The legal structure of your business will have a profound effect on the financial and legal realities of its day-to-day maintenance and administration. It will affect everything from the records you need to keep to the type and amount of tax you pay. Crucially, the legal structure of your business will also determine how much personal liability, if any, you would assume in the event that your business encountered financial difficulties. For all of these reasons, it is vital that you make the right decision.
New business owners are faced with a choice between several legal structures, and it is important that you understand the characteristics of each before making a decision.
If you wish to run a simple business with the minimum of fuss, a sole trader arrangement may well be the best option for you. Sole traders are self-employed, with any profits being counted as personal income. There are very few regulations to be adhered to; it is not necessary, for example, to register with Companies House or to file company accounts each year. Rather, you will be required only to fill out a standard self-assessment form and register for self-employment. Any profits are treated as regular income for tax purposes.
However, operating as a sole trader requires a trade-off. While you will avoid the significant administrative demands that are placed on the directors of limited companies, you assume complete liability in the event that your business fails. As a sole trader there is no separation between your business and personal assets, and you can be personally bankrupted by the failure of your venture. As such, depending on the size of your debts, as a sole trader you should be prepared to lose your home if your business collapses.
Like a business operated by a sole trader, a partnership is not considered a separate legal entity. Rather, the two or more partners involved assume the same responsibilities as those taken on by a sole trader, but the liabilities are split between them. The partnership will have to submit accounts to HM Revenue and Customs, in addition to the self-assessments submitted by each individual partner.
Partners generally manage the business themselves, although in many cases there is scope for some responsibilities to be delegated or outsourced. However, the responsibility for raising funds rests with the partners themselves. Partners assume joint liability for any debts that are run up, even if they were taken out by one partner individually. This can cause problems when one partner is less involved in the day-to-day management of the business than the others, or when a ‘sleeping partner’ exists. Sleeping partners put up money for the venture but are not involved in the actual running of the business.
For these reasons it is important to formulate a written agreement, and for this to be signed by all partners. Regardless of how close you are personally, it is good sense to have the terms of the partnership clearly recorded from the outset in order to avoid potential conflict later on.
Limited Liability Partnership (LLP)
Limited Liability Partnerships are a sensible choice for those who value the flexibility of a traditional partnership, but want to be insulated as far as possible from potential liabilities.
Under an LLP arrangement, each partner’s individual liability is limited to the total sum that they initially invested. Partners cannot be held liable for any debts run up after that point, unless they have provided personal guarantees against any such debts.
While there is no upper limit on the number of partners permitted in an LLP, there must be at least two ‘designated partners’. These individuals assume extra responsibilities, including signing off accounts and delivering annual returns.
As in a regular partnership, each individual partner must submit their own self-assessment to HMRC in addition to the accounts submitted by the partnership itself.
Limited liability company
The most important aspect of limited liability companies is that, in a legal sense, they have an existence separate to that of their directors. As such, the personal finances of these individuals are separate from any liabilities that the business might have. In the event of the collapse of the business, therefore, the directors’ liability is limited to the total value of their initial investment.
Limited liability companies have shareholders, which may or may not be separate from the directors. It is perfectly possible, for example, for a limited company to have a single shareholder who is also the only director. However, other shareholders, if they exist, may be either individuals or other companies. The shareholders do not assume any liability for the business’s debts, unless they have offered personal security against them.
The administrative requirements of limited companies are more exhaustive than those applying to partnerships or sole traders. In the first instance, the business must be registered with Companies House in order to qualify as a limited company. Accounts must then be submitted to Companies House every year. There are significant financial penalties for companies which fail to send in their accounts on time, or which are overdue on their tax payments.
The effects that your choice of legal structure will have on your business cannot be overstated. As such, you should consider seeking advice from a solicitor or accountant before making a decision. These individuals would be able to help you get your business on the right legal footing; they should take the time to understand your business model and your personal requirements, and come up with a suitable solution. Furthermore, many accountants will offer free initial consultations, often with no obligation on your part.
Finally, it is worth remembering that a limited company is relatively difficult to disband once it has been incorporated. The process of ‘striking off’ can be lengthy, and involves a lot of paperwork. However, sole traders can establish partnerships or limited companies at any time, with the minimum of effort. Depending on the unique needs of your business you may, therefore, choose to start out as a sole trader and later incorporate a company. The flexibility of a sole trader arrangement can help you establish and grow your business effectively; at a later date you may find that the trade-off between freedom from administration and insulation from liability makes incorporation the best option.
Either way, this is not a decision to be rushed into. Ensure that you do sufficient research, and seek expert advice before making a choice. Taking your time at this point will pay dividends in the future.