If you have a brilliant business idea and are busy planning how to turn your dream into a reality, one of the many things you need to consider is the legal structure of your business.
As a start-up business in the UK you have four choices of legal structure, all with different advantages and disadvantages. So how do you decide which legal structure will work best for you?
Lawyers and accountants will usually talk about complex issues of legal status, statutory reporting requirements and limitations of liability – but in my experience for most entrepreneurs starting small businesses it comes down to an assessment of three basic questions.
Looking at the four options – operating as a Sole Trader, Partnership, Limited Company or Limited Liability Partnership – through the lens of these questions will hopefully help you in your structural deliberations.
As a start-up business in the UK you have four choices of legal structure, all with different advantages and disadvantages. So how do you decide which legal structure will work best for you?
Lawyers and accountants will usually talk about complex issues of legal status, statutory reporting requirements and limitations of liability – but in my experience for most entrepreneurs starting small businesses it comes down to an assessment of three basic questions.
- If the business falls into debt, is my house at risk?
- How much paperwork is involved?
- Which structure will minimise my tax bill?
Looking at the four options – operating as a Sole Trader, Partnership, Limited Company or Limited Liability Partnership – through the lens of these questions will hopefully help you in your structural deliberations.
Is my house at risk?
As a Sole Trader there is no legal distinction between you as an individual and the business. This means that the risks and rewards of the business are borne by you personally. If your business owes money and cannot afford to pay, your creditors are able to claim against your personal assets. In other words, your house is at risk if you chose this structure.
A Partnership is essentially the same as a Sole Trader in this respect, the only difference being you are only responsible for your share of any debts, along with your Business Partner.
By incorporating your business as either a Limited Company (Ltd), or Limited Liability Partnership (LLP), your business takes on a separate legal entity of its own. This means that even if you are a Director or sole (100%) shareholder in the company you are not personally liable for the company’s debts unless you have offered personal guarantees. This limitation of liability is the biggest benefit of incorporation and the main reason why the majority of businesses in the UK take the Ltd form.
If limiting your liability is the main priority for you consider Ltd or LLP structures over becoming a Sole Trader or Partnership.
How much paperwork is involved?
Sole Traders have to file a Self-Assessment tax return every year. But they don’t have to file their accounts publicly - so, because your tax return is not on the public record, your business’s figures are kept private.
A Partnership must not only file a partnership tax return, but also each partner must file an individual one - so there will be at least three tax returns to file each year. Like a Sole Trader, Partnerships are not required to publicly file their accounts.
An LLP must file accounts every year with Companies House, and a document called an annual return which lists the partners (or “members” for an LLP). This means your accounts will be available on the public record, so anyone can buy a copy of them for a couple of pounds. In addition an LLP must complete the same tax returns as a Partnership, meaning it must be registered with HMRC and each partner must register and file individual returns, as well as a partnership return each year.
An Ltd structure has similar disclosure and reporting requirements to an LLP, with each Director completing a self-assessment return and being named on the public record at Companies House. In addition Directors have legal obligations, for example they must not let the company keep trading if it can’t pay its debts.
The level of administrative burden for Ltd or LLP businesses will normally require professional support, so be sure to factor fees for an accountant into your business plan if you structure your business in this way.
If limiting the amount of paperwork you will need to complete and the minimising the amount of disclosure you will have to provide is the main priority for you consider Sole Trader or Partnership structures over incorporation as Ltd or LLP.
Which structure will minimise my tax bill?
This question is the least straightforward of the three since tax implications always depend on individual circumstances. But to generalise the situation you need to consider two different scenarios – where the business is generating profit, and where the business is generating a loss.
If the business is generating a profit, a Ltd structure gives the most flexibility for tax planning as you have three options for your business profits: pay them to yourself as wages, pay them to yourself as dividends, or leave them in the business to extract at a later date that may be more advantageous for tax purposes.
You need to carefully consider the impact that the differing rates and bandings of income tax will have on the tax payable on any wages and dividends, and be sure not to forget the impact of national insurance in your calculations.
Setting up as a Sole Trader, Partnership or LLP provide far less flexibility as all profit from the business is taxed as if self-employed. This does not always mean you will pay more tax under these structures, but do have less flexibility.
If the business is generating a loss, then the situation may be reversed. This is because losses incurred from a Sole Trader, Partnership or LLP can be offset against any other personal income straight away, carried over or carried back as loss relief.
In an Ltd on the other hand, losses must remain in the business until they can be offset against future business profits which may or may not come about.
As you can see, tax can get pretty complicated!
The best way of determining an accurate answer for your specific circumstances is to do some Tax Scenario Planning. The example below shows how this could work, by looking at Luke’s proposed business selling replica Lightsabers that is planning to make a profit of £50,000 in 2016. Luke is deliberating over whether to structure his business as a Sole Trader or Ltd. By optimising the balance between wages and dividends from an Ltd structure, Luke can end up taking home an additional £2,658 over what she could from a Sole Trader structure.
