The best legal structure for your business depends on your circumstances and what you propose to achieve. One size does not fit all and there are several options, each with it’s own advantages and disadvantages. Make sure that you have weighed up the pros and cons of all legal structures to see which is the most suitable for you and your business. Simple mistakes at this stage can prove very costly when setting up a business, so seek the advice of a qualified professional accountant to help you make the right decision.
The following is a guide to what you need to know.
A sole trader is the most popular legal structure in the UK and is the easiest to set up, with approximately 3.4 million sole proprietorships created in 2017, that account for 60% of small businesses within the UK.
A sole trader is a self-employed person who owns all of the business. This means that from a legal perspective, you and the business are considered to be one entity. You run the business as an individual, but you are also responsible for all the liabilities of the business including finances. If you accumulate business debts or your business goes bust, your personal finances and assets are in danger. Consequently, you need to ensure that you have small business insurance policies in place to protect yourself from being sued personally.
As a sole trader, you must keep accurate records of all your business transactions, including all sales and expenses, and bank records, to be kept safe for a minimum of six years. Although you do not need to have a separate business bank account, there are clear advantages in doing so, such as keeping your personal and business expenditure separate.
There is no need to incorporate at Companies House, but you do need to register for self-assessment with the HM Revenue and Customs (HMRC) for tax purposes. This can be completed online in just a few minutes, and there is no registration fee. If you employ other people, you will also need to operate a Pay As You Earn (PAYE) payroll scheme and collect taxes from your employees on behalf of the HMRC.
As a sole trader, accounting costs are usually lower, and you may even be able to do your own accounts and tax returns. Your personal or business details are not disclosed on public record, and you can take all your business profits once you have paid the taxes that you owe.
Subject to certain rules, you can choose a name for your business, or use your own name.
If you go into business with one or more people, you may consider setting up a business partnership. A partnership arises whenever two or more people co-own a business and share in the profits and losses of that business.
A partner does not have to be an actual person. A limited company (see below), for example, is regarded as a ‘legal person’ and can also be a partner. When a company is a partner in a partnership it is taxed on it’s profits according to corporation tax rules.
Charities and not-for-profit organisations cannot form partnerships.
In the UK, partnerships are divided into three types.
- General Partnership
- Limited Partnership
- Limited Liability Partnership
General Partnership: A general partnership exists when two or more co-owners share in the profits and losses of their business. Consequently, each individual partner assumes full responsibility for all of the business’s debts and obligations. This includes liabilities incurred by partners who subsequently leave the business. It is important therefore, for each partner to be adequately covered by small business insurance policies to protect their personal finances and other assets. Although such personal liability can be daunting, it comes with a tax advantage. Partnership profits are not taxed to the business, but pass through to the partners, who include the gains on their individual tax returns at a lower rate.
Limited Partnership: A limited partnership (LP) restricts the personal liability of each partner to the amount of their investment. At least one participant must accept general partnership status, exposing himself or herself to full personal liability for the business’s debts and obligations. The general partner retains the right to control the business, whilst the limited partners cannot participate in management decisions. Limited partners may not draw out nor receive back any part of their contributions to the partnership during it’s lifetime. The business profits are passed through to both general and limited partners.
Limited Liability Partnership: Limited liability partnerships (LLP) offer some personal liability protection to their participants, whilst retaining the tax advantages of a general partnership. Individuals in an LLP are not personally liable for the misconduct of other partners, nor for the debts nor obligations of the business. As a result, the LLP is more suitable where all investors intend to take active roles in management. The Internal Revenue Service (IRS) views these businesses as partnerships, however, and allows partners to use the pass-through technique.
A joint venture is a general partnership that remains valid until the completion of a project or a certain period has elapsed. All partners have an equal right to control the business and share in any profits or losses. They also have a fiduciary responsibility to act in the best interests of other members as well as the venture.
