The three main options for structuring your business are: -
- sole trader
- partnership or limited liability partnership (LLP)
- limited liability company
Choosing the right legal structure is important from both a tax and legal perspective. In particular, it can significantly affect: -
- the amount of tax you have to pay
- your personal liability for the debts of the business
- your ability to raise finance
Sole Trader
Legal formalities
A self-employed person can set themselves up as a sole trader without going through any formal legal process. They do, however, have to register as self-employed with HM Revenue and Customs.
There are no ongoing legal administrative requirements resulting specifically from being a sole trader although in the course of running their business sole traders may, like any other business, need to consider legal issues in a range of areas such as licences or approvals/certifications required by their industry, employees, property purchase/leasing, banking/financial matters and their terms and conditions of business.
Tax/accounting
Sole traders must register with HMRC, keep records of their income and expenditure and complete an annual self-assessment tax return. Profits made by sole traders are taxed as income and sole traders also require to pay class two and (above a certain level of profits) class four National Insurance contributions.
Advantages
Being a sole trader is relatively simple and cheap to set up and administer. As a sole trader you are entitled to receive all the profits from the business and do not have to involve any third parties in decision making.
Disadvantages
Sole traders have unlimited liability for the debts of their business. Sole traders have a limited range of options for raising external finance. The fact that all profits made by a sole trader are taxed as income will tend to make it less tax efficient than a company structure if the business makes large profits.
Partnership
Legal formalities
A partnership is formed by agreement between two or more people to carry on business together with a view to profit. It is not necessary to register a partnership with Companies House, nor to enter into a formal written partnership agreement. However, if there is no formal written partnership agreement, the law will apply default obligations to the partnership which may not reflect the intentions of the partners as to such important matters as the sharing of profits and the circumstances in which the partnership can be brought to an end.
For this reason, we would always strongly recommend entering into a formal written partnership agreement when starting out in partnership.
Tax/accounting
Each partner must register as self-employed. Income tax is payable on each individual partner’s share of the profits of the business. It is important to note that all the profits of the business are taxed as income of the partners, whether the partner is paid the profits, or they are retained within the business. In this respect, partnerships are not the best option for retaining profits. The self-assessment tax regime applies to both the partnership tax return and those of the individual partners.
Money may be withdrawn from the partnership by way of salary or drawings or both and such withdrawn money will be set off against final profit entitlements determined at the end of the partnership's financial year. Release of a Partner's capital from a partnership will always be subject to the agreement of the other partners.
Advantages
Partnership accounts do not have to be filed publicly, nor do partnerships have to file annual returns or other documents with Companies House. This therefore affords confidentiality for such matters which can be advantageous. A partnership structure can be tax efficient for certain specialised undertakings in particular, property investment. In some professions and industries where the ability to incorporate is restricted, a partnership, or possibly an LLP, may be the only options available for going into business with others.
Disadvantages
One of the biggest disadvantages is that Partners are exposed to unlimited personal liability for the debts of the partnership. A partnership also generally offers fewer options for raising finance than a limited company. In particular, it cannot issue shares or grant a lender a floating charge (a security over all its assets from time to time). Partnership profits are taxed as income and this will tend to be less efficient than paying corporation tax if the business makes significant levels of profits. Partnerships generally tend to scale less well to large scale enterprises than companies.
LLPs
LLPs are generally taxed in the same fashion as partnerships. As with the shareholders of a company, the members (as the partners of an LLP are technically known) are each only liable for the LLP’s debts to their pre-agreed individual limit. This is known as limited liability and is one of the major benefits offered by companies and LLPs in comparison with partnerships and carrying on business as a sole trader. LLPs are regulated by a modified form of company law rather than partnership law and are required to comply with similar requirements to those applying to companies as to the filing of accounts and other documents with Companies House. An LLP is established through registration at Companies House. As with a regular partnership, it is generally advisable to have a formal written LLP members agreement to regulate the affairs of an LLP and its members.
Company
Legal formalities
Formation of a company can be done by use of a ready-made “shelf” company available from company formation agents or by incorporation from scratch. In the former option the company can then be tailored to meet the client’s requirements, i.e. changing of directors/secretary, issuing or transferring of shares, changing of objects, name, etc.
Incorporating a company creates a separate legal person distinct from its members. The company structure separates the role of day-to-day management of the company (which is left in the hands of the directors) from that of ownership and ultimate control (which rests with the shareholders), although in practice, the directors and shareholders of many small companies may in-fact be the same people.
The shareholders of a company benefit from the concept of limited liability, their liability being limited to the amount which they have paid or agreed to pay for shares. Directors of a company generally have no personal liability for the debts of the company, except in cases where they breach duties under company or insolvency law.
Accounting/Tax Treatment
Annual accounts require to be in a certain prescribed format depending upon level of turnover and must be lodged annually at Companies House. The company is charged corporation tax on its profits. Compared with the higher rate personal (income), companies are far better business mediums than partnerships for retaining profits. Directors can be paid by way of salary or fees and will generally be subject to Schedule E income tax and national insurance contributions on any salary they receive. Most importantly, directors can be shareholders and receive dividends. No NIC is due on the latter and payment by way of dividends can potentially result in considerable tax savings.
Advantages/Disadvantages
As discussed, limited liability is an obvious large attraction of incorporation. However, it should be noted that banks dealing with a company may seek personal guarantees from Directors. Another attraction of incorporation is the ability of a company to raise debt finance by the grant of a floating charge over its assets and/or equity investment from business angels or venture capitalists.
The main disadvantages of incorporation are the administrative requirements imposed upon directors, given that all major decisions taken by directors on the day-to-day management of the company should be formally minuted in writing. There is also a high amount of regulation of the activities of a company, for example, publicity requirements and the lodging of accounts and annual returns at Companies House. The financial affairs of the company are to a large extent publicly accessible and therefore not entirely confidential.
