You're ready to start your new business, but have you considered how the decisions you make now will affect its growth? One of the earliest is company structure: we look at the pros, cons, ongoing filing and tax associated with the four main start-up structures, to help you decide which is right for you.
Unless it’s part of the business plan to raise significant funds on the stock exchange within a defined period, you probably won’t want to start off as a public limited company (PLC), so it’s a four-way crossroad: become a sole trader, form a partnership, or incorporate a limited liability company or partnership (LLP) at Companies House.
There are other models, including Community Interest Companies and co-operatives, offshore companies and franchises, but here we will focus on the most commonly chosen routes. Having looked at all the options, it's a good principle to start out with the simplest structure your business plan will allow. You can easily change to a more sophisticated model as the business scales up.
Registering as a sole trader
If you are not going to employ anybody you will probably be best as a sole trader – there are no dues or fees to register and you can go straight out and order your business cards. Most new businesses are set up this way – it is easy, it is inexpensive and there is very little in the way of red tape.
While a sole trading business can employ staff, most are one (wo)man bands, and most operate in service sectors, such as photography, hairdressing, construction and business-related services.
As a sole trader any decisions you make will be instant, ideal if you have been frustrated by having to convince colleagues or board members while competitors steal your market advantage. More importantly, everything you make belongs to you alone (after tax). However, on the flip side, the law makes no distinction between the business and its owner: liability is unlimited, meaning any business debt can be met from the owner's personal wealth if the business fails. Meanwhile, the business won't usually continue in the event of the owner's retirement or death.
As a sole trader, your profits are taxed as income by HMRC, and as you are self-employed, your tax will be self-assessed. But you should be no worse off than you were as an employee. Initially you will feel better off because many expenses such as business travel and some cost of your premises, even if you are working from home, are tax-deductible. You will have to register for self-assessment with HMRC and fill in a tax return each year, but the paperwork more or less ends there.
It’s when the business starts to grow that the problems of being a sole trader emerge. Since your profits are taxed as income you will be paying 40% as soon as they top £35,000 and 50% above £150,000. So taxation is a risk, but even greater is the risk of liability.
If yours is a low-cost start-up and you are not likely to need to borrow to grow the business then this may not matter too much, but it can’t be stated too many times that as a sole trader you alone pick up the bill for any commitments made in the name of the business.
Being a sole trader can be a lonely and exposed position. The advantage of being your own boss is counterweighed by not having anyone to validate your path. You are liable for debts, but also future liabilities. If you are sued you might go bankrupt: as with personal debt your assets – your house and family – are exposed.
Forming a partnership
A partnership is for you if you are offering services with people you know well. Many building and domestic services firms are either sole traders or partnerships, but bear in mind that if you hope to gain sub-contract work from larger companies you may need to incorporate to satisfy their guidelines. Partnerships are a very common extension of the sole trader model, for example when two individuals or a husband and wife work together to build the business. The partnership is just as flexible, has the benefit of two or more heads, and the business won’t collapse if one of you is sick or needs a holiday.
There has to be an agreement as to how the liabilities, ownership and profits of the business are split and what happens if one partner wants to leave, which should be enshrined in a partnership agreement. However, the only legal requirement, as with a one-person business, is that each partner is registered as self-employed and puts in a separate tax return.
In a standard partnership, as with sole traders, all partners are also responsible for all the debts owed by the business. This doesn't only apply to debts you have incurred as a partner but to those of any partner, so you need to pay particular care to the conduct of the people you go into business with.
A partnership like this is ‘unlimited’, and as such is a very different animal from a limited liability partnership (LLP), which we look at below. But in both cases your share of the profit will be taxed as income: in addition you will have to pay 9% Class 4 National Insurance contributions (NIC) as well as £2.50 a week Class 2 NIC – though the former carries no benefit.
Incorporating a limited liability company (Ltd)
Incorporating means registering a limited company or LLP at Companies House: it’s a move that will lend credibility to the business. It may also make it easier to borrow money when the time comes. But do look carefully at your motives: being the managing director of a limited company may bring status, but you may regret the move when struggling with the year-end accounts.
Once you register at Companies House as a private limited company you are letting yourself in for more administration. But it is not as daunting as it used to be – these days you can be the sole shareholder and director, and act as company secretary too (although appointing a company secretary is no longer a legal requirement).
Most private limited companies are owned by their shareholders and are limited by shares. This means that the face value of their share in the business is the most they can be called on to pay if things go wrong.
The great advantage of limited liability is that you can control your exposure to financial risk. There’s a firewall between your money and the company’s. This is because a limited company is a separate legal entity to the company directors, therefore it is the business itself that shoulders the financial liability if the business goes under. Your home, your family and your lifestyle are protected.
The tax regime is more favourable to a registered company than to a sole trader. Limited companies pay corporation tax on their profits and their company directors are taxed as employees in the same way as other people who work for the company. UK small profits corporation tax rate, applied up to £300,000, is 20% and only rises to 26% once profits exceed £1.5m (with a sliding scale in between). But in a limited company profit there is also a firewall between profit and your income: you will have to pay income tax on the salary the business pays you.
Once you are trading, you will be required to submit full statutory accounts and a company tax return to HMRC each year, as well as making monthly or quarterly payments of employees' income tax (PAYE) and NICs.
You will also have to file statutory accounts and an annual return to Companies House, although small and medium-sized companies (with a turnover of less than £5.6m) can submit an abbreviated version. Here is a handy checklist to help you keep on top of your tax and accounts.
Before you can start trading, you need to officially register your limited company, decide on the company officers and choose a name for your business. Then, once you’ve filed the correct documents with Companies House, you are ready to go. If this sounds like the right move for you, read our step-by-step guide to setting up a limited company.
Incorporating a limited liability partnership (LLP)
LLPs are Britain’s newest business vehicle especially suited to professional services companies. They may be seen as a hybrid between limited liability companies and traditional partnerships, in that they offer the limited liability available to limited company shareholders combined with the tax regime and flexibility available to partnerships. The number of partners is not limited but at least two have to be ‘designated members’ responsible for filing annual accounts.
Just as with a limited company the LLP model protects its members’ assets, limiting their liability to however much they have invested in the business and any personal guarantees they may have given when raising loans. But it doesn’t give you the same tax advantage.
As in an ordinary partnership, the members’ share of profit is taxed as income – each member has to register with HMRC as self-employed. LLPs also have to register at Companies House and there should be a members’ agreement stating what share of the profit each member should receive.
If the business you are starting is in the financial services space, for example, and you are hoping to grow it by attracting other professionals to join you it may be worth considering an LLP from the outset. It has been adopted with enthusiasm by some of the largest accountancy and law practices in the UK.
Business legal structure checklist
Low cost, easy to set up
Full control retained
Very little financial reporting
Full liability for debt
Pay more in tax
Lacks credibility in market
The above, but with more heads
More potential to raise finance
The above, affecting all partners
Can be messy to wind up
Less personal financial exposure
Favourable tax regime
Ability to work for corporate clients
Administrative and regulatory demands heavier
Annual accounts and financial reports must be placed in public domain
|Limited liability partnership (LLP)
Flexibility: can be incorporated in members' agreement
Advantages of limited company and partnership combined
Profit taxed as income
Partners must disclose income
LLP must start to trade within a year of registration – or be struck off