How should you structure your business?
In a previous article we explored why an increasing number of UK based freelancers are opting to supply their services as sole traders (you can read more on that article here), but what if you’re not a freelancer? And what other factors should you consider beyond tax mitigation?
Unfortunately, there isn’t a ‘one size fits all solution’ and each case will need to be considered on its own merits. A business structure suitable for one person may be completely inappropriate for another, so it’s usually a good idea to seek professional advice.
In the UK there are four main ways you can structure your business – sole trader, partnership, limited company, or limited liability partnership - and we explain the main features of each below.
Sole trader (self-employed)
Starting a business as a sole trader is viewed as the simplest form of business structure because there are minimal compliance obligations. To begin as a sole trader, you will need to let HMRC know that you’ve started trading and file annual self-assessment tax returns, which should include details of your income and expenses for each tax year (note that from April 2024 sole traders will need to report their income and expenses to HMRC every three months under new Making Tax Digital rules. Learn more here).
Although a sole trader can recruit any number of employees and generate as much profit as in any other business structure, they are often viewed as less established and perhaps emit less of a professional feel than incorporated entitles. This can erode confidence from potential clients or outside investors.
In fact, some businesses will outright refuse to work with sole traders because of a perceived risk of exposing themselves to claims in employment law. For example, if HMRC were to retrospectively challenge an individual’s worker status and deem that individual to be an employee instead of a sole trader, the individual would suddenly have legal employment rights. There isn’t a risk of this when contracting a limited company because limited companies don’t have the same legal rights as employees (even where IR35 rules are triggered. Learn more about IR35 rules here).
Another perceived disadvantage of a sole trade structure is that you and the business are treated as a single entity so you may be personally liable for the debts of the business (in other words there is no ‘limited liability’). This is less of an issue if you don’t require a loan to finance your business, as taking out appropriate insurance to cover against any public liability or professional indemnity claims, for example, might provide sufficient protection.
The reasons for structuring your business as a sole trade will therefore usually hinge on the ease, flexibility and (sometimes) favourable tax rates that self-employment offers.
General Partnership
A general partnership allows two or more persons to share in the profits and losses of a business. The structure of a general partnership is very similar to that of a sole trader to the extent that (where all the partners in a partnership are individuals) each partner is taxed on their share of the underlying business profits in the same way as a sole trader i.e. profits are subject to income tax and class 2 & 4 national insurance via self assessment.
As with sole traders, partners don’t have limited liability so may become personally liable for the debts of the business, but again, often taking out appropriate insurance is sufficient. Note though that each partner can be held liable for any other partners’ negligence, which adds an increased risk of liability to all parties.
One additional compliance burden for general partnerships is that a partnership tax return needs to be filed each tax year as well as each partner’s individual self assessment tax return.
Partnerships can be useful where there is an anticipation that new partners will join the business in future, but without a comprehensive Partnership Agreement, changes to the individual partners (for example, if one decides to leave), can get messy. It’s therefore imperative that the details of how profits, debt and assets should be split in the event a partner exits are agreed upon contractually from the outset, and drawing up such agreements can be complex and costly.
Limited Liability Partnership (LLP)
A limited liability partnership is taxed in the same way as a general partnership above, however it has the added protection of limited liability, meaning that it’s members won’t become personally liable for the debts of the business in the event of liquidation. [Note that the partners in an LLP are known as ‘members’, which helps to distinguish between an LLP and a general partnership.]
As for a general partnership, an LLP tax return needs to be filed in addition to each member’s individual self-assessment tax return each year. Unlike a general partnership though, there is the additional compliance burden of filing annual accounts to Companies House.
The same considerations surrounding the LLP Agreement and member exits/arrivals outlined above also applies to LLPs.
Limited Company (Ltd)
Unlike for sole traders where the individual is the business, a limited company is treated as a separate entity from its owner(s).
To understand some of the tax implications of operating via a limited company, check out our previous article here.
As the name suggests, limited companies have the added protection of limited liability, which can be useful if things don’t go to plan. This added protection may make it a little easier for a companies to attract investment.
Note however that some lenders require ‘personal guarantees’ where the business is a new business and has limited liability (such as a limited company or limited liability partnership). In this instance the protection of limited liability is eroded as the individual or individuals can become personally liable for the debt in the same way as a sole trader.
Because a limited company is a separate entity from its owners, it will continue to exist beyond the life of its shareholders, which ensures security for employees and other stakeholders.
The main disadvantage of using a limited company structure are the additional compliance burdens and therefore costs, associated with running it – the need for bookkeeping, annual accounts, corporation tax returns and confirmation statements can add thousands to your bill.
Sole trade or Limited Company?
The most common question we get asked is whether an individual should structure their business as a sole trader or limited company.
Below we have set out some very broad examples of when a limited company might be more appropriate than going self-employed:
Those wanting to give the impression of a larger, more established business. A limited company adds a layer of professionalism that can infuse confidence in your business.
Those taking on debt or obtaining outside investment may want to take advantage of the ‘limited liability’ a limited company provides to protect themselves from personal responsibility of the company’s debts, while others might find that taking out personal insurance is sufficient for their needs.
Those seeking outside investment also sometimes find it advantageous to operate as a limited company because it’s easier to sell shares in a company. There are also a number of government schemes (such as EIS SEIS & VCT) that can be used to promote and attract investment, which are only available to limited companies.
Highly geared landlords seeking to avoid the restrictions to loan interest relief can benefit from buying property through a limited company.
Those looking to carry out business succession planning – it can often be easier to pass business assets to beneficiaries, by gifting shares for example.
Small businesses with profits of between £12,500 and £50,000 who have simple affairs and minimal accountancy fees (you can read more on why this can be true here).
Where a spouse or civil partner has unused personal allowance and/or has a lower tax rate than the other it can be beneficial to operate out of a limited company to divert profits to the spouse/civil partner with the lower tax rate.
This list is by no means comprehensive and the facts surrounding each case will vary significantly. For this this reason it’s a good idea to obtain professional advice from a firm of fully qualified Chartered Tax Advisers & Accountants like Bearstone.