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
A self-employed person can set themselves up as a sole trader without going through a formal legal process. They do, however, have to register as self-employed with HM Revenue and Customs.
There are no on-going 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 required by their industry; employees; property purchase/leasing and your terms and conditions of business.
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.
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.
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.
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 partnership agreement. However, if there is no 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 strongly recommend entering into a written partnership agreement when starting out in partnership.
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 this money will be set off against profits at the end of the year. It is easier for partners to release their capital from the firm than with limited companies although this will be subject to the agreement of the other partners.
Partnership accounts do not have to be filed publicly, nor do partnerships have to file annual returns or other documents with Companies House. 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.
A partnership generally offers fewer options for raising finance than a 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. Partners are exposed to unlimited personal liability for the debts of the partnership.
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 require 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 partnership agreement to regulate the affairs of an LLP and its members.
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, 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.
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, the highest rate of tax of 28% being applied to profits of £1,500,001 and above. Compared with the higher rate personal (income) tax of 40%, companies are far better business mediums than partnerships for retaining profits. Directors can be paid by way of salary or fees and will be subject to Schedule E income tax and national insurance contributions on any salary he receives. 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.
As discussed above, limited liability is an obvious attraction of incorporation. However, it should be noted that banks dealing with a company may seek personal guarantees from shareholders/members. Another attraction is the ability of a company to raise finance by the grant of a floating charge over its assets and also the increased willingness of venture capitalists to provide investment in the company.
The main disadvantage of incorporation is the cumbersome administrative requirements imposed upon directors, given that all major decisions taken by directors on the day-to-day management of the company should be minuted. There is also a high amount of regulation of the activities of a company, for example, publicity requirements, the lodging of accounts and annual returns.