A limited liability company (Ltd) is a completely separate entity from it’s owners. It has it’s own legal identity – a ‘legal person’ in effect, and its finances will be kept separate from your own personal finances. As a director, you will have limited liability on any losses or debts incurred by the business, giving you greater protection on your personal finances and other assets.
As a company owner with limited liability protection, it is imperative that you keep your personal financial activities distinctly separate from your company financial activities. Such oversights within the eyes of the law, could compromise your limited liability protection, leaving your personal finances and assets in danger.
Limited company owners fall into two types: ‘guarantors’ and ‘shareholders’. Guarantors of a limited company guarantee a sum of money to the company. Shareholders of a limited company each own at least one share in the company. Collectively, they are known as ‘members’, but the original members of a new limited company are also referred to as ‘subscribers’. These original members agree to form a company by subscribing (adding) their names to the memorandum of association.
There are many benefits to running a business as a limited company, but it won’t appeal to everyone. There may be more difficult and time-consuming administrative and tax requirements, but the tax advantages can often outweigh the disadvantages. Although you are under no legal obligation to do so, as a limited company owner, you are advised to seek the help of a limited company accountant to ensure that your accounts are thorough. Such professionals perform many important tasks in addition to preparing tax returns and the value they offer often justify their fees.
As with sole proprietorships and partnerships, limited liability companies are pass-through entities, whereby profits are not taxed to the business, but pass through to the owners.
The main advantage of a limited company is that you can legitimately pay less personal tax than a sole trader. As a limited company owner, you can be paid both a salary, as well as company dividends which are taxed at a lower rate. Also, the pension funds that you provide for your employees can be deducted before any tax is paid. This can offer another significant tax advantage over those who are running their business as self-employed.
Just like a sole trader, you register your limited company at Companies House. Once this is done, your company name is protected by law. No-one else can use the same name as you, nor anything deemed to be too similar. For example, if Ebonisa Smith sets up a company making potato chips or crisps, she cannot call her business “Smith’s Crisps”, since that name has already been registered by a similar company. She would have to call her business “Ebonisa Smith’s Crisps”, assuming that name was available.
Some larger companies prefer to only deal with limited companies rather than sole traders or partnerships. A limited company offers a more professional image, better credibility and an improved status. Larger organisations often view limited companies as larger and established corporations, even if they are owned and managed by just one person. A limited company can also sell shares in exchange for capital investment. So, the advantages of a limited company are important factors when raising capital investment.
Unlike a sole trader whose business is tied to the existence of the original owner, a limited company is a separate legal entity and enjoys perpetual existence. This means that the company can remain in existence beyond the involvement of the original owners. Consequently, the original owners have more opportunities to make a clean break from a limited company than other business structures.
Public Limited Company
As with limited companies, a public limited company (PLC) is a separate legal entity, which gives greater protection to the owner’s personal finances and assets.
Both limited companies and public limited companies can raise capital through shares, the major difference being that a public limited company can quote it’s shares in a stock exchange, but a limited liability company cannot. Consequently, public limited company shares can be bought and sold through the stock exchange without the need to consult the owners for selling and buying shares. Conversely, limited liability company shares are normally sold to close relatives and friends, but only with the agreement of all shareholders.
There are more stringent legal requirements for setting up a public limited company.
Public limited companies are less focused on making profits and focus more on providing goods and services to the public. Should anything adverse happen to a public limited company, the effect is often more detrimental to the public than if it were a limited liability company.
Limited Liability Corporation
A limited liability corporation is a separate, legal entity guided by a group of officers known as the board of directors. The main difference between a limited liability company and a limited liability corporation is the ownership of the business. A corporation is owned by individuals who purchase shares, whilst a limited company is owned by individuals and possibly shareholders.
Profits and losses of corporations are held by the corporation itself and are not passed directly through to the owners. Consequently, unlike limited companies, partnerships and sole proprietorships, which are pass-through entities, corporation profits are subject to corporation tax. Employees are paid salaries, and the owners profit from share dividends and asset appreciation.