary legislation. Being a form of partnership, LLPs are also subject to the Partnership Ordinance and any other law that applies in relation to a general partnership, unless they are inconsistent with the Legal Practitioners Ordinance (Cap. 159).
Transfer of interests
The transfer of interests in a partnership to existing or new partners may be carried out in accordance with any 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.
Name of partnership
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 partnership "XX Company" or "XX & Co". An LLP must include the words “Limited Liability Partnership” or the abbreviation “LLP” or “L.L.P.” as part of its English name and the words “有限法律責任合夥” as part of its Chinese name. Subject to aforesaid, the English name of a partnership must not include the words "Limited" or "Company Limited" and the Chinese name of a partnership must not include the words “有限” or “有限公司”, 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.
The Partnership Ordinance and the Limited Partnerships Ordinance contain default provisions on matters relating to profit and loss sharing, management of partnership business, changes to the composition of partners and duration and termination of partnership which shall apply to a partnership that does not have an agreement to the contrary. Such default provisions may not suit the manner in which partners would like to run the business and it is therefore important for the partners to enter into a Partnership Agreement to modify these provisions and agree on other relevant matters e.g. settlement of 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 (other than the limited partners and partners of an LLP) do not have the benefit of limited liability.
- Generally speaking, 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 (except a limited partner) dies or becomes bankrupt, unless the Partnership Agreement states otherwise (section 35 of the Partnership Ordinance and section 5(3) of the Limited Partnerships Ordinance).
The most common types of limited company used to run a business is the company limited by shares.
Companies limited by shares
A company is a company limited by shares if the liability of its members is limited by the company’s articles to any amount unpaid on the shares held by the members. The key characteristics of a company limited by shares can be described as follows:
- A company limited by shares 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.
- A company limited by shares is responsible for its own debts and obligations and the liability of each shareholder is generally limited to the amount which remains unpaid on that shareholder’s shares.
- Small and medium-sized businesses are usually run as private companies limited by shares, rather than public companies limited by shares. A private company limited by shares 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 the CO).
- A private company limited by shares (“private company”) must have at least one director (section 454 of the CO). 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.
- It used to be the law that a company must have a memorandum of association which sets out what it can do as a legal entity. However, the CO, which follows the modern trend of law of most jurisdictions, have abolished the memorandum of association. For older companies (i.e. companies formed under a former Companies Ordinance), 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 CO).
- Limited companies incorporated under the CO are required to have certain mandatory articles of association, e.g. the company name (section 81 of the CO), details of the liabilities or contributions of the members(sections 83 and 84 of the CO), etc.
- Company directors must declare any actual or potential conflicts of interest in relation to the company to the board of directors. In any event, company directors should try to avoid dealings which might have conflicts of interest in relation to their company.
- A limited company must keep specified record such as minutes of the proceedings of general meetings and meetings of directors, resolutions of members passed otherwise than at general meetings and resolutions passed by directors without a meeting, at its registered office or a prescribed place in accordance with the CO.
- Certain companies are allowed to prepare simplified financial and directors’ reports. Companies which are qualified for simplified reporting are referred to in the CO as companies “falling within the reporting exemption”. Sections 359 to 366A and Schedule 3 of the CO 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 its English name or “有限公司” as the last words of its Chinese name (section 102 of the CO). However, the Registrar of Companies, may, by licence, exercise power to dispense with the use of the word “Limited” or the words “有限公司” (section 103 of the CO) for non-profit making companies .
- 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.
Companies limited by guarantee
A company limited by guarantee is a rather peculiar kind of company. It has many of the same characteristics as a private company limited by shares subject to the following key differences:
- A company formed under the CO as a company limited by guarantee does not have any share capital.
- A member of a company limited by guarantee is not liable to contribute to the company’s capital while the company is a going concern. Instead, the member undertakes that if the company is wound up while he/she is a member of the company or within one year after he/she ceases to be such a member, he/she shall contribute an amount not exceeding a predetermined amount to the company’s assets (i) for the payment of the company’s debts and liabilities contracted before he/she ceases to be such a member, (ii) for the payment of the costs, charges and expenses of winding up the company, and (iii) for the adjustment, among the contributories, of their rights (section 810 of the CO).
- Due to its intrinsic nature, companies limited by guarantee are usually set up for charitable or non-profit making functions, rather than for carrying on normal business activities where the primary object is to make profits and distribute those profits to the members. Generally speaking, profits or other income generated by a company limited by guarantee will not be shared among its members but will instead be used to promote the objects of the company.
- A limited company may be permitted by licence to delete the word “Limited” or the words“有限公司”in its company name if it is proved to the satisfaction of the Registrar of Companies that (i) the objects of the company are restricted to promoting commerce, art, science, religion or charity or any other useful objects and to objects incidental or conducive to those objects, (ii) the company is required by its articles to apply profits or other income in promoting its objects and (iii) the company is prohibited by its articles from paying dividends to its members (sections 103(3) and 103(4) of the CO). It is not unusual that a company limited by guarantee may be granted such licence.
- A company limited by guarantee must have at least two directors (section 453 of the CO) and a body corporate must not be appointed a director of the company (section 456 of the CO).
Advantages of forming a company limited by shares
- 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 has 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 company limited by shares
- A company limited by shares 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 company limited by shares 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 CO 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 companies limited by shares 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 a company’s certain information like its Articles of Association, registered office address, details of shareholders and directors at the Companies Registry.
- There are prolonged and costly procedures for dissolving the company after the business has ceased or if it fails (further details can be found in the Bankruptcy, Individual Voluntary Arrangement and Winding-up of Companies 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.