What are the different types of UK business structures?
There are several ways in which a business can be set up. The most appropriate type of ownership depends on factors such as:
- do the business owners require limited or unlimited liability
- is the business a profit or not for profit enterprise
- is ownership to be restricted to the people who started the business
- are shares in the business to be offered in return for capital investment?
There are four main types of business structures in the UK and each has various tax and liability implications for owners and shareholders:
- 1. Sole trader
- 2. Partnership
- 3. Limited liability partnership
- 4. Limited company
Before You Go Any Further, You Need to Understand Unlimited Liability.
In a business that has unlimited liability, the owners have full responsibility for the contracts entered into by the business, and are fully-liable for the debts of a business. This means that that if the business gets into debt, the owners are responsible (jointly and severally) for the debts and will need to meet this liability from their own money. They can be required to sell their possessions, including their homes, to raise money to pay the debts. If the business is found negligent in its business dealings, then the owners are fully responsible and can be fined or imprisoned.
Why would anyone want to choose to set up an unlimited liability business? One reason is that it is much easier to start this kind of business, and there are fewer costs involved in administering the business. Although unlimited liability seems potentially quite serious for the owners, providing that they business trades within the law, takes appropriate public liability and professional indemnity insurance, and does not run up high levels of debt, liability is not an issue.
There are three main types of unlimited liability businesses: sole traders, partnerships and unincorporated associations.
Sole trader
This is the simplest way to set up and run a business as the ownership and control of the business rests with a single individual. Being a Sole Trader is inherently risky because the individual is not separate from the business and has sole unlimited personal liability for the business, its debts and contractual obligations, and any claims against it. They own all the assets of the business and can dispose of them as they wish, and may employ staff and trade under a business name. However it is unlikely that sole trader status will be suitable for businesses which need more than a small level of external investment – being unincorporated limits borrowing and prevents the business raising equity finance by issuing shares. Regulation for the Sole Trader is minimal: there is no requirement for a formal constitution for the business, and no need to register or file accounts and returns with Companies House. Sole Traders are treated as self-employed by HMRC and must register and make an annual self assessment tax return – profits from the business are treated as personal income subject to income tax and national insurance contributions. The main disadvantage of a sole trader is that the owner has unlimited liability.
Partnership
A Partnership is a relatively simple way for two or more legal persons to set up and run a business together with a view to profit. A partnership can arise, without any formal agreement, when people carry on a business in common, but typically there is agreement to trade as a partnership.
Partnerships are referred to as unincorporated entities in that the partners are self employed. They are personally responsible for the losses or debts that the business undertakes.
Partners will usually draw up a legally binding partnership agreement, setting out such matters as the amount of capital contributed by each partner and the way in which they will share the profits (and losses) of the business. Again, the Partnership has no separate legal personality. Partners share the risks, costs, and responsibilities of being in business.
Because partners generally bear the consequences of each other’s decisions, partners usually manage the business themselves, though they can hire employees. Partners usually raise money for the business out of their own assets, and / or with loans, although again being unincorporated 2 limits borrowing in practice, and not being a company with a share capital prevents the business itself from raising equity finance by issuing shares.
Each partner is self-employed and pays tax on this basis on their share of the profits: The partnership itself and each individual partner must make annual self-assessment returns to HMRC, and the Partnership must keep records showing business income and expenses.
Legal persons other than individuals – such as Limited Companies or Limited Liability Partnerships – can also be partners in a partnership. They are treated like any other partner except that they have additional tax and reporting obligations – for example companies must pay corporation tax rather than income tax on their profits from the partnership.
Separate entities:
Limited Liability Partnership (LLP)
An LLP is similar to a partnership except that the partner’s liability is limited to the amount of money they invest in the business. The LLP must be registered at Companies House and with HMRC. Annual accounts also have to be prepared and filed.
An LLP can be incorporated with 2 or more members and a member can be an individual or a company. Members responsibilities and share of the profits are set out in an LLP agreement and all members must submit a personal Self Assessment Tax Return every year, pay income tax on their share of the partnership’s profits and pay National Insurance to HMRC.
Private Limited Company
A limited company is a privately managed business, owned by its shareholders and run by its directors. The company is a separate legal entity with its own legal rights and obligations. This means the company is responsible for everything it does and its finances are separate to the personal affairs of its owner(s).
Any profits generated are retained by the company, after it pays Corporation Tax. Only then can the profits be distributed to shareholders in the form of dividends. Limited companies can be limited either by shares or by guarantee which is explained below, plus they have annual reporting and filing requirements with both Companies House and HMRC.
On incorporation under the Companies Act 2006, a company is required to have two constitutional documents:
- A Memorandum, which records the fact that the initial members (the subscribers) wish to form a company and agree to become its members. The Memorandum cannot be amended; and
2. Articles of Association – often just referred to as the Articles – which are essentially a contract between the company and its members, setting the legally binding rules for the company, including the framework for decisions, ownership and control. The Companies Act 2006 provides significant flexibility to draw up articles to suit the specific needs of the company, provided it acts within the law.
The filing requirements of a limited company include preparing annual accounts for Companies House every year. This applies to dormant companies as well. The purpose of accounts is to report the financial activity of your company at the end of its financial year. The type of accounts you need to prepare and file will depend on the size or trading status of your company.
The benefits of this are:
- You can decide on remuneration packages at your discretion (if you are the controlling shareholder)
- The business can retain profits
- You can protect your brand
- You can claim back expenses on the business
1. Limited by shares
Most limited companies are limited by shares which means the shareholders responsibilities for the company’s financial liabilities are limited to the amount that the shareholder has agreed to pay for the shares.
2. Private company limited by guarantee
A company limited by guarantee does not usually have share capital or shareholders, but instead has members who act as guarantors. This form of private limited company is commonly set up by not-for-profit organisations and charities. In a company that is limited by guarantee, profits are not distributed to members but are retained in order to be used for future activities of the organisation.
Incorporation
For both the sole trader and the partnership you don’t need to go through any formal processes to set the business up. Both of these don’t require the formation of a separate entity. However, you will need to register with HMRC and comply with the associated rules.
The formation of a separate entity required for a Limited Liability Partnership and a Limited Company is a more complex process. You will firstly need to register the company at Companies House and draft the company’s Memorandum and Articles of Association.
Why you should use an accountant to incorporate
Whilst it’s possible to incorporate a company for a small fee without professional help, someone without an in depth knowledge of financial/business matters may have problems completing the forms and documents accurately.
Financial & accounting advice before starting up can provide invaluable insight as to which of the different business structures might best suit your ambitions and personal financial requirements. If you incorporate without making use of this knowledge then you could find yourself running into all sorts of issues further down the line.
