Choosing the right legal structure for your business

Choosing a suitable legal structure for setting up your new business is a very important part of the process and a key decision to be made when you decide to start your business. In most cases you will want to choose between sole trader, partnership, limited company or limited liability partnership. There are other structures that can be used for social enterprises or not for profit businesses, but in this article we will focus on the four most common business structures.

Sole Trader

Setting up as a sole trader is possibly the easiest way to start a business. There is less administration as you are required to only maintain simple, unaudited accounts. A sole trader can have employees. A sole trader must register with HM Revenue & Customs within three months of starting up. You will be taxed as a self-employed sole trader and all profits after tax would be yours. It is important to note that, as a sole trader, you are personally liable for any debts and liabilities incurred by the business. Your possessions – including your home – can be at risk if you fail to pay any business debts.

However, at a later stage, if you decide that your business has expanded and would be better constituted as a limited company, you have the option to form a limited company and transfer the business to it, though there may be stamp duty implications.

Partnership

A partnership is a business set up by two or more people. This allows for the sharing of profits, management responsibilities and risks, but also requires the sharing of liability. As with a sole trader, each partner has to register with HMRC as self-employed and file separate tax returns. All partners in a partnership will be liable for debts incurred by not just themselves, but of all partners. Essentially, if one of the partners is unable to pay, the other partner will become liable for the defaulting partners share of the business debt also. Similarly, business contracts entered into by one partner can be binding on the other partners, even if they themselves have not consented. It is important to understand that, as a partner, your possessions – including your home – can be at risk if you fail to pay business debts.

A common mistake which is made when getting into partnership is to carry on without a formal partnership agreement. While there is no legal requirement to enter into a formal agreement, it would be highly advisable to get a solicitor to draw up a formal agreement clearly setting out the rights and responsibilities of each partner and the manner in which business should be carried on by the partnership.

Limited Company

A limited company is formed by registering with Companies House. Once formed, a limited company has a separate legal existence and is responsible for its own bank accounts, debts and loan applications. Any loss is generally limited to how much you personally invest in the business and any personal guarantees given to obtain finance (such as bank loans). There are more administration requirements with a limited company as a trading or dormant company will be required to prepare and submit statutory accounts and annual returns with Companies House. You will also have to submit annual accounts and tax returns to HMRC. Depending on the turnover of the company, you may also have auditing requirements. Payroll and PAYE systems are required to be in place to pay employees, including directors.

One advantage of a limited company is that the company will be eligible to pay corporation tax which is generally more favourable than income tax. However, the directors will have to pay income tax on the salary they receive from the company.

Setting up a limited company involves some expenses and although you can complete the process yourself to save money on professional fees, registering a company can be complex. A solicitor, accountant or company formation agent could help you ensure you get it right first time. You can also speed up the process by buying a ready-made company from a solicitor or formation agent. If you decide to cease trading, it can be more difficult and expensive to wind up a limited company.

Limited Liability Partnership

A limited liability partnership (LLP) is a unique way of forming a partnership. Members of an LLP are not responsible for another partner’s debts and are not personally liable for the negligence of another partner. Each member’s liability is limited to any personal guarantees they have made to secure finance and any money they have personally invested.

However, forming an LLP is more expensive and complicated than setting up a partnership and there are administrative requirements and costs associated with it. As with a limited company, an LLP is also required to prepare and file annual accounts with Companies House. It also has to file an annual return giving details of the LLP and its members. As regards taxation, members of the LLP are generally taxed as self-employed and will pay income tax on their share of profits.

Influencing factors

The most common considerations that people have when deciding on which structure to adopt is:

1. Tax considerations – depending on the structure you choose, there will be varying tax implications and this can affect your choice. While sole traders and partnerships will have to pay income tax, some may wish to adopt the limited company structure and pay the lower corporation tax by retaining profits in the company.

2. The level of personal liability you are willing to take for business debts – in a limited company or LLP your personal exposure is in most cases limited to your investment in the business and to the extent of any personal guarantees that you may give. In other structures, you will have personal liability and your possessions – including your home – can be at risk if you fail to pay any business debts.

3. Regulatory and compliance requirements – in sole proprietorship and partnership structures, the regulatory and compliance requirements are minimal, while these requirements can be more cumbersome in the case of limited companies and Limited Liability Partnerships.

4. Industry perception – your choice can be affected by the kind of structure that customers or the public associates with a particular type of business or industry.

Conclusion

As mentioned at the beginning of this article, there are other options that may be available for social enterprises or not for profit businesses. The right choice of business structure will vary depending on your circumstances. It may be prudent not just to consider your present needs, but also to consider the future plans for your business.

If you would like any more information in relation to this post then please feel free to contact me via email: krishen.patel@bowlinglaw.co.uk.

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