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 will 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 organisation. Each has its own benefits and drawbacks and is treated differently for legal and tax purposes.
Sole proprietorship
A sole proprietorship (also called a sole tradership) is typically a business owned and operated by one individual. A sole proprietorship 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 proprietorship is combined with the other income of an individual for income tax purposes.
A sole proprietorship is perhaps the easiest form of business to own and operate because it does not require any specific legal organisation, except, of course, the normal requirements such as licenses or permits. A sole proprietorship typically does not have any rules or operating regulations under which it must function. The business decisions are solely the result of the owner’s abilities.
Partnership
A partnership is when two or more people agree to join in business with the aim of making a profit. All partners own the business and are equally responsible for any profits or liabilities. A partnership does not have a separate legal entity from its partners and can’t own assets in its own name (for example, property or machinery). Its partners are subject to income tax and are taxed individually as if they were sole traders.
As with a sole proprietorship, a partnership is simple to set up and there are no registration requirements, though a partnership agreement is strongly recommended.
It is to be noted that each partner is ‘jointly and severally’ liable for any debts the partnership incurs.
Limited company
A limited company is a separate legal entity that exists under the authority granted by statute. A limited company has substantially all the legal rights of an individual and is responsible for its own debts. It must also file tax returns and pay taxes 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 often require personal guarantees of the principal owners before extending credit. The legal protection afforded to 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.
A limited company must file annual tax returns (CT600 corporation tax returns) with HM Revenue & Customs.
Incorporating a business allows several other advantages such as the ease of bringing in additional capital through the issue 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. From a tax perspective, the act of incorporation can create advantages via:
- Selling the business assets to the company at market value and paying Capital Gains Tax (CGT) on the first £1 million of gain at 10%, with the benefit of business asset disposal (BAD) relief (previously entrepreneurs’ relief), instead of the normal rate of tax when funds are withdrawn from a limited company. Once the £1 million lifetime limit has been used any additional capital gains on disposal are taxed at 20% if the shareholder is a higher rate taxpayer. Note that BAD relief is not available against the gain attributable to goodwill transferred on incorporation.
- Saving National Insurance contributions (NICs) by drawing profits as dividends rather than as salary.
Should you decide to incorporate your business venture, please seek advice from us. We can also assist in forming the company.
Limited Liability Partnership
The Limited Liability Partnership (LLP) offers limited liability to its members but, like a traditional partnership, is tax transparent and offers flexibility in terms of its internal organisation.
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. These members can be individuals, limited companies or even another LLP.
The main "price" paid in return for limited liability is public availability of financial statements. An LLP must file accounts (prepared on a "true and fair view" basis) annually at Companies House, the same as a limited company.
In addition, the LLP must also file details of the name and address of every member at Companies House. At least two members must be "designated members" responsible for making proper filings at Companies House (and subject to penalties in the event of default).
Provided an LLP carries on a trade or a profession and is not simply an investment vehicle, it is tax transparent - that is, the LLP itself is not taxed on its income or capital gains. Instead, the members are taxed on their shares of the LLPs’ profits and gains, just as partners in a partnership are currently taxed.
Up until 6 April 2014, all members of an LLP were taxed as self-employed individuals. However, from 6 April 2014, certain members (mainly those deemed to be receiving a salary) are now required to be taxed as employees with PAYE and Class 1 National Insurance Contributions (‘EEs and ‘ERs) being payable on their remuneration from the LLP.
LLPs were originally intended for use by the professions. However, any type of business operating for profit may use LLPs. An LLP may be suitable for use as a joint venture vehicle or as an alternative to a limited company, particularly for small businesses.
What’s next?
If you’re starting a company and would like advice on which is the most appropriate legal entity, please get in touch with us. We have significant experience with new start ups and will be very pleased to help.
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