As a Sole Trader there is no legal distinction between you as an individual and the business. This means that the risks and rewards of the business are borne by you personally. If your business owes money and cannot afford to pay, your creditors are able to claim against your personal assets. In other words, your house is at risk if you chose this structure.
A Partnership is essentially the same as a Sole Trader in this respect, the only difference being you are only responsible for your share of any debts, along with your Business Partner.
By incorporating your business as either a Limited Company (Ltd), or Limited Liability Partnership (LLP), your business takes on a separate legal entity of its own. This means that even if you are a Director or sole (100%) shareholder in the company you are not personally liable for the company’s debts unless you have offered personal guarantees. This limitation of liability is the biggest benefit of incorporation and the main reason why the majority of businesses in the UK take the Ltd form.
If limiting your liability is the main priority for you consider Ltd or LLP structures over becoming a Sole Trader or Partnership.
How much paperwork is involved?
Sole Traders have to file a Self-Assessment tax return every year. But they don’t have to file their accounts publicly - so, because your tax return is not on the public record, your business’s figures are kept private.
A Partnership must not only file a partnership tax return, but also each partner must file an individual one - so there will be at least three tax returns to file each year. Like a Sole Trader, Partnerships are not required to publicly file their accounts.
An LLP must file accounts every year with Companies House, and a document called an annual return which lists the partners (or “members” for an LLP). This means your accounts will be available on the public record, so anyone can buy a copy of them for a couple of pounds. In addition an LLP must complete the same tax returns as a Partnership, meaning it must be registered with HMRC and each partner must register and file individual returns, as well as a partnership return each year.
An Ltd structure has similar disclosure and reporting requirements to an LLP, with each Director completing a self-assessment return and being named on the public record at Companies House. In addition Directors have legal obligations, for example they must not let the company keep trading if it can’t pay its debts.
The level of administrative burden for Ltd or LLP businesses will normally require professional support, so be sure to factor fees for an accountant into your business plan if you structure your business in this way.
If limiting the amount of paperwork you will need to complete and the minimising the amount of disclosure you will have to provide is the main priority for you consider Sole Trader or Partnership structures over incorporation as Ltd or LLP.
Which structure will minimise my tax bill?
This question is the least straightforward of the three since tax implications always depend on individual circumstances. But to generalise the situation you need to consider two different scenarios – where the business is generating profit, and where the business is generating a loss.
If the business is generating a profit, a Ltd structure gives the most flexibility for tax planning as you have three options for your business profits: pay them to yourself as wages, pay them to yourself as dividends, or leave them in the business to extract at a later date that may be more advantageous for tax purposes.
You need to carefully consider the impact that the differing rates and bandings of income tax will have on the tax payable on any wages and dividends, and be sure not to forget the impact of national insurance in your calculations.
Setting up as a Sole Trader, Partnership or LLP provide far less flexibility as all profit from the business is taxed as if self-employed. This does not always mean you will pay more tax under these structures, but do have less flexibility.
If the business is generating a loss, then the situation may be reversed. This is because losses incurred from a Sole Trader, Partnership or LLP can be offset against any other personal income straight away, carried over or carried back as loss relief.
In an Ltd on the other hand, losses must remain in the business until they can be offset against future business profits which may or may not come about.
As you can see, tax can get pretty complicated!
The best way of determining an accurate answer for your specific circumstances is to do some Tax Scenario Planning. The example below shows how this could work, by looking at Luke’s proposed business selling replica Lightsabers that is planning to make a profit of £50,000 in 2016. Luke is deliberating over whether to structure his business as a Sole Trader or Ltd. By optimising the balance between wages and dividends from an Ltd structure, Luke can end up taking home an additional £2,658 over what she could from a Sole Trader structure.
If minimising your personal tax liabilities is your priority carefully consider the expected profitability of your business and your personal circumstances. In normal profit-making circumstances it is generally preferable to incorporate as a Limited Company (Ltd) over all other forms.
If this point is really really important to you consider hiring a tax advisor or accountant to do some tax scenario-planning for you and provide a definitive answer for your specific circumstances.
If this point is really really important to you consider hiring a tax advisor or accountant to do some tax scenario-planning for you and provide a definitive answer for your specific circumstances.
Our advice: when thinking about how to structure your business, carefully consider what your personal priorities are. Draw up a list of the pros and cons of each structure as related to your specific circumstances to help make the best decision for you.
This guide outlines some – but by no means all – aspects to consider regarding UK company legal structures. For further advice or to get a full understanding of the legal implications of each structure please ask a professional advisor or consult Companies House.
Venta Partners can provide help and support to determine the best structure for your business, including specific tax scenario-planning and company registration services. Contact us today for an introductory discussion.
Venta Partners can provide help and support to determine the best structure for your business, including specific tax scenario-planning and company registration services. Contact us today for an introductory discussion.
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