Choosing the Right Business Legal Structure

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Anyone starting a new business needs to decide which legal structure it will have, and before starting up should carefully consider the issues involved, including their own potential liability for any future business debts, and the tax implications of their chosen structure.

This factsheet outlines the main legal structures for a business, which are sole trader, ordinary partnership, private limited company, limited liability partnership (LLP) and community interest company (CIC).

Different types of business such as franchises, co-operatives and not-for-profit organisations (which are not in themselves legal structures) can be set up as sole traders, partnerships or limited companies as appropriate.

What are the main types of legal structure?

Sole trader Sole traders (often referred to as a sole proprietors or sole operators) are treated by HM Revenue & Customs (HMRC) as self-employed for tax purposes and retain all their business profits after tax. A sole trader is personally liable for the debts of the business, which means that their home and other personal assets may be at risk if they are unable to pay the business's debts as they fall due.

Sole traders must register with HMRC for tax self-assessment as a self-employed person. They must complete an annual self-assessment return and pay income tax and Class 2 (and in some cases also Class 4) National Insurance contributions.

Partnership An ordinary partnership, usually simply known as a 'partnership', is legally defined by the Partnership Act 1890 as two or more people 'trading in common with a view to profit' and is the format normally chosen for a business that will be owned by two or more sole traders. This kind of partnership does not have to be registered with Companies House.

Each business partner has unlimited liability for the debts of the business. Partners are 'jointly and severally' liable, so each can be held responsible for transactions or contracts entered into by any of the others.

Partners are treated by HMRC as self-employed for tax purposes in the same way as sole traders, and they retain and share all their business profits after tax. They do not all have to be individuals, as a private limited company is treated in law as a 'legal person' that can also enter into partnership.

It is essential, as best practice, to have a partnership agreement (also known as a deed of partnership) drawn up by a solicitor before starting to trade. The partnership agreement clarifies each partner's legal position and provides a framework for dealing with any problems that may arise. If there is no partnership agreement, the partnership will be governed by the terms of the Partnership Act 1890.

Private limited company A private limited company has a separate legal identity to that of its owners, unlike a sole trader or a partnership where there is no distinction. This means that the owners of a company, who are called 'members', benefit from limited liability, and the company itself can own property and other assets, as well as sue and be sued.

A private limited company must be incorporated with Companies House and registered with HMRC. It can be limited either by shares, which means that the members' liability is limited to the money they have invested buying those shares in the business, or by guarantee, which means that the members' liability is limited to the amount they have agreed to contribute to the company's assets if the company is wound up.

Members of a company limited by shares are known as shareholders. Shareholders buy shares issued by the company when it is incorporated and may buy further shares at a later date. The money for the purchase of the shares is invested in the company. Shares in private limited companies cannot be publicly traded.

Directors, who may or may not be shareholders, are appointed to manage the company. Directors must be aged 16 or over but there is no maximum age limit. A person who is an undischarged bankrupt cannot be a company director.

In practice, for most small companies, the shareholders and directors will be the same people. A private limited company can be set up with only one shareholder, who can also be the sole director. Under the Companies Act 2006, private limited companies are no longer required to have a company secretary, although they can still appoint one if they wish.

Limited liability partnership A limited liability partnership (LLP) is a common legal structure for two or more sole traders to set up in business together while limiting their personal liability. An LLP is similar to a private limited company in that it has a separate legal identity to that of the partners (known as 'members') in the LLP.

In many ways LLPs operate in the same way as ordinary partnerships, but while ordinary partnerships do not have to be registered with Companies House, it is a statutory requirement for LLPs to be registered.

Each LLP must have at least two 'designated members' who are responsible for various administrative duties such as dealing with accounts and tax matters on behalf of the partnership. However, there is no limit to the number of ordinary members an LLP can have. Members can be either individuals or limited companies (known as 'corporate members') and each member acts as an agent for the LLP and can form binding contracts on its behalf.

Since the LLP has a separate legal identity to its members, legal claims against the business can only be made against the LLP itself and not its members. The liability of the members is limited to their capital contribution to the LLP, so their personal assets cannot be seized to settle the partnership's debts.

Management of the partnership is normally shared among the members, as specified by an LLP agreement, which is a contract between the members of the LLP. This sets out the members' rights and obligations and provides a plan for how the partnership will be run. It is essential, as best practice, to have an LLP agreement drawn up by a solicitor before starting to trade.

If there is no agreement, the partnership will be governed by the terms of the Limited Liability Partnership Act 2000.

Community interest company Community interest companies (CICs) were introduced to provide a legal structure to encourage people to establish ventures that provide genuine benefits for their local communities, rather than being driven by personal profit.

A CIC is a specific type of limited company that trades commercially as a social enterprise and has clear social objectives, such as providing employment opportunities for people with disabilities.

CICs must be registered with, and are regulated by, the Office of the Regulator of Community Interest Companies and must pass a 'community interest test' before being approved. This test ensures that activities undertaken by a CIC provide benefits to the community.

New CICs can be set up either as private companies limited by shares or as private companies limited by guarantee. (A CIC limited by guarantee is a not-for-profit company.)

CICs that are limited by shares and that make a profit can distribute some of their profits to shareholders, subject to certain conditions. To ensure that CICs use their assets and profits for the benefit of the communities they serve, there are restrictions on the distribution of profits to shareholders, known as the 'asset lock'. The dividend that may be paid to shareholders is capped at a rate set by the CIC Regulator.

Hints and tips

  • Solicitors and accountants can assist with making decisions about legal structure as well as helping with the practical procedures involved in setting up more complex structures such as LLPs and private limited companies.

  • As a business grows, the legal structure may need to be reviewed to meet changing business needs. Alternatively, the particular structure chosen at start up may not suit a trader's individual circumstances later.

  • While it is possible to change the legal structure, this may cause problems by disrupting business activities and it can be costly and time consuming.

Contact Ashored for help and support with choosing and setting up the right business structure.

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