How to Choose the Best Legal Structure for Your Business (UK)

What Is a Legal Structure When It Comes to Business?

Starting a business is exciting; however, it can also be risky.

To minimise the risks, you must carefully consider which legal business structure will best suit your needs.

For example, suppose you are running a not-for-profit business. In that case, you might consider setting up a charity or social enterprise.

Businesses for profit usually fall into four main categories: sole trader, partnership, limited liability partnership (LLP) or private limited company (PLC).

Your chosen structure will have an impact on:

• The authorities you must notify that your business exists
• The tax and National Insurance contributions your business will be liable to pay
• The records and accounts you must keep
• Your financial liability for the business
• The methods your business can use to generate capital
• How management decisions can be made

If you are unsure which structure to choose, you should seek professional advice from an accountant, solicitor or specialist tax advisor.

Types of Business Structures for Small and Medium Business

Sole Trader

This is the most straightforward structure to choose. As a sole trader, you will not have a separate legal existence from your business.

You will be classed as being self-employed; therefore, you must register for Self Assessment and submit a tax return each year.

You can still employ others, but they will not have responsibility for any legal requirements.

Your profits will be taxed in the same way as income, and in most cases, you will be required to pay Class 2 National Insurance contributions.

You will also have to pay Class 4 National Insurance contributions on any business profits.

There is no maximum ceiling on how much you can earn; however, working as a sole trader can be less tax-efficient if you move into a higher tax bracket.

You will be entirely responsible for all debts incurred by the business. Your home and any other personal assets you own could be repossessed if your business encounters financial difficulties, therefore, including any assets that you own jointly with another person.

Personal creditors can also pursue your business assets if you fail to repay a personal debt.

A sole trader setup is useful if you want to use your business profits to fund personal expenses. For example, your monthly rent/mortgage and bills.

Partnership

Partnerships fall into three categories:

• Ordinary or traditional partnerships
• Limited partnerships
• Limited liability partnerships (LLPs)

An ordinary or traditional partnership does not have any legal existence distinct from the individual partners.

If a partner resigns, goes bankrupt or passes away, the partnership will need to be dissolved; however, the business can continue.

Using this type of partnership is a reasonably easy and fast method for two parties or a group of people to set up, own and manage a business.

The partnership must be registered with HMRC for tax purposes. This can be set up by the nominated partner registering the partnership for Self Assessment.

All partners will have joint liability for anything owed by the partnership. They have equal responsibility for repaying the entire debt.

Creditors may claim a partner’s individual assets to pay back debts, including debts built up by another partner.

Should a partner leave the partnership, each of the partners left within the partnership may be jointly liable for the total sum of any debts incurred by the partnership as a whole.

If the business fails, partners do not benefit from any protection.

There is no upper threshold on the number of partners permitted to join the partnership.

Set up is simple and very flexible, and there is no requirement to publish company accounts.

When setting up a business using the ordinary partnership structure, you must create a Partnership Agreement to detail:

• How much capital each partner will contribute
• How profits will be divided
• Key responsibilities and duties for each partner
• What will happen in the event of resignation, retirement or death of a partner
• Dispute resolution process

You should always enlist the help of a commercial solicitor to ensure all relevant terms are included in the Partnership Agreement.

A limited partnership is formed of ordinary partners and limited partners.

If you decide to form a limited partnership, you must register the business with Companies House; however, you will not usually have to submit an annual return or file accounts.

Once your registration has been received, Companies House will contact HMRC to confirm that the limited partnership has been created.

HMRC will set up tax records for the partnership, so there is no need to register with them separately.

Within a limited partnership, ordinary partners share liability for the debts incurred by the business.

They have equal responsibility for paying off the entire debt.

The liability of limited partners is set at the value of their investment in the business and any personal guarantees they have made to generate finance.

Limited liability partnerships (LLPs) are a popular choice for large partnerships providing professional services, for example, firms of accountants, architects or solicitors.

LLPs must nominate a minimum of two designated members who will take on legal responsibilities such as filing the annual accounts.

Accounts will be made public by Companies House, which means anyone can view them.

If the number of designated members is reduced to one for any reason, all other members will be considered designated members.

As an LLP, you must complete the registration process with Companies House. You will be required to file accounts and send an annual return to Companies House.

There is substantial paperwork to complete; therefore, employing an administrator to manage this may be appropriate.

Each partner within the LLP must register as self-employed and file an individual tax return.

The liability of each partner is limited to the value of their investment in the partnership.

Private Limited Company

A private limited company (PLC) is usually limited by shares or by guarantee.

If the members’ liability is limited to the amount (if any) unpaid on the shares they hold, the company is considered limited by shares.

If the members’ liability is limited to an amount agreed between the members to be contributed in the event of it being wound up, the company is considered to be limited by guarantee.

If a company is limited by shares, the shareholders are not responsible for the company’s debts unless they have agreed to give guarantees, for example, a bank loan.

They stand to lose any money that they have invested in the company if it fails, however.

Shareholders can either be individuals or other companies; however, shares cannot be made available to the general public.

As office holders of the company, directors are considered employed earners to pay National Insurance Contributions. This means they must pay both Income Tax and Class 1 National Insurance Contributions on their earnings.

Public Limited Companies

In a public limited company (PLC), the company finances are totally separate from the member’s personal finances.

