The importance of your business legal structure
What are the different types of business legal structure?
Many of you will know that the structure of your company will have a big impact on your costs structure, risk and taxes. You will be aware of the main company structures available to each businessman. The different company structures are sole trader, partnership and private limited company.
A sole trader setup would essentially be the default scenario. If you're earning money and it's not from an employer then you will likely default to sole trader status. Sole traders have very little paperwork or disclosure. They must fill out a tax self assessment for each year (normally put together by their accountant) and pay HMRC the amount of tax owed from the previous year.
A partnership is similar to a sole trader in terms of setup except that there will be at least one other person involved in your business. You will likely split the profits in some way with your partner. There will be a contract or partnership agreement in place that will determine how profits are split and how decisions are made.
A private limited company is quite different from a sole trader and a partnership. The private limited company is a separate legal entity altogether. The activities and assets of the business are separate from the owner of that business. Instead the owner may be entitled to a share of profits should the business make any.
What are the difficulties with a private limited company versus a sole trader or partnership?
The first key difference is that since a company is a separate legal entity, the losses of that business are restricted to the capital base. The original owner can never lose more than their invested amount. Whereas with a partnership or a sole trader the losses could be unlimited. In the case of a sole trader or partnership any creditors can ask the business owner or partners themselves to stump up the cash for any liabilities owed by the business. Not so with the company. The losses are limited to the assets of the business and not a penny beyond.
Whilst the company may have limited liability there are drawbacks to having your business structure as a company. There is a lot of filing and paperwork in a company. Accounts must be filed with Companies House and are available to all the public - not the case in a sole trader or partnership. Within company accounts there will be far more disclosure required when reporting revenues, costs and assets, liabilities.
The final major difference is the way in which the different business structures are taxed. Companies pay tax at 20% in the U.K. on their profits. Companies also get various tax reliefs including for research and development and in the case of losses. Whereas in the case of sole traders or partners taxes are paid as if the individual were paying income tax and national insurance at their marginal rate of tax. This can have a big impact on the amount of tax paid by the business. In some cases, particularly when the business is growing and reinvesting its profits it can make more sense to have a company structure. However, the added complexity of paperwork and regulation must be accepted with it.