The right business structure can mean the difference between a successful and unsuccessful business. Here’s a basic overview to help you determine which is right for you.
Want to save money on income tax, increase profits, and build credibility? Choosing the right business structure at the right time can mean the difference between success and failure.
A business structure refers to how a company is organised, in regard to its legal structure and status. There are many different business structures to choose from.
When setting up a company, deciding on an appropriate business structure helps your company to be formally acknowledged legally. A clear business structure also provides guidelines for how you should operate your business, file taxes, etc as a small business owner.
There are different business structures for every type of small business, each creates a different legal structure, affects personal responsibility (liability) for the business, and includes many other benefits and drawbacks.
The most common types of business structures include sole trader, partnerships, limited liability partnerships (LLP), limited companies, and corporations. We’ll take a look at each business structure so you’ll have a better idea of what makes sense for you. Of course, a professional can advise you best, but educating yourself about business structures available for your UK business is the best place to start.
- What Does a Business Structure Do?
- A Quick Tour of Business Structures
- Sole Trader (Sole Proprietorship)
- Ordinary Partnerships
- Limited Liability Partnership (LLP)
- Limited Partnership (LP)
- Limited Company (Corporation)
- Extra Responsibility
- When Should You Incorporate?
- How Do You Incorporate a Business?
- The Difference a Year Makes
What Does a Business Structure Do?
A business structure indicates who the owner of a company is, how it should pay income tax, how profits generated are distributed, and which managers perform what tasks. A clear and legally identifiable business structure is necessary for tax and liability purposes, the business will be taxed differently, and managers and owners are personally responsible to different extents in the event of wrongdoing or a lawsuit.
A Quick Tour of Business Structures
Sole Trader (Sole Proprietorship)
If you’re the only one responsible for the business, you can choose to run it as a sole trader. It’s easy to set up as a sole trader, and you’ll have complete control over the business. You keep the profits of the business after you’ve paid tax on them. On the flip side, you’ll also be liable for the business debts, meaning if anything goes wrong, your personal assets could be at risk.
If you have one or more partners who are also responsible for the business, you can set up a partnership. The profits are shared between the partners, who pay tax on their portion. But just like a sole trader, the partners are liable for business debts.
Whichever of the several types of business partnerships you choose for your business, it’s important to set it up correctly in order to comply with legal requirements and to help deal with and avoid business disputes in the future.
Regardless of your type of partnership one thing to consider is discussing and agreeing on how you are going to run the business as there are numerous things to consider.
Once everything is fleshed out and agreed upon, record everything legally and in writing in a partnership agreement.
Partnership law was written a long time ago and clearly, a lot has changed since then. The way modern businesses operate is clearly much different. Without a partnership agreement in place, you could find yourself adhering to default rules, written a hundred years ago, that now apply to parts of your business.
Here are a few important things to work out before you start your business partnership:
- the percentage ownership of each partner
- who contributes what into the partnership, and whether those assets belong to the partnership or not if the business is later sold or wound up
- how profits and losses will be allocated
- how decisions will be made at meetings, and possibly whether any partner has a casting vote or more say on a particular matter
- the principal duties of each partner
- the limits of authority of each partner who makes decisions by himself or herself, for example, you might agree that no partner can borrow or make an order for more than £500 without the agreement of the others.
- the procedure for admitting a new partner
- the procedure for removing a partner from the partnership, or what happens when a partner decides to leave
Basically, an ordinary partnership is 2 or more people carrying out business together. Pretty ordinary right? While it’s fairly basic you still need to decide if you want to trade under a business name, and what that name should be. There are also some rules surrounding what name you can choose.
One bit of paperwork you can avoid is registering with Companies House as an ordinary partnership doesn’t need to be registered with Companies House. The way you decide to run your business remains private between you and your partners.
When setting up your ordinary partnership it’s important to choose a nominated partner that is responsible for registering the partnership with HMRC. Sorry, you can’t avoid all paperwork. This person then becomes responsible for keeping the business records and filing tax returns.
On top of that, all partners need to register for self-assessment with HMRC.
Limited Liability Partnership (LLP)
A limited liability partnership (LLP) is an alternative business option that brings all of the benefits of limited liability, it also allows flexibility when organising an internal structure. In an LLP, one partner is not responsible or liable for another partner’s misconduct or negligence. As the name suggests, the liability of members of a limited liability partnership or LLP is limited.
In a partnership, the liability of the partners is unlimited. That means, if a partner is negligent there are ways to take legal action against that partner. If the same work is contracted to a limited liability partnership, then on the face of it, no liability can fall to the partner who was negligent, as a separate legal entity has been created.
