Start-ups - choosing a business structure


One of the most difficult tasks for any start-up business is deciding on the most appropriate legal structure. The choice will be influenced by a number of issues, including:

• the nature of the business and, in particular, the extent of potential liabilities to which it may be exposed;

• the forecast level of profit for the first few years of trading; and

• the number of persons involved in the business.

The two deciding factors are most commonly the business owners’ attitude to personal liability, and the tax treatment of the relevant structure. Choosing a structure is, however, far from straightforward and it is important to seek legal and tax advice. In this note, we summarise the pros and cons of each alternative.

It is recommended that, regardless of the chosen structure, joint business owners draw up a formal agreement (whether a partnership agreement, LLP members agreement or company shareholders’ agreement) setting out their rights and responsibilities.

Sole Trader (self-employed, no special legal structure, only relevant where there is one business owner)

Advantages: This is by far the simplest structure for those starting up in business on their own as there are no formation costs and ongoing administrative and accounting costs should be low.

Disadvantages: Any liabilities of the business will be met out of the sole trader’s personal assets. Whether or not this is acceptable depends on the level of potential financial liability – sole traders are perhaps most common in the service sector where capital expenditure is less significant. In any event, comprehensive insurance against potential liabilities is essential, but sole traders should be aware of any policy excess.

It is usually harder to raise money without adopting a limited liability structure.

Tax treatment: Profits are taxed as income by HMRC and the sole trader will be liable for class 2 and profit related class 4 national insurance contributions. A qualified tax adviser is best placed to determine whether the limited company tax regime would be more attractive. This will depend partly on the forecast profit levels – unless earnings are high, total tax payments will usually be lower for a sole trader than a limited company.

Partnership (must be two or more persons, sharing profits and losses)

Advantages: Again, there are no obligatory start-up costs. It is strongly recommended, however, that individuals entering into a business partnership put in place a formal partnership agreement governing, amongst other things, the split of profits and liabilities, and what happens if one of the partners wishes to retire. Legislation sets out the default position in the absence of agreement and this may be very different from what the parties intend.  Our INTEGRALtemplate documents do not currently contain a template partnership agreement, but we would be happy to provide a fee estimate for drafting a bespoke agreement.

There are no ongoing administrative filing requirements and as partnerships do not have a share capital structure, there is arguably more flexibility in determining, for example, profit entitlements (with the proviso that a partnership agreement is essential to achieve certainty on this).

Disadvantages: Each partner will be potentially responsible for all liabilities incurred by the partnership (not merely those resulting from his own actions).

Tax treatment: Each partner pays income tax on his share of the profits, together with Class 2 and Class 4 national insurance contributions.

The issues of personal liability and the tax treatment are therefore broadly the same as those for a sole trader, save that a partner will also be potentially liable for the actions of his fellow partners.

Limited Liability Partnerships (must be two or more persons, LLP is a separate legal entity but taxed in the same way as partnerships).

Advantages: An LLP confers limited liability status. Unless he has personally guaranteed any obligations of the LLP (or is guilty of any wrongdoing) a member of an LLP will therefore generally be liable only up to the amount of his capital investment in the LLP.

LLPs do not have a share capital structure and therefore potentially offer greater flexibility regarding the division of capital and profits. Again, however, a formal agreement between the members is essential.  Our INTEGRAL template documents do not currently contain a template LLP members agreement but we would be happy to provide a fee estimate for drafting a bespoke LLP members agreement.

As the LLP is a separate legal entity from its members, it can hold property in its own right – from an administrative perspective this is more convenient than a partnership, whose assets must be held by the individual partners (or certain of them) and therefore transferred each time that a partner retires.

LLPs are most commonly encountered in the professional services sector, where lawyers or accountants may wish to preserve a “partnership” structure without the risk of unlimited personal liability.

Disadvantages: LLPs need to be incorporated at Companies House and are required to file annual returns and annual accounts, meaning that start-up and administrative costs are more significant.

Tax treatment: As with partnerships, each member of an LLP is liable to incur tax on his share of the profits.

Limited Companies (can be one or more shareholders, separate legal entity, subject to corporation tax on profits)

Advantages: A limited company confers limited liability status on its shareholders. As with an LLP, unless an owner manager has guaranteed the company’s obligations and/or is guilty of misconduct, his liabilities will be capped at the level of his equity investment.

As limited companies are subject to increased regulation, with the certainty that this confers, they are the most appropriate vehicle for raising external finance. Incorporation may also be a pre-requisite for entering into significant contractual arrangements with large corporates or public authorities.

Disadvantages: A company is formed by the Registrar of Companies and is required to file annual accounts and returns publicly, as well as filing a corporation tax return with HMRC. Start-up and ongoing costs are therefore more significant than for a partnership. An independent audit is compulsory for companies whose turnover exceeds a certain level.

A company with a single class of ordinary shares offers less flexibility regarding division of profits and surplus assets than partnerships. More sophisticated structures involving separate classes of shares can be created, but are potentially complex to implement and will require professional legal input.

Tax treatment: Companies are liable to corporation tax on their profits, which are then extracted by shareholders through a combination of salary and dividends. Depending on the level of profit and the dividend/salary mix, the tax regime may be more favourable than the partnership/LLP option, however, professional tax advice should be sought on the most appropriate remuneration structure.

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