PLCs must:

• Have a minimum of two shareholders
• Have issued shares to the value of at least £50,000 (or equivalent value in euros) to the public
• Be incorporated at Companies House (registered with)
• Have a minimum of two directors, at least one of which must be an individual. Individual directors must be 16 years of age or older.
• Employ a qualified company secretary

Companies House offers an online service to incorporate your limited company. This web service is used to incorporate a private company that is limited by shares with model articles of association.

Unlike the other business structures, PLCs are allowed to raise capital by selling shares to the public.

Individuals or other companies can buy shares. Shares can also be traded on the stock exchange; however, this is not essential.

All PLCs must send an annual return and file annual accounts with Companies House. Unless the company has an exemption, the accounts must be audited.

If the company structure or management hierarchy changes, the director(s) must notify Companies House of these changes.

Profits are usually paid as dividends to the shareholders. The only exception to this is profits retained by the business as working capital.

If the PLC has taxable profits or income, it must inform HMRC of its existence and it will be required to pay Corporation Tax.

The PLC must pay any Corporation Tax due and submit an annual Company Tax Return to HMRC.

As office holders of the company, directors are considered to be employed earners for the purposes of paying National Insurance Contributions. This means that they must pay Income Tax and Class 1 National Insurance Contributions on their earnings.

Company directors are required to complete a Self Assessment tax return on an annual basis. As part of this, they must provide details of their earnings from the directorship on the employment pages.

If you are not already registered for Self Assessment, you will need to set up this registration first.

Each member’s liability is limited to the amount unpaid on their shares.

Members do not have responsibility for the company’s debts unless they have provided guarantees. For example, when setting up a bank loan.

Tips for Choosing a Legal Structure for Your Business

When setting up a business, most people look for a structure that will offer low liability, minimal complexity with tax status and a low tax burden.

How important each of these factors is will vary from business to business.

As sole traders are considered to be self-employed, they are personally responsible for the business. Running your business using a sole trader structure is usually the simplest option.

While you will have a low to medium tax burden, you will have a high level of liability if you work in a litigious or high-risk line of work.

A partnership is easy to set up in comparison to other legal structures. Still, partners remain personally responsible for the business.

LLPs and companies are separate legal entities to their members. LLPs are considered partnerships for the purpose of calculating Capital Gains Tax and Income Tax.

Limited companies must pay Corporation Tax.

Maintaining a limited company is onerous as they are subject to stricter legislation and reporting requirements than other legal business structures; however, they benefit from low personal liability.

Finding the right option for your business will depend on who else is involved in the business, what industry you are working in and how much investment the business requires.

Key Elements to Consider Before Deciding on a Legal Structure for Your Business

Income

As a sole trader or partner within a partnership, you will need to pay Income Tax on any profits made by the business. The amount of tax to be paid will be worked out using an accounting timeframe, which usually begins on the date that the business started trading.

Most companies choose an accounting timeframe end date of the 5th of April, in line with the last day of the standard tax year.

As a sole trader, you are permitted to retain all business profits (minus tax).

Company directors use a few different methods to take funds out of the business. They might be paid an annual salary or receive taxable benefits.

If they are also shareholders, most of the money they receive from the business is likely to be taken as dividends.

These are paid from the company’s remaining profits, following the deduction of any Corporation Tax due.

Investment Opportunities

Your chosen business structure will have an impact on who is able and willing to invest.

As a sole trader, there is no straightforward way to initiate third-party investment.

If this is important, you will need to consider an alternative structure.

Decision-Making Structure

As a sole trader, there is minimal red tape, and you can set your own policies and working practices.

The more stakeholders your business has, the more difficult it can be to manage decision making.

Ensure that you are comfortable with the hierarchy imposed by your chosen legal model.

Tax

Regardless of business structure, all individuals must pay tax on their income.

As a sole trader, you will be required to submit a tax return annually, pay Income Tax on your business profits and pay contributions for National Insurance.

In addition to the above, companies are liable to pay Corporation Tax. They are also subject to other reporting deadlines.

These additional tax requirements are payable within nine months and one day of the last day of the accounting timeframe.

Setting up as a limited company may mean that you pay less tax than a sole trader; however, you will need to consider whether the associated accountancy fees will result in a net loss.

Risk or Liability

Sole traders and partners within partnerships are personally responsible for any debts incurred by the business.

This is sometimes referred to as unlimited liability. As a sole trader, you have personal liability for any business debts and contractual obligations.

If you choose a partnership model, you could be liable for debts run up by partners on behalf of the business.

Similarly, disagreements about business operations can escalate, leading to a breakdown of the partnership.

Shareholders have limited liability: any losses they make will be limited to the sum of money they invested in their business shares.

In an LLP, the liability will be limited to the sum of money the business partners have invested or agreed to invest in the business.

Responsibilities

Sole traders and partners must pay tax and National Insurance through the Self Assessment process.

A partnership will have other commitments relating to partnership accounts.

Companies have additional responsibilities and obligations, which are often highly complex. These include filing accounts, paying Corporation Tax and filing P11Ds.

Many businesses enlist the help of a professional accountant to meet these requirements.

Annual Accounts

As a sole trader, your business accounts can remain private. If you decide to set up as a limited company, your annual accounts must be made available in the public domain.

Final Thoughts

Choosing the right legal business structure is an important factor in setting up a company.

Even if you decide to start as a sole trader or partnership, you may decide to form a limited company at a later stage as the business grows.

The most effective way to establish the right legal business structure is by discussing your circumstances with an experienced tax advisor or commercial solicitor.

They will have the skills and knowledge required to offer advice on contracts and other legal considerations to protect your interests.