How to structure your business for maximum benefit

Getting to grips with sole trader status, partnerships, limited companies and limited liability partnerships

Having made the decision to be your own boss, it’s important to decide the best legal and taxation structure for your enterprise.

Business owners are often unsure about which entity to trade as, whether that’s as a sole trader, partnership or limited company. But contrary to popular belief, a business is generally not obliged to operate using a particular entity, regardless of size, ownership structure or industry. But there are stark differences between them and it’s the impact of these differences that must be evaluated in order to decide which entity to trade as.

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

The possible options you have are as follows:

Sole trader

This is the simplest way of trading. There are only a few formalities to trading this way, the most important of which is informing HM Revenue & Customs. 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 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 business personally, regardless of what profits you physically withdraw from the business bank account. Consequently, when the business is going well and you can afford to leave some of the profits in the business, it may be time to form a limited company.

Conversely, 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.

Partnership

A partnership is an extension of being a sole trader. Here, a group of two or more people will come together, pool their talents, clients and business contacts so that collectively they can build a more successful business than they would individually. The partners will agree to share the joint profits in predetermined percentages, so it’s advisable to draw up a
partnership agreement that sets the rules of how they will work together.

Partners are taxed in the same way as sole traders, but only on their own share of the profits. As with sole traders, the partners are legally liable to pay the debts of the business. Each partner is ‘jointly and severally’ liable for the partnership debts, so that if certain partners are unable to pay their share of the debts then they 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 are particularly popular in the professional services industry because partners have unlimited liability, which reassures clients. They may also be more suitable for businesses that want to vary their profit distribution regularly and don’t want the burden of having to alter shareholdings.

Limited company

A limited company is a separate legal entity from its owners. It can trade, own assets and liabilities in its own right. Your ownership and personal liability is 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 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.

Should you wish 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 limited liability one of the biggest draws is the tax implications.

Firstly, you essentially only get taxed personally on whatever you withdraw, which is relevant when the business is growing 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 in running a limited company, such as statutory accounts preparation, company secretarial obligations and PAYE procedures. It’s also a big mind shift for owner-shareholders to grasp 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.

Limited liability partnership

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

Before making a decision about which entity to trade as, it’s recommended you discuss your circumstances with a professional. They can talk you through the different responsibilities and reporting requirements for each entity. In addition, they will also be able to calculate a rough idea of your tax liabilities for each one.

The author

Jo Nockels is financial controller and senior commercial manager at TaxAssist Accountants