Setting Up A Business: Which Entity Is Best?
Limited company, partnership, sole trader, which is best for your business? We explain the differences to help you decide in this guide.
By MyLegalAdviser - Last Updated April 2018
When you’re setting up a new business it’s important to carefully consider which type of entity is best for your business.
The right type of business structure can help reduce the tax you'll pay, make it easier to hire employees and rent property and ensure the owners receive a fair share of the profits.
The wrong type of structure can mean paying too much in tax or, in the worst case scenario, bankruptcy.
With a range of options available, from limited companies to limited liability partnerships, there are a number of possibilities to consider. But which is best for you?
IN THIS GUIDE:
- What are your options?
- Limited companies
- Sole traders
- How do you set up your business entity?
- Can you change vehicle later?
What are your options?
When setting up a business, you have a number of options as to how to structure your business. These are usually:
- Limited company
- Partnership (general and LLP)
- Sole trader
Which vehicle is most appropriate will usually depend on a number of factors, such as: the nature of the business, who will be investing initially and in the future, the short and long-term goals of the business and the tax benefits/drawbacks for investors.
Let's look at each in turn.
Limited companies are often a popular choice. But what are they and why are they so popular?
Let's find out.
What is a limited company?
A limited company is a legal entity in its own right. It is run by its directors, who are generally appointed by the shareholder(s), and can enter into contracts in its own right via its agents.
When is a limited company the best option?
Generally speaking, a limited company is the best vehicle where:
- there may be third-party investors at the beginning or in the future;
- the company will own valuable Intellectual Property;
- the business is likely to grow in value and you may want to consider selling it at some point;
- the business is likely to hire employees;
- the business is likely to rent or buy premises;
- the owners/directors want to protect themselves from unlimited liability (i.e. to safeguard their personal assets from business disputes).
It should be borne in mind that company formation and company admin comes with a certain amount of complexity.
Certain formation documents will/may be required (e.g. articles of association and shareholders' agreements), the company will have to file certain records (e.g. annual accounts and a confirmation statement with Companies House) and taxation is more complicated, often necessitating the involvement of an accountant.
What is a partnership?
A partnership is a collection of individuals who form a legal entity. There are a couple of different types of partnership with big differences, which we'll explore below.
What different types of partnership are there?
There are a number of types of partnership, the most common being:
- General partnership - this involves two or more owners in business together. Although recommended, no formal legal document (e.g. a partnership deed) is required to create a partnership. Partners in a general partnership share equal rights and responsibilities for managing the business and each and every partner can enter into a legal obligation on behalf of the entire partnership. Each partner is jointly and individually liable for the business's debts and obligations. Although such personal liability can be concerning, there is an administrative and tax advantage: partnership profits are not taxed to the business, but pass through to the partners, who include the gains on their individual tax returns at a lower rate (rather than having to file corporate and individual tax returns).
- Limited Partnerships - a limited partnership allows the partners to limit their personal liability to the amount of their investment. However, not every partner can benefit from this limitation - at least one partner must take on the role of 'general partner'. This means that have full personal liability for the business's debts and obligations. The general partner controls the business, while the limited partners do not participate in management decisions. Both general and limited partners can benefit from the profits of the business.
- Limited Liability Partnerships (LLPs) - LLPs are the most similar to companies, in that they are distinct legal entities, but still have some key differences. There are no shareholders, directors or shares. An LLP must be started by at least two members and at least two partners must be ‘designated’ members and assume additional legal responsibilities on behalf of the entire LLP and its members. The limit of each LLP member’s liability is agreed between the members and usually stated in the partnership agreement. LLPs are registered with Companies House and have ongoing administrative requirements (like companies). An LLP must be set up as a profit-making business, it cannot be used for non-profit enterprises or charities. LLPs do not pay corporation tax, each LLP member is taxed through individually as a self-employed individual (although a member who is a limited company themselves may pay corporation tax). LLPs do not have shares and, therefore, cannot receive capital investment in exchange for a portion of ownership of the business from non-LLP members. Instead, LLPs often operate a capital 'buy-in' for the partners in order ensure there is some working capital to start with and that the partners have some 'skin in the game'.
When is a partnership the best option?
Partnerships are generally best where:
- any capital investment isn't intended to appreciate in value;
- the owners will work in a partnership style (often as a number of professionals at the forefront of their field);
- the partners want to limit their liability and so choose to operate as a Limited Partnership or LLP;
- the partners want to simplify their tax reporting requirements;
- the entity isn't going to operate as a non-profit; and
- the partners will make similar contributions and draw comparable profits (although there can be some flexibility on this).
Sole trader simply means operating a business under your personal name.
When is acting as a sole trader the best option?
Operating as a sole trader is usually best where you are acting as one man band and:
- any investment is limited borrowing;
- the business isn't likely to grow in value and you aren't likely to sell it in future;
- the business isn't going to hire many employees (hiring contractors is less of an issue);
- the owner understands they are open to unlimited liability (i.e. their personal assets are not protected from business disputes) and they may wish to take out insurance to protect against this.
Operating as a sole trader is simpler and cheaper than setting up a company or a partnership, but it comes with certain risks and isn't best suited for hiring employees or growing in size or value.
How do you set up your business entity?
Once the appropriate vehicle is chosen for the business’ needs, bespoke corporate documentation should be put in place to ensure the smooth running of the business in accordance with the needs of the management and investors.
Although it's possible to register a company in a few minutes with Companies House, it's usually best to have a lawyer do this for you.
A lawyer will ensure you have the appropriate formation documents in place (i.e. articles of association), the right classes and numbers of shares issued in the correct way and an appropriate shareholders' agreement in place if needed.
Likewise, although nothing is needed to start a general partnership, it's usually best to have a partnership deed drafted formalising the arrangement and limiting the scope for argument amongst the partners, or with HMRC, in future.
Can you change vehicle later?
Setting up with the wrong vehicle, or not setting up with a corporate vehicle at all, can have disastrous effects later on. Whist it may be possible to rectify later, putting those wrongs right may require a large amount of corporate, commercial, employment, property and tax advice, all of which could be very expensive.
Ultimately, a little time and money spent at the very beginning, and along the way, may avoid all those potentially disastrous pitfalls, saving a lot of expense and sleepless nights down the line.