How to select the right legal entity for your business?
One of the most important decisions you make when starting a business is the type of legal structure you select for your company. This decision impacts your tax responsibilities, the amount of tax you pay, the paperwork your business is required to complete, your personal liability and your ability to raise money.
In this blog we explain the various legal entities as well as sharing the tax implications, benefits and disadvantages of each.
What is it?
A sole trader is a business set up by an individual and is the most common form of business in the UK. There is no legal distinction between the individual and the business, meaning any debts incurred by the business must be borne by the owner.
How to set-up
In order to set-up as a sole trader, the individual must register as a sole trader with HMRC by the October of the second year of the business. This is fairly straightforward though, and can actually be completed online.
If the business is expected to make taxable supplies of more than £83,000 per year, then it must be registered for VAT.
After this, the profits of the business become available to the owner. They will be subject to Income Tax and Class 2 and 4 National Insurance Contributions. The return of the profits to HMRC will be completed via Self-Assessment.
Seek the assistance of an accountant to help you complete your Self-Assessment to ensure that all the information you provide is correct and transparent. Your Self-Assessment can be time consuming. By passing the responsibility to an accountant you can spend the time instead on activities that are vital to your business objectives like working on growth strategies or building relationships.
– Ease – Setting up as a sole trader is extremely easy, and has little cost associated. Beyond the initial set-up, there are few regulations around the accounting requirements of the business, which means the owner can concentrate on running the business.
– Control – The owner can decide which direction their business goes in, how they specialise, and have ultimate executive control. Being your own boss is a major attraction for most sole traders.
– Unlimited Liability – The owner and the business are one and the same, so if the business is liable to debt it passes to the owner without limit.
– Finance – Some sole traders may find it difficult to raise finance, as many lenders may find them too risky.
– Customer Trust – Customers may find it difficult to work with a sole trader, as there is (rightly or wrongly) a perception of security with other legal entities, such as a registered company.
What is it?
Ordinary partnerships are similar to sole traders with the exception that there is more than one person at the helm. The partners are liable for the debts of the business, and will share the profits. How they decide to split these will be agreed by the partners beforehand.
The tax implications are similar to a sole trader. Partnerships expected to take more than £83k must register for VAT, and the individual partners are liable to Income Tax and Class 2 and 4 NICs on their respective shares of profit.
– The advantages are similar to a sole trader, except everything is shared. This includes the debts of the business, which would spread the risk.
– The profits and control are also shared.
Limited Liability Partnerships
What is it?
A Limited Liability Partnership (LLP) is a partnership that is treated as a separate legal entity from the partners themselves, so partners can only stand to lose what they have invested into the business.
How to setup
When compared to a sole trader or an ordinary partnership, a business faces more obstacles when setting up as an LLP. This is due to the limiting of liability. For example, the business requires a registered address, and be registered with both HMRC and at Companies House. Annual Accounts must then be filed at Companies House every year thereafter.
Members must also make an LLP agreement, which will detail how the partnership will be run, how the profits will be shared, what the decision making process is, the individual members’ responsibilities, as well as how to add or remove members in the future.
LLPs are not subject to Corporation Tax. Business profits are taxed in much the same way as a sole trader or ordinary partnership, in that the member takes their share of the profit, and pays Income Tax and Class 2 and 4 NICs. This is done through self-assessment.
Again, if revenues are expected to be above £83,000 per annum then the LLP must register for VAT and make an annual VAT return.
– Limited Liability – There is less risk on the individual partners in an LLP. If the business runs up debts that it cannot pay, then the personal assets of the members cannot be used to meet them.
– No Corporation Tax – Tax is calculated at an individual level.
– Succession Planning – The business is separate from the owners, so if a founder member does not wish to continue (or dies) then the business will continue. This continuity can bring advantages to the running of the business.
– Compliance – There are more legal obstacles for an LLP, including filing Annual Accounts, and in some cases even requiring an audit.
– Cost – The legalities and accounting requirements will bring an associated cost.
What is it?
A Limited Company is a separate legal entity, so owners, or shareholders, are only liable for the money they have invested in the business.
Although there are many forms of Limited Company, the two most common are Private Limited (Ltd.) and Public Limited Companies (plc.). The main difference between the two relates to how the equity in the business is traded. In a Private Limited Company, equity can only be purchased by invitation of the existing shareholder(s), whereas shares in a Public Limited Company will be floated on the Stock Exchange, and can be purchased by anyone.
How to set-up
Limited Companies must be registered with Companies House – this is the process of incorporation. This must include the Memorandum of Association – an agreement made by the initial shareholders to create the company, and the Articles of Association, which details how the business will be run.
Limited Companies must be registered for Corporation Tax, which is due on all trading profit, investment profit, and chargeable gains on the sale of assets. Seeking the assistance of an accountant is likely to be helpful for any Limited Company to ensure the information provided to HMRC is accurate and transparent.
Individual Tax depends on how the individual is paid. Directors who are managing the company will be paid a salary, in which case they will be charged income tax and NICs through a PAYE system. Shareholders, however, will receive dividends from the profits of the business. These will be subject to Income Tax at the Dividend Rates, which are different to the rates for regular income.
– Limited Liability – Like with LLPs, the company is a separate legal entity to the owners, so creditors cannot chase the business owners for debts the company cannot meet.
– Tax efficiency – Companies have access to a wider range of allowances and reliefs, as well as the owners being taxed on dividends rather than or in addition to pay. This can make the tax outcome different for the shareholder owners. However recent changes to the rates of tax on dividend income are closing the gap on the potential tax benefits of running a business through a company in comparison with other legal entities.
– Finance – – It can be easier for a company to raise finance. Not only will lenders potentially see the business as separate from the owners, there is also the option to sell equity in the business in order to raise funds.
– PR – Customers may be more willing to work with a Limited Company as opposed to a sole trader.
– Cost – There are legal, accounting, and administrative requirements and regulations associated with a company, all of which add cost into the business.
– Dilution of Control – The sale of equity to raise finance will dilute the control of the ownership over the business. In the case of a public traded company, this would mean that the business could be exposed to a takeover bid.
Considerations to make when choosing a legal entity
Cost – Some entities are not only cheaper to set up, but cheaper to administer also. The individual must decide whether this is something that will be worthwhile.
Liability – The individual must also decide whether they wish to limit their liability in the business. High-risk businesses will need to consider this point in particular.
Control – Sole Traders have ultimate control over the direction of their business and are under no risk of it being diluted. At the other extreme, a plc must answer to a much larger share ownership.
Continuity – The continuity of the business should be considered. What will happen to the business when the founder cannot continue?
If you need further advice on selecting the right business entity for your enterprise, we’re always here to help. Get in touch by calling 020 7317 0040 or by emailing us at firstname.lastname@example.org.