For many entrepreneurs starting a business, here’s your best legal move. You’re debating the pros and cons of having the business established as a sole proprietorship (in Hebrew – esek moorshah) or a registered company (in Hebrew – chevrat ba’am). You may be are aware of the accounting differences between the two. However, few appreciate the significant legal advantages derived from a company being a separate legal entity from its owners.
When the owner (or shareholder) is a separate, independent legal entity from the business, he or she is protected against claims against the business. This would be in situations where finances get complicated, and even in cases where the business collapses.
As soon as the company is registered it receives an identity number (called CO – the abbreviation symbolizes a “private company”). Once the company opens its own bank account, it may enter into any agreement or legal obligation. Since the company is a body without “arms and legs” all its actions are performed by someone who is authorized to do them on behalf of the company. And it’s as if the actions were taken by the company itself.
The following extreme (and exaggerated) short theoretical story is about Motti, an ordinary man who wanted to build modern kitchens.
Motti decided to open a carpentry shop to produce those kitchens. The first thing Motti did was consult with an accountant, who suggested that he open a sole proprietorship. The accountant suggested he rethink this step after a year if the tax burden justified it.
Soon after, Motti turned to a lawyer and that very next day, he registered his company as “Motti Modern Kitchens Ltd” – a registered company.
At the beginning of the company’s business operations, it took out loans to finance the start of operations. Motti, by virtue of being the CEO, signed the loan agreement, on behalf of the company.
Motti liked to do everything in a big way, so he (the company) rented a building on a half-acre with hopes that it would serve as a modern carpentry shop. Motti also purchased expensive, modern and sophisticated production equipment. Since he wanted to create a high-tech atmosphere, he recruited 12 employees, committing to high salaries and a leased car for each one. He made sure that the company paid him a respectable salary as well. After all, he was the CEO.
Unfortunately, the company’s coffers emptied pretty quickly. That, however, did not stop Motti from ordering huge quantities of goods. The payment terms in the industry were “current +90” meaning, Motti would have to pay for the goods he now received in three months. Motti hoped that in the meantime, the company would have enough goods to produce modern kitchens and they would sell quickly.
Ultimately, things did not work out as Motti had planned. The company was required to pay the current expenses such as rent, property taxes, salaries to employees, etc. and it had no funds with which to lay these expenses. Since Motti’s personal accounts (as opposed to the company’s account) had quite a bit of money accumulated over the years, Motti decided to lend money to the company, himself. This is called an “owner loan”).
Motti contacted his lawyer again and entered into a loan agreement between himself and the company. On the one hand, Motti signed as a lender, and on the other hand, he signed on behalf of the borrower – the company of which he is the CEO.
Shortly afterwards, the company simply collapsed. Lawsuits began to arrive from every direction. The workers had not received their wages. The car leasing companies did not receive their money. Customers for whom the goods were not supplied and suppliers who did not receive payment for the goods also tried to sue. In a short time, liens were taken on the bank accounts of the company (in which there was no money to seize) and against the company’s property. (In fact the company had no property).
The employees filed a liquidation claim against the company (what was formerly popularly called “bankruptcy), and a receiver was appointed to liquidate the company’s assets. All of the company’s debtors had to file a debt claim, with the goal being that the receiver would sell the company’s assets, and would pay each debtor the proportionate share from any remaining funds (a complex and cumbersome procedure).
Surprisingly, among the creditors was also Motti!
Motti demanded from “Motti Modern Kitchens Ltd” the full amount of the loan he gave to the company because it was made as a secured loan and had priority against the assets it was secured against. The rest of the debt holders got a relative share of what remained from the liquidation of the assets of the company (i.e. from nothing).
A really outrageous situation was created. Motti Kitchens Ltd. was disbanded, the suppliers did not receive the value for their money, the workers did not get their full rights, and Motti? Well, Motti bought a Mercedes.
This story is meant to illustrate the point!
Starting a business in Israel involves considerable risks. In practice even the owners of a company have risks – as when a personal guarantee is required to be signed or in cases where a screen can be raised. But as the story illustrates, in the end, a company is a separate legal entity from its owner.
If Motti had set up the carpentry shop as a Sole Proprietorship, the business number would have been his ID number. The agreements he signed with the suppliers and with the employees would have been with Motti personally and directly. The lawsuits would have been filed against Motti. The liens would have been made on his savings, on his vehicles, on his private home. All his property would have been taken from him.
From an accounting point of view, there are differences in the manner of taxation in which a limited company is taxed compared to the way in which a Sole Proprietorship is taxed. Therefore, from an accounting point of view, it will usually be worthwhile to run the business as a registered company only after it has achieved a certain amount of revenues and profits.
But legally? Of course, each case should be determined independently. But risk-takers, will usually prefer to start a business as a limited company.