Finding the best business structure for your start-up

Having made the decision to work for yourself, it is important to decide which legal and taxation structure is best for your venture.

When starting up, business owners are often uncertain about which entity to trade as – sole trader, partnership or limited company.

Contrary to popular belief, a business is generally not obliged to operate using a particular entity, regardless of size, ownership structure, industry etc. However, there are stark differences between them, and it is the impact of these differences that must be evaluated when deciding which entity to trade as.

The most suitable structure for you will depend on your personal situation and your future business plans. The decision you make will influence the way you are taxed, your exposure to creditors and other matters. 

What is a sole trader?

Being a sole trader is the simplest way of trading as there are only a handful of formalities, the most important of which is registering with HM Revenue and Customs (HMRC). You are required to keep business records in order to calculate profits each year and they will form the basis of how you pay your tax and national insurance. The business of a sole trader is not distinguished from the proprietor’s personal affairs so that if there are any debts, you are legally liable to pay those debts down to your last worldly possession.

You are taxed on the profits or losses of the sole trade personally, regardless of what profits you physically withdraw from your business bank account. Consequently, when the business is doing well, and you can afford to leave some of the profits in the business, it may be time for you to form a limited company.

On the flip side, it can be an advantage when the business is young and investing. As a sole trader, you may be able to access losses personally, which can allow you to recoup some of the tax you paid in employment before starting your own business.

What is a partnership?

A partnership is an extension of being a sole trader, in which a group of two or more people will pool their talents, clients and business contacts so that, collectively, they can build a more successful business than they would on their own. The partners will agree to share the joint profits in pre-determined percentages. It is advisable to draw up a Partnership Agreement which sets the rules of how the partners will work together.

Partners are taxed in the same way as sole traders, but only on their own share of the partnership profits. As with sole traders, partners are legally liable to pay the debts of the business. Each partner is ‘jointly and severally’ liable for the partnership debts, meaning that if certain partners are unable to pay their share of the partnership debts, those debts can fall on the other partners.

A partnership is likely to be a more expensive route in terms of tax and national insurance, than a limited company. They were particularly popular in the professional services industry because partners have unlimited liability, which reassures clients. They may also be more suitable for businesses that wish to vary their profit distribution regularly and don’t want the burden of having to alter shareholdings.

Sole trader versus limited company

The difference between a sole trader and a limited company is that the latter is a separate legal entity from its owners and can trade, own assets and liabilities in its own right. Your ownership and personal liability are denoted by your shares in the company. People often think a limited company offers your personal assets complete protection, but that’s rarely the case if the company is new. Directors will often be asked for personal guarantees of fledgling companies, which effectively nullify the limited liability.

If you work for the company and/or you appoint yourself as a company director, you are both the owner (shareholder) and an employee of the company. When a company generates profits, they are the company’s property. If you want to extract money from the company, you must either pay a dividend to the shareholders, or a salary as an employee. If you do pay yourself a salary, you may have to operate a payroll and have workplace pension obligations, depending on the circumstances.

There are lots of reasons for trading as a limited company, but aside from the limited liability, one of the biggest draws is the tax implications. Firstly, you essentially only get taxed personally on whatever you withdraw. As mentioned in the sole trader section above, this is relevant when the business is growing well, and you can afford to leave profits in the business. Furthermore, although companies pay corporation tax on their profits, the overall tax position tends to be lower because you don’t pay national insurance on any dividends you withdraw, and dividend tax rates are lower than normal income tax rates. As you can see, effective tax planning requires profits, salary and dividends to be considered together.

There are additional administrative factors to consider in running a company, such as statutory accounts preparation, company secretarial obligations and PAYE (Pay as You Earn) procedures. Owner-shareholders will need to change their mind set in order to realise that the company is a separate legal entity, and they cannot use the company bank account or assets as they had done prior to incorporation. Mismanagement can lead to tax charges, additional national insurance and reporting errors (which can trigger penalties). 

What is a limited liability partnership?

A limited liability partnership is legally similar to a company as it is administered like a company in all aspects except its taxation. In this, it is treated like a partnership. Therefore, you have the limited liability, administrative and statutory obligations of a company but not the taxation and national insurance flexibility. They are particularly suitable for medium and large-sized partnerships.

How we can help

If you would like more information about any of the above business structures, call us on 0141 632 1863  to arrange a free, no obligation meeting to discuss the available options. We will be able to talk you through the different responsibilities and reporting requirements etc for each entity, as well as calculate a rough idea of your tax liabilities under each entity.

Date published 28 Jan 2020 | Last updated 22 Sep 2020

This article is intended to inform rather than advise and is based on legislation and practice at the time. Taxpayer’s circumstances do vary and if you feel that the information provided is beneficial it is important that you contact us before implementation. If you take, or do not take action as a result of reading this article, before receiving our written endorsement, we will accept no responsibility for any financial loss incurred.