If you’re looking to start a new business, a key consideration is the form of legal entity you will choose. This might be decided by how your operations are organised, or whether you work on your own or with others. However, if a number of options are available to you, it’s important you understand the financial and legal advantages and disadvantages the different structures offer.
Do your market research. Create a thorough business plan. Forecast potential cashflow. These actions will allow you to determine what legal entity will work best for you.
In this article, we cover the four basic forms of business organisation and what makes them unique. Additionally, you might consider other legal structures, including community interest companies, cooperatives, or franchises, dependent on what you want to achieve.
We aim to provide an overview of the regulations in force at the date of publication. Consequently, we would urge you to check the government website for the most up-to-date and detailed legal and financial information, as this may evolve over time.
Sole proprietorship
A sole proprietorship is typically a business owned and operated by one individual. It’s not a separate legal entity, but an extension of the individual who owns it.
The owner has possession of the business assets and is directly responsible for the debts and other liabilities incurred by the business. The profit or loss of a sole trader is combined with an individual’s other income for Income Tax purposes.
A sole proprietorship is perhaps the easiest form of business to own and operate, because it does not require any specific legal organisation, besides requirements such as licenses or permits. Business decisions are solely the result of the owner’s abilities.
Also, there is no formation cost.
Sole traders are not required to file annual accounts, but annual accounts information must be submitted to HMRC in their Self-Assessment Tax return. They are taxed on their business profits irrespective of the amount they draw out of their business, and are therefore less able to control the level of taxable income in comparison to directors/shareholders of other businesses.
Partnership
Partnerships are where two or more individuals run a business enterprise together.
Each individual partner has authority in running the business, as well as ownership of the organisation’s assets and responsibility for liabilities. The rights, accountabilities and obligations of partners should be outlined in a partnership agreement. There are no formation costs.
The authority of the partners, and the way in which profits or losses are shared, can be modified by the partnership agreement. The responsibility for liabilities can also be modified by agreement among the partners. Partnership creditors will generally ask the organisation to pay its own debts, but when the organisation cannot pay, they may ask the individual partners to pay.
A partnership is a legal entity with its own rights and responsibilities, so it can sign contracts, obtain trade credit, and borrow money. However, when a partnership is small, most creditors require a personal guarantee of the general partners.
Partnerships must file an Income Tax return, but these organisations don’t typically pay Income Tax. The information from the partnership tax return is combined with the personal income of the partners to determine their overall tax liability. Like sole traders, partnerships don’t have to file annual accounts, but annual accounts information must be submitted to HMRC in the partnership tax return.
Partners are taxed on their share of business profits regardless of the amount that they withdraw from the organisation and have less control over income related tax liabilities, unlike directors/shareholders of companies.
Limited Liability Partnership
A Limited Liability Partnership (LLP) offers limited liability to its members but, like a traditional partnership, is tax transparent and allows flexibility of organisational structure.
An LLP is a separate legal entity from its members. Therefore, it may enter into contracts and deeds, sue and be sued and grant floating charges over its assets in its own name. This is unlike partnerships, where it’s often necessary for every partner to be party to certain documents or litigation, and the creation of floating charges is not possible.
The members of the LLP are those persons registered (including names and addresses) at Companies House; they can be individuals, limited companies or even another LLP. At least two members must be ‘designated members’ responsible for making filings at Companies House, who are subject to penalties in the event of default. An LLP must file publicly available annual accounts at Companies House, the same as a limited company.
If an LLP is involved with a trade or profession (as opposed to being an investment vehicle), the organisation itself is not taxed on income or capital gains. Instead, the members are individually taxed on their shares of the LLPs’ profits and gains, as with partnerships. Since 6 April 2014, certain members (mainly those deemed to be receiving a salary) are now required to be taxed as employees with PAYE and Class 1 National Insurance Contributions being payable on their remuneration from the LLP.
Any type of business operating for profit can be an LLP. This structure can be suitable for use as a joint venture vehicle, or as an alternative to a limited company, particularly for small businesses.
Limited Company
A company is legally separate from its owner (or owners), meaning it’s responsible for its own debts.
Companies are incorporated and limited by shares. This means that the organisation has shareholders, whose liability to creditors of the company is limited to the money they originally invested. A shareholder’s personal assets are protected in the event of company insolvency, but money invested in the company may be lost. However, when a limited company is small, creditors often require personal guarantees of the principal owners before extending credit.
A company limited by guarantee must have at least one director and one guarantor. An individual may assume both positions, or there can be multiple directors and guarantors. Company directors run the company on behalf of the shareholders; it’s possible to be both a director and shareholder.
Limited companies must file tax returns and pay taxes on income from their operations.
Approval from Companies House is required for a company to use its proposed name and there is an initial set up cost (currently £50). These organisations must adopt and file a Memorandum and Articles of Association, which govern their rights and obligations to shareholders, directors and officers.
Companies must:
- Keep accounting records
- Have the accounts audited (unless exempt)
- File accounts and an Annual Return with the Registrar of Companies
- Maintain Statutory Books showing details of shareholders and directors
Advantages or incorporating include greater ease in raising additional capital (through share capital or borrowing), using current assets as security by creating a floating charge, and the ability for an individual to sell or transfer their part of the organisation, with greater continuity if an owner retires.
Read our article on the pros and cons of incorporating your business…
In terms of tax, you can read about the reliefs and allowances to limited companies here.
Business owners who are both a shareholder and director can control their personal tax liability, as they only pay tax personally on what they draw out of the company. Many director shareholders pay themselves a low salary to minimise National Insurance and receive most of their income by paying themselves dividends. Read our article on balancing salary and dividends…
Beyond the legal and financial intricacies, incorporation can make a business seem more professional and trustworthy, although this is not always the case.
Need some guidance
Picking the correct structure for your business will entirely depend on how you want to function and what you aim to achieve. However, it’s worth seeking some professional guidance on what the different entities could offer you, as it’s not necessarily a straightforward decision.
Contact us if you are considering your options and a member of the Burton Sweet team will be happy to guide you where possible and assist in setting up this organisation, should you choose.
