When you start your own business there are a lot of decisions you need to make. But before you jump in, the first thing you need to do is choose the right legal structure for your business start up.

Choosing the right business legal structure is vital as it can affect the amount of financial risk you’re taking on, the amount of tax you have to pay, the control you have over your new business, and the administration you’ll need to do.

But do you form a limited company? Form a business partnership? Or act as a sole trader?

Here’s a brief guide to the different business legal structures you can choose for your business start up:

Business legal structure #1: Sole trader

Operating as a sole trader is the simplest form of business legal structure.

As a sole trader you are in charge of all aspects of your business start up. You’re personally liable for all debts of the business, even in excess of the amount invested. You and the business are considered the same entity.

Pros of a sole trader:

  • There is no requirement for you to file Accounts or Annual Returns or other information at Companies House, which means that you have greater privacy.
  • You are in complete control of the business.
  • You may pay less tax.

Cons of a sole trader:

  • Unlimited liability – you’re personally liable for any debts run up by your business start up, no matter how incurred, which means that your personal property can be used to settle business debts.
  • Potential difficulty in raising capital because you cannot transfer an interest in the business to investors as security for their investment.

Business legal structure #2: Business partnership

A business partnership involves two or more individuals carrying on a business together with a view to profit. Each business partner is personally liable for all debts of the partnership, including those incurred by the other partners.

So, when you’re forming a business partnership, it’s important to draw up a Business Partnership Agreement. A business partnership agreement gives a proper foundation to the business relationship and it outlines how any problems will be resolved, should the business get into trouble.

A business partnership agreement is also part of the evidence that you must give to HM Revenue & Customs to prove that the business partnership is in existence.

Pros of a business partnership:

  • There is a broader management base than a sole trader.
  • You may pay less tax, by avoiding double taxation, for example. This is where the company pays corporation tax on its profit, but later the shareholders effectively pay tax on the same profits through capital gains tax on the sale of their shares and income tax on their dividends.

Cons of a business partnership:

  • There is unlimited liability for all the business partners. The personal assets of each business partner are available to satisfy the debts of the business partnership.
  • Obtaining large sums of capital is relatively difficult as investment cannot be obtained from new shareholders.
  • Business decisions taken by just one partner bind all the business partners.
  • The business partnership may come to an end when existing business partners leave or die. If there are two business partners and one leaves or dies, the remaining business partner automatically becomes a sole trader, unless s/he admits another business partner.
  • It may not be easy to sell or transfer an individual business partnership interest.
  • Some tax incentives, such as employee share option schemes, are not available to business partnerships.

Business legal structure #3: Limited liability partnership (LLP)

The business legal structure of a limited liability partnership (LLP) is similar to an ordinary business partnership in that a number of individuals or limited companies share in the risks, costs, responsibilities and profits of the business.

But with a limited liability partnership the liability is limited to the amount of money the business partners have invested in the business and to any personal guarantees they have given to raise finance. This means that business partners have some protection if the business runs into trouble.

Pros of a limited liability partnership:

  • Limited liability partnerships retain the flexibility of a business partnership.
  • With a limited liability partnership, your personal liability is limited.

Cons of a limited liability partnership:

  • Limited liability partnership formation is more complex and costly than that of a business partnership.
  • Problems can occur when there are disagreements between the business partners.

Just like a business partnership, it’s important when forming a limited liability partnership to draw up a Limited Liability Partnership Agreement.

Business legal structure #4: Limited company

The benefits of forming a limited company are limited liability and raising capital easily. But the advantages of this business legal structure may not outweigh the disadvantages of higher costs, increased paperwork and greater regulation to which you will be subjected once you form a limited company.

Pros of limited company formation:

  • Limited liability. The shareholders are not personally liable for the debts of the limited company. The limited company can only ask shareholders to pay for their shares in full, if they haven’t already done so. The shareholder’s responsibility is limited to this amount and this amount is determined when the shareholder agrees to buy shares. Should your business start up fail, the creditors cannot obtain possession of shareholders’ assets, such as homes or cars, in settlement of debts. But the directors may find themselves liable to pay the limited company’s debts.
  • Capital can be raised with relative ease because investors can buy shares in the limited company. But this doesn’t mean that a new company can simply offer shares to the general public. Share offers are regulated by law.
  • Subject to the Articles of Association, shares can be transferred to existing members and to family members as gifts or otherwise. It’s possible to sell your shares in the limited company to other people, but not in a general offer to the public. Investors in a private company don’t receive the same protection as they would have if they were investing in companies listed on the Stock Exchange.
  • Since the limited company is an independent legal entity, it doesn’t cease to exist because one of the shareholders dies or retires. So it’s easier to ensure the continuity of a limited company than of a business partnership.

Cons of limited company formation:

  • The limited company must comply with statutory rules and disclose information to the public.
  • A limited company is usually the most expensive form of business to organise and run, although a business partnership can be equally expensive, especially a Liability Limited Partnership.
  • Both the limited company and the individual shareholders have to make tax returns.
  • Record keeping (such as keeping a minute book) can be more extensive for a limited company.
  • Winding up a limited company and, in many cases, even changing the business legal structure can be more complicated and expensive than for business partnerships and sole traders.
  • Any money in the company’s bank account belongs to the limited company and it can only be taken out as a dividend or wage, or set against money you put into the business.

For help and advice on forming up a limited company yourself, read our Limited Company Formation Kit, which provides all the guidance and company formation forms for you to use.

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Published on: October 11, 2010