Choosing the right structure


Choosing the right structure for your business


There are legal and tax implications regarding what business structure you choose. Below is a brief introduction to the options.

This content relates only to the UK.

Always check with an accountant before making any decisions.

choosing the right business structure


Before starting a business, you first have to decide on its legal structure.

This largely depends on three things.

  1. Your current resources in terms of capital sources and people wanting to be part of the business venture.
  2. The type of business in terms of potential risks and rewards.
  3. Your exit plan.

There are broadly four different structure types.

  1. Sole Trader
  2. Partnership (This can be a Partnership or Limited Liability Partnership)
  3. Limited Company (Ltd)
  4. Public Limited Company (plc)

Changing your business legal structure when already in business

You can change the business from being Sole Trader to Limited Company at any time during your business journey. You can even change the company from Limited to Sole Trader (although this is rare and requires good advice as regards accounts and tax).

Moving from Limited Liability to Public Limited Company (going public) is more complex and is a separate section in itself.


Sole Trader

The Sole Trader option is sometimes known as Sole proprietorship.

The most important aspect of being a Sole Trader is that you will have unlimited rather than limited liability.

This means you have sole unlimited personal liability for the business; including business debts, contractual obligations and any legal claims made against it.

Everything you own is entwined with the business because in law, a Sole Trader is the business and the business is you the Trader. If you owe money to suppliers and cannot pay them back then they could come after your house.

The good news is that any assets you create from doing business will directly belong to you (subject to tax).

Other key points to being a Sole Trader

  1. There is no incorporation paperwork to complete: you can just start doing business. Although be sure to keep purchase receipts, copies of sales invoices and accurate records of all transactions to keep your accountant and tax man happy.
  2. Being a Sole Trader means you can trade under your own name or choose a business name (subject to trademark).
  3. You can still employ staff.
  4. HMRC treats Sole Traders as self-employed. This means the profits made by the business are treated as personal income and subject to income tax and national insurance contributions. You must therefore register and complete an annual self-assessment tax return. An accountant can also do all this for you if you wish.

These are some of the Pros and Cons of choosing to be a Sole Trader as compared to other options.

Summary

Pros

  1. You directly own all the assets created from the business.
  2. Setting up the business is relatively simple.
  3. There is no need to register or file Accounts and Returns to Companies House.
  4. The financial state of your business is not published at Companies House for all to see.
  5. You do not have to pay Corporation Tax on profits.

Cons

  1. You are directly liable for business debts.
  2. You are directly liable for contractual commitments.
  3. You are directly liable for any legal claims.
  4. You cannot raise money by issuing shares.

Setting up a Partnership

This is a gentle introduction to what a partnership arrangement entails. The variables of a Partnership can be complex so always obtain professional advice before making any decisions.

This section relates to Partnerships in the UK.

A Partnership is a business arrangement between two or more individuals.

Partnerships have no separate legal personality and because of this all responsibilities including the risks and costs of the business are shared within the Partnership. (See below for an introduction to the Limited Liability Partnership option.)

Partners have a ‘fiduciary relationship’ both with each other and with the Partnership as a whole. This means trust and confidence in each other is a pre-requisite to a working business partnership. In practice, this means two things.

  1. Each Partner must act in the best interest of the business and the other Partners.
  2. Each Partner is liable for any actions taken by other Partners on behalf of the business.

Partnership Agreements

Partnerships can be set up without any formal agreement; although it is prudent and typical to have a legally binding Partnership Agreement between Partners. A Partnership Agreement clarifies arrangements and expectations and reduces the risk of future complications.

The Partnership Agreement confirms the amount of capital each Partner has contributed and how profits and losses of the business are to be shared out.

Note that Partnership Agreements do have certain constraints; for example creditor liability.

Always seek professional advice when both constructing and deciding upon a Partnership Agreement.

Constructing an enduring Partnership Agreement

As with any relationship, a partner’s’ views, ambitions and priorities are likely to evolve.

A good agreement should therefore possess insight as regards potential future situations; no matter how unlikely they might appear. This is particularly true at the beginning of a partnership arrangement when all involved are infused with optimism and consideration of potential future issues might be interpreted as doubt or lack of conviction.

Below is a summary of circumstances that need to be considered and agreed. This list is by no means exhaustive and is provided only to encourage thinking. Always see a professional when constructing or agreeing to any arrangement.

Basic agreement considerations

  1. Allocated percentage of ownership for each Partner.
  2. Allocation of profits and losses.
  3. Binding of Partnership. This is the ability of any one Partner to make decisions on behalf of the Partnership – with or without the consent of any or all of the other Partners.

Procedural considerations

  1. Agreed exit procedures for each Partner. For example: what happens to that part of the business? What notice period is expected?
  2. What happens if a Partner develops a permanent disability or illness that impacts on the performance of the Partnership?
  3. What happens if a Partner dies during the agreement?
  4. What if a Partner wishes to introduce another Partner?
  5. What is the process when a Partner wishes to delegate his or her part of the business to someone new?
  6. The process for resolving disputes.
  7. The process for handling allegations, misconduct and misdemeanours.

The fun of being joined at the hip

Partnership liability: all for one and one for all

Each Partner is liable for the actions of another in that each Partner will be acting as an agent for the Partnership. In legal terms this means Partners are ‘jointly and severally liable’ for the firm’s debts.

If the Partnership owes money then creditors will ask the Partnership business to pay. If the Partnership cannot pay then creditors can ask each and every Partner to pay. This can happen regardless of any Partnership Agreement.

Decision making: designing a camel to win a horse race

In essence, a Partnership is a committee; and committees can be notorious for reaching reluctant compromises. This can result in agreeing the design of a camel when the objective was a fast horse to win a race. Internal compromise in business rarely results in the penetration of markets with potent execution using laser sharp strategies. Partnerships therefore run the risk of being rather plodding in both reaching decisions and the quality of those decisions.