Despite the similarity with a limited company, the members in a limited liability partnership are not employees of the partnership, whereas the directors of a limited company are employees of the company.
Some partners of a limited liability partnership might not be members, but instead would be employees. This is common in professional service firms where there are both salaried partners (employees entitled to a share of the profit of the firm as a bonus through their employment contract) and equity partners (who are members who share in both the profit and losses of the partnership).
Limited Partnership (LP)
A limited partnership business structure has two types of partners:
- General Partners: These business partners have no limited liability
- Limited Partners: These business partners have limited liability
With so much importance placed on partners being personally liable, it’s important to decide which partner or partners will be general.
Sometimes a limited company is designated as the general partner. The advantage to doing this is that while the company has unlimited liability as a partner, as a company the liability of its shareholders is limited. One thing to be cognizant of is that for small businesses, this structure may involve more administration than the value of the extra protection. If this sounds a little confusing that’s because it is, but it’s just one way of structuring your business.
Just as for other types of partnerships, you should choose a business name and agree on terms within a written LP agreement.
Like an LLP, a limited partnership is registered at Companies House. You do this by filling out Form LP5.
And like other types of partnerships, each partner must separately register for self-assessment with HMRC.
Limited Company (Corporation)
A limited company is a corporation. When you set up a corporation you are creating an entity that’s separate from your personal finances, which isn’t the case with sole traders and partnerships. This separation offers some key benefits, such as:
- Limited liability: As an owner, your assets aren’t affected if the company gets into financial trouble, except when you’ve signed a personal guarantee.
- Tax efficiency: Corporate tax rates are lower than the highest personal tax rates. This means that if profits reach a certain threshold, a limited liability structure allows you to pay lower taxes compared to a sole trader or partnership.
- Funding: It’s much easier to raise funds through a limited company and different classes of shares mean you can offer investors different rights to dividends and have different amounts of control over the company.
When an organization intends to go public through the issue of common stock to the public, it must first be incorporated as a limited company. Limited companies are required to pay both federal and local taxes, while the shareholders are required to disclose their dividend payments when filing their personal income taxes.
One of the advantages of a limited company business structure is the ability to raise capital. The entity can raise finance in large amounts by selling shares of stock to the public. Also, the limited company business structure comes with limited personal liability, offering the business owners protection against debts, liabilities, and obligations of the business.
On the downside, a limited company is subject to more requirements, such as meeting, voting, and the election of directors, and it is more expensive to form compared to a sole trader or partnership.
With incorporated structures, there are extra responsibilities that company directors have. Directors must abide by the Companies Act 2006, and must exercise reasonable skill, care and diligence. Directors must also act in the interest of the company and not themselves. Limited Companies are also required to keep very good records, more so than a sole trader or partnership. This is the director’s responsibility and failure to do so can see the director held personally accountable.
When Should You Incorporate?
For many first-time business owners, starting as a sole trader is usually the easiest option because it’s pretty simple to set up. A sole trader may want to incorporate down the line, as the business gets bigger and is making reasonable profits. At this stage, there is obviously more risk is involved and incorporation can ensure personal assets are protected. There are also tax savings that can be made on incorporation. It’s wise to consult a professional to help guide the decision since there are many factors involved.
How Do You Incorporate a Business?
You can incorporate your business at any time by applying to Companies House. Typically a speedy process—most companies can usually incorporate within 24 hours. It could, however, take longer if Companies House objects or needs additional information from the applicant.
You can apply using old-fashioned pen and paper forms, completed and returned to Companies House. Unless you are a public company, you can also apply online through the Companies House Web Incorporation Service.
There are costs associated with incorporation, ranging from £30 to £200, depending on whether a business owner tackles things solo or hires a professional. Some businesses choose to use a formation agent to help guide the process and handle the paperwork. Having a reputable agent carry out the process ensures all documentation is prepared correctly.
The Difference a Year Makes
Because a corporation is a separate entity, it will have its own financial year, based on the day you incorporate. This financial year can create some complex issues because there are other “years” that come into play when doing accounting and tax planning, namely the personal tax year (April 6 through April 5) and the corporate tax year (April 1 to March 31). To make things easier, many companies align their financial year-end close to the tax year-ends, which allows you to complete all accounting, payroll and tax work at the same time, rather than staggering the work throughout the year. However, because things can get quite complicated, a professional advisor can help make sure you’ve got the best arrangement set up.
This post was updated in January 2022