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Choose the right form of business - sole trader, limited company or partnership?

Choosing the right form of business with which to trade is a vital initial step that every entrepreneur and contractor must take when they first launch their business.

Each of the four most common forms of trading vehicle – a sole tradership, a partnership, a limited liability partnership or a limited company – has advantages and disadvantages. Some are easier to administer, others are more tax efficient.

For contractors, the most appropriate trading vehicle is a limited company or umbrella company. That is because clients and agencies hiring contractors want to manage the risk of employment rights claims by having an intermediary such as a company between their organisation and the worker.

What form of business is the simplest to start?

As soon as an individual decides they want to start a business and sets about marketing and generating sales from paying customers, then they become a self-employed sole trader by default.

The sole trader must register with HMRC and file a self-assessment tax return each year. A separate business bank account and business insurance is usually advisable, as is choosing an accountant to help with tax returns but otherwise the statutory and administrative burden is small. The sole trader is the business – it is not a separate legal entity.

Partnerships are equally simple to start by two or more people who want to launch a business together. The partners are treated as self-employed for tax purposes, so registering the partnership and the partners with HMRC is mandatory, and a partnership agreement is advisable, as are insurances and an accountant.

Partnerships are also not separate legal entities, and require only a set of partnership accounts to be filed, alongside the partners’ self-assessment tax returns. A partnership dissolves instantly if one partner leaves the partnership, leaving a sole partner remaining.

How can I protect my personal assets from business liabilities?

Because sole traders and partnerships are not separate legal entities, then the self-employed sole trader and partners are personally liable for any business debts and liabilities. In a partnership, all the partners are equally liable, even if it was the actions of only one partner that created a debt.

This places the sole trader’s and partners’ personal assets at risk, and they could be made bankrupt if their business fails owing money to creditors and any unpaid income tax and National Insurance Contributions (NICs) to HMRC.

A limited liability partnership (LLP) and a limited company are separate legal entities from their partners/shareholders/directors, and so any business debts are not passed on to the individual LLP partners and limited company directors, unless there has been tax evasion or fraud.

However, both LLPs and limited companies require registration with Companies House, although this can be completed cheaply online. They also require separate company bank account alongside filing formal paperwork such as annual returns, statements of capital, company accounts and corporation tax returns.

What is the most tax efficient form of business?

The business owners of sole traderships, partnerships and limited liability partnerships are all treated as self-employed for tax purposes. For a sole trader, that means calculating business expenses and subtracting them from sales income to give a profit on which they pay income tax and NICs at the same rates as permanent employees.

With partnerships and LLPs, although partnership accounts must be filed, the profits pass through the business and are shared between the partners. The exact share is determined by how much capital each partner put in at start-up, or is stated in the partnership agreement. The partners complete self-assessment tax returns and pay income tax and NICs

In contrast, a typical limited company that has shareholder directors is much more tax efficient. Assuming the shareholder/directors pay themselves a minimal salary that is just below the threshold to pay NICs, but just within the NI band to qualify for state pension, and the balance as dividends, a limited company is much more tax efficient.

Business forms making business and brand growth and an exit strategy difficult

Business owners who are not planning on running a lifestyle business but who are planning to grow and eventually exit their business need to carefully choose their business form.

Sole traderships can employ people and the self-employed principal in the business can own assets, but it is difficult to raise money for growth, as there is no mechanism to share ownership. It is also difficult to unpick the owner from the business if they want to sell.

Partnerships can grow by adding new partners who invest money and own a stake in the business. However, as the partnership grows so do the risks and liabilities, for which the partners will be personally liable. LLPs can grow by adding new partners, but the liability is limited, and LLPs are a common business form for growth businesses.

Choosing a limited company can offer greater flexibility

A limited company is the business form that best facilitates growth, brand building and exit strategies. A separate brand from the business principal can be created by choosing a company name.

Templates are readily available for company documents such as articles of association, and an accountant can help with company accounts, corporation tax returns, payroll, PAYE and Real Time Information (RTI).

Investors can put money into the business and receive shares in the company in return. The company’s shares can be expanded almost indefinitely enabling the company to grow through marketing, sales and ongoing investment.

The company’s founders and original owners can exit the business by selling their shares to new owners, or even through an initial public offering on a financial market.

Updated: 18 July 2017

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