Both legally and financially, the ramifications brought into effect by your company’s legal structure makes it a far-reaching and hugely important decision. Whichever way your business is structured, everything will be affected, including but not limited to its record keeping, the amount of tax it pays and the degree of personal liability.
With this in mind, how do you know which legal structure is the one for you and your business? Broadly speaking, there are four basic types of business entity, each with their own respective pros and cons that will need weighing up. Here we’ll examine these business types, along with the advantages and disadvantages that go with them, to help you reach a conclusion as to what is the most suitable legal structure for your company.
Of all the business types, sole proprietorship is the easiest legal structure to understand and organise, and the one most preferred by solo business owners. Keep in mind, you can still hire staff if you so wish, but you’ll have to comply with the rules and regulations of sole trader employment as a result.
Examples: Sole traders own businesses in many different industries, so while their duties will understandably differ, the overall legal structure remains the same.
Freelance writers, private tutors, bookkeepers and landscapers, to name but a few, can all fall under the umbrella of sole proprietorship. They may work alone or hire a small team of employees, but the legal structure as a solo business owner applies only to them.
Since you might not be working with colleagues, and there are no other board members or shareholders to deal with, your decisions will be quick and instantaneous. For business owners, registering as a sole trader is very attractive; there are no registration fees, very little legal red tape to get caught in, and it’s relatively straightforward compared to other business types - which is great if you’re merely looking to test a business concept.
Liability and tax are perhaps the two biggest cons when it comes to sole proprietorship. In terms of the former, the onus will be on you and only you. If your business starts to fail, it runs into bankruptcy or faces legal action, then your personal assets will be at risk, too. As a sole trader, there is no distinction between business and owner.
As for tax, sole traders can face problems when the business starts to succeed. Your profits are taxed as income, so if you’re making over £41,865, your tax reaches 40%, while profits over £150,000 will be taxed at 45%.
A general partnership is relatively similar to sole proprietorship in that it’s not considered a separate legal entity, except two or more people are responsible and divide the liabilities between them. Each partner registers as self-employed and then files separate tax returns.
A limited liability partnership (LLP) allows more safeguarding from potential liabilities as partners will be limited to the total sum that they initially invested. After that point, they cannot be held liable for any debts.
Examples: When it comes to examples, there are many world-renowned companies that originally began as partnerships. Warner Bros., McDonald’s, Apple and Microsoft – all leaders in their field – started out as humble business partnerships before gaining global popularity and fame.
Many of the advantages of sole proprietorship, such as the low cost and relative ease, also apply to a partnership. It’s just as flexible, and if one partner is taken ill or has taken a holiday, there’ll be another person to keep the business afloat in the meantime.
A water-tight written agreement, signed by all partners, is a necessity. The terms of the partnership have to be as transparent as possible in the event the partnership runs into problems down the line. This includes how the liabilities, ownership and profits of the business will be split as well as what will happen if a partner leaves. Even so, if another partner sinks the company then everyone can still personally be at risk.
A Limited Liability Company (LLC) is a private company in which the owners are legally responsible to the extent of the amount they initially invested. This safeguards personal finances in the event of collapse and avoids the double taxation of a partnership, too.
Examples: Pepsi-Cola, Blackberry, Sony and Nike are all well-known LLCs that began small and are now huge names in their respective industries.
Compared to corporations, setting up an LLC avoids a lot of the corporate formalities and red tape surrounding big business, and tends to be less expensive, too. As well as minimising the liability, the flow-through taxation for LLCs means there are no restrictions on the number and type of owners they can have. Additionally, LLCs don’t have the formal management structure of a corporation, allowing for more flexibility on decision-making and the way they run the business.
Despite its relative ease compared to corporations, there’s more admin to work through than there is for sole trader and partnership businesses. You must register with Companies House to qualify for limited company status. Once this is confirmed, accounts must be submitted annually to Companies House, failure to do this, along with overdue tax payments, risks significant financial penalties.
Example: Reading like a who’s who of the world’s biggest brands and companies, examples of corporations include Amazon, Google, Domino’s Pizza and General Motors. As we mentioned earlier, Microsoft and Apple started out as partnerships before becoming the global corporations we know them as today.
Existing as an entity separate from its owners, corporations are subject to their own legal rights. In this capacity, they can use, own and sell property, and sell the rights of ownership in the form of stocks.
Two types of corporation exist: The S corporation and the C corporation. The former pays no corporate-level income taxes; the profits and losses of the corporation will be reported on the individual tax returns of the shareholders. C corporations have different benefits, but can end up paying double the tax on its profits.
Theoretically, there are no risks to your personal assets since the corporation’s debt is not considered the owners’. If a corporation needs to raise funds, their publicly-held position can let them accrue substantial amounts by selling shares or issuing bonds. If it were privately held, then selling shares in the event of ownership transfers would be difficult. And when the time comes to transfer ownership, the corporation’s lifespan can theoretically go on in perpetuity as it gets passed through many generations of investors.
An S corporation can only have up to 99 shareholders, limited types of shareholders, and can only have one class of stock. A C corporation can have unlimited shareholders and any number of stock classes while still providing the limited liability of an S corporation. Additionally, it’s an expensive and complex process that requires a lot of accounting and tax-prep to make sure you’re compliant with the rules, regardless of your type of corporation.
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Type of legal structure
- Full control of your business
- No registration fees
- Straightforward setup
- Great for testing out business concepts
- Owner is fully liable
- Tax can be high
- No distinction between business and owner
- Low cost, easy to set up
- Business can stay running in the event of illness or holiday
- Scope to outsource responsibilities
- The same as above now affects all partners
- Agreements need to be made in writing in the event a partner leaves
- If a partner does leave, everyone is still personally at risk
Limited Liability Company
- Relatively inexpensive
- Minimal formalities compared to corporations
- Lots of administrative demands and regulations
- Reports and accounts must be submitted annually
- Large fines for non-compliance
- Very little risk to personal assets
- Requires a lot of complex accounting
- S Corporations have limited shareholders and one class of stock
- C corporations can be taxed double
Gov.uk offers more advice on the different business structures, and provides information about how to register as a sole trader, limited company or partnership. Click here to start the process of registering your business.
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