One of the first major decisions you will have to make as you start your new business is the form of legal entity it will take. To a large degree this decision may be dictated by the way you have organised your operations and whether you intend to work on your own or in conjunction with others.
The form of entity you choose can have a significant impact on the way you are protected under the law and the way you are affected by taxation rules and regulations. There are four basic forms of business organisations. Each has its own benefits and drawbacks and is treated differently for legal and tax purposes.
Sole Trader
A sole trader is typically a business owned and operated by one individual. A sole trader is not considered to be a separate legal entity under the law, but rather is an extension of the individual who owns it. The owner has possession of the business assets and is directly responsible for the debts and other liabilities incurred by the business. The profit or loss of a sole trader is combined with the other income of an individual for income tax purposes.
A sole trader is perhaps the easiest form of business to own and operate because it does not require any specific legal organisation.
Partnership
In a partnership, two or more individuals join together to run the business enterprise. Each of the individual partners has ownership of company assets and responsibility for liabilities, as well as authority in running the business. The authority of the partners, and the way in which profits or losses are to be shared, can be modified by the partnership agreement. The responsibility for liabilities can also be modified by agreement among the partners, but partnership creditors typically have recourse to the personal assets of each of the partners for settlement of partnership debts.
The rights, responsibilities and obligations of partners are typically detailed in a partnership agreement. It is a good idea to have such an agreement for any partnership.
A partnership is a legal entity recognised under the law and, as such, it has rights and responsibilities in and of itself. A partnership can sign contracts, obtain trade credit and borrow money. When a partnership is small, most creditors require a personal guarantee of the general partners for credit.
A partnership is also required to file an income tax return. A partnership typically does not pay income tax; the information from the tax return is combined with the personal income of the partners to determine their overall tax liability.
Limited Liability Partnership
Limited Liability Partnerships (LLP) have been around since 2001, and are a hybrid, offering the benefit of limited liability of a limited company with the flexibility of a partnership.
An LLP is a separate legal entity from its members. Therefore, it may enter into contracts and deeds, sue and be sued and grant floating charges over its assets in its own name. This avoids the problems that exist in relation to partnerships, where technically it is often necessary for every partner to be party to certain documents or litigation, and the creation of floating charges is not possible. The members of the LLP are those persons registered at Companies House as members.
The main "price" paid in return for limited liability is public availability of financial statements.
Members are taxed on their shares of the LLP's profits and gains, just as partners in a partnership are currently taxed.
Limited Company
A limited company is a separate legal entity that exists under the authority granted by statute. Therefore, it has substantially all of the legal rights of an individual and is responsible for its own debts. It must also file tax returns with HM Revenue and Customs (HMRC) and pay corporation tax on income it derives from its operations. Typically, the owners or shareholders of a limited company are protected from the liabilities of the business. However, when a limited company is small, creditors may require personal guarantees of the principal owners before extending credit. The legal protection afforded the owners of a limited company can be useful.
A limited company must obtain approval from Companies House to use its proposed name. A limited company must also adopt and file a Memorandum and Articles of Association, which govern its rights and obligations to its shareholders, directors and officers.
Incorporating a business allows a number of other advantages such as the ease of bringing in additional capital through the sale of share capital, or allowing an individual to sell or transfer their interest in the business. It also provides for business continuity when the original owners choose to retire or sell their shares.
Sometimes, the entity you wish to use may be obvious; however, this may not always be the case and opportunities may exist to structure your tax affairs in a more efficient way, which is particularly relevant for small family owned businesses. If you wish to explore some of the options further, please do not hesitate to get in touch.