In other words, focusing on and achieving agreements can distract from effective and quick solutions.

The Pros and Cons of choosing to be a Partnership as compared to other options

Pros

  1. The potential of working with a like-minded individual or team.
  2. There is no corporation tax to pay for unincorporated Partners.
  3. The financial state of the business is not publicly published.
  4. The legal structure and shape of the business can easily evolve and change to meet circumstances.

Cons

  1. Unlimited liability. Partners are personally liable for business debts (as with the Sole Trader option).
  2. There could be limited ability to raise funds beyond the Partnership (cannot issue shares as with the Limited incorporation option).
  3. Relationships can become intense: there is a business consequence to a degrading relationship.
  4. Risk of committee type decisions and delays in decision making.
  5. You can be personally liable for the actions of another Partner acting on behalf of the Partnership.

Tax

Partners are classed as self-employed and on this basis, their share of the profits are taxed.

The Partnership and each individual in that Partnership must file annual self-assessment returns to HMRC.

The Partnership must keep records of business income and expenses.

Other types of partner

Sleeping partner

Sleeping or silent partners do not take active roles in the daily running of the business but are still jointly and severally liable for Partnership debts.

Limited Liability Partners

Other legal persons, such as Limited Companies or Limited Liability Partnerships, can become Partners in a Partnership. These entities will have additional obligations concerning tax and reporting; for instance paying corporation tax instead of income tax on their share of the profits from the Partnership.

The limited liability of debt to the Partnership for Limited Liability Partners means their potential loss can be no more than that invested in the Partnership.

Limited Liability Partnership (LLP)

The LLP is similar to the traditional Partnership except that each Partner will have limited liability. This means the Partners’ liability for debt is limited to the amount of money invested in the company including any personal guarantees provided in raising finance.

Limited Partnerships must register at Companies House.

Limited Liability Partnerships must have at least two or more designated members who appoint the auditors for signing off and filing the accounts at Company House.


Limited Company (Ltd)

A Limited company structure can be complex. This content is provided as information only. Always seek professional advice before making any final decisions.

This section relates to private limited companies in the UK.

Summary key points regarding liability in a Limited Company

  1. Being incorporated as a limited Company means you can use the word LTD, Ltd or Limited in your company name. Choosing whether to use Ltd or Limited in your company name is made when you register the business and only affects the incorporation documents.
  2. The owners of a Limited Company are liable for company debts only to the value of the investment placed in the shares they own. In other words, if you made £1000 investment in a business and the business goes pop then you lose the £1000 – even though the debts that took the business down were more than the total value of all the shares and therefore the total investment in the business. This is different from the Sole Trader and Partnership options where you and the entity of the business are the same and therefore liable for all debts incurred due to the conduct of business.
  3. A Limited Company must be registered with Companies House.

Typical aspects of Limited Company structure

  1. A Limited Company is seen as a separate entity from its owners (unlike a Sole Trader or Traditional Partnership).
  2. The Limited Company therefore conducts business in its own name.
  3. Ownership of the company is in the form of shares. These are called Shareholders or Members.
  4. The proportion of ownership of the business is determined by the distribution of shares.
  5. There is a difference between a share owner and an executive to the business.
  6. Shareholders appoint a board of executives (Directors) to run the business on their behalf.
  7. Directors work in the best interests of the shareholders by appointing and managing managers.
  8. Shares come with rights to vote on decisions that affect the company. Normally there is one share to one vote; although companies can create different classes of share with different voting rights.
  9. Shareholders can also be directors and therefore can be both the owner and executive of the Limited Company. These are more common in small to medium sized businesses and large businesses where the creator of the business or his or her family is still directly involved in the business.

Distribution of profits

  1. Profits from the business are distributed to shareholders in the form of Dividends.
  2. Deciding on the level of Dividend or whether to even pay a Dividend is determined by the Company’s Board of Directors.
  3. This decision is then voted on and approved by the Shareholders.
  4. If you are both the owner and director of a Limited Company then this can obviously be quite a short meeting.

Typical aspects of Shareholder decision making

  1. Shareholders pass resolutions at shareholder meetings.
  2. These resolutions usually relate to top level aspects of the business, such as amending the Company Articles of Association and appointing, removing or extending the contract of a director or directors.
  3. Resolutions are passed by voting.
  4. Voting rights usually depend on the number of shares held by the Shareholder. For example, if a Shareholder owns 51% of the Company’s shares then that Shareholder is certain to pass the resolutions he or she is in favour of.

The Pros and Cons of choosing to be a Limited Liability incorporation as compared to other options

Pros

  1. Owners have limited liability as regards any debt incurred by the business.
  2. There is a little extra flexibility in raising investment through the issue of shares.
  3. Being a Limited Company can appear to be more professional to customers and suppliers.

Cons

  1. Obligations as regards document submission to Government are more extensive and complex. For example: Annual Return, Confirmation Statement, Corporation Tax Return.
  2. Compared to the Sole Trader option, business management procedures are more formal and complex.
  3. There is an extra layer of tax in the form of Corporation Tax – but there is more flexibility as regards tax options when compared to the Sole Trader option. See an accountant.
  4. Accounts must be filed at Companies House: This includes the Income Statement (Profit and Loss or P&L Account), Balance Sheet, Director’s Report, Auditor’s Report and notes to the Accounts. The extent of reporting of these accounts depends on the size of the business.
  5. The financial details of the business must be published at Companies House and these can be seen by the public and more specifically by your competition.
  6. Compared to the Sole Trader option, you have less privacy. The directors, owners and people of significant control (PSCs) will be published for all to see.