How to choose the right business structure
When setting up your own business, there are a lot of things to consider. One of the most important decisions you’ll make early on is how your business will be structured.
To support you in making this decision, we have weighed up the pros and cons of the three main types of business structures in the UK. These are sole proprietorships, partnerships, and limited companies. Each business structure is distinct and can benefit you in different ways.
Why does my business structure matter?
How you choose to structure your business will affect you in many ways. Among other things, it will determine how much you pay in tax, the level of risk or liability to your personal assets (e.g. your house, personal savings), and also your ability to raise capital from different sources. This makes choosing the right structure a high priority when starting your business.
1. Sole proprietorship or sole trader
As the name suggests, if you set up as a sole proprietorship, it means that you, as the individual business owner, can operate the establishment alone. The business and you, the business owner, are essentially seen as one single entity by the law. This means that you can file all tax returns using your personal tax filing information.
If you wish to avoid time-consuming administrative tasks and higher costly fees when registering your company, you may opt to organise it as a sole proprietorship. This business structure allows you to focus on growing your business, rather than extensive paperwork and legal compliance.
Suppose you’re opening a bakery for example. A business like this can easily be maintained with just a few workers and only requires direct control from one person. This business structure is perfect for low-risk businesses and business owners who want to test their idea before forming a more formal business in the future.
Advantages of a sole proprietorship
The distinct advantage of this structure is that you can make all of the decisions alone; it gives you maximum control over the company. As a sole trader, you're seen as self-employed and therefore all profits are entirely your own.
Moreover, this simple business structure is fast and easy to set up and does not incur a lot of costs. To set up your sole proprietorship, you only need to register the trade name to secure the local business licence.
Disadvantages of a sole proprietorship
However, as a sole trader, you’ll equally be solely responsible for the losses of the business. If the business defaults to pay any debt it owes, the creditors can file a bankruptcy petition against you. This may have consequences for your personal assets.
As a sole trader, it may be a disadvantage for you that the business’ income and losses are taxed on your personal tax return. This means you’re not separated from the business. When naming the business, you may wish to use a trade name, rather than your actual name. But even if you do use a trade name, you and your business will still be treated as one entity.
You may also find it challenging to raise money for your sole proprietorship. Banks and other financing sources may consider you a risky investment and be reluctant to approve a loan. As a sole trader, you’re not able to sell shares as a way to start raising capital for the business. Often, sole traders are dependent upon their own financing sources such as savings, home equity, or loans from family or friends.
The partnership structure is an extension to the sole proprietorship structure. It’s created when a legal agreement is implemented, allowing two or more individuals to work jointly on a venture as co-owners, and in doing, share responsibility. In a partnership, all members contribute capital to support the business.
A partnership structure may suit you if the idea of setting up a business alone is daunting, or if you have a particular, experienced partner in mind who would benefit the company. Responsibility and liability will vary depending on the number of shares each partner has in the company.
A partnership structure means that all business partner owners act on behalf of the business. Profits should be shared according to the partners' shares in the business, and this should be noted in a partnership agreement.
There are two types of partnerships: general partnerships and limited partnerships
A general partnership is where all members actively participate in the daily operations and workings of the company. The partners manage the company and all assume responsibility for the partnership's obligations and debts, according to their stake in the company.
In a limited partnership, partners have different levels of responsibility and liability within the company. The general partners are responsible for the business’ daily activities and operations, and are personally liable for all debts incurred.
However, passive partners are only required to contribute a certain amount of capital to the business and aren’t liable for any debts. This means that passive partners have limited liability. They serve only as investors and have no control over the decisions within the business.
Generally speaking, limited partnerships aren’t ideal for new businesses, unless you expect to have many passive investors. They are administratively complex and require extensive filing. If two or more partners want to be actively involved, a general partnership is easier to form.
Advantages of a partnership business structure
It’s relatively easy to set up a partnership. It doesn’t require complex reporting and can easily be dissolved if necessary. If a partner wishes to leave the business, they can opt-out of the partnership and reclaim their share.
A big advantage of the partnership structure is the tax treatment it enjoys. A partnership does not pay tax on its income; rather any profits or losses are passed through to the individual partners.
Depending on your business experience and personal preferences, sharing business decisions and jointly directing the company can be either an advantage or a hindrance. A partner allows you to discuss issues, receive a second opinion and support you in your tasks. And as this person is financially and emotionally invested in the business like yourself, you’ll likely receive support from them in a way you wouldn’t if you simply outsource certain tasks.
Disadvantages of a partnership business structure
Yet, just like a sole proprietorship, personal liability should be a major concern. General partners are personally liable for the partnership’s obligations and debts.
Also, general partners can act on behalf of the partnership if permitted by the partnership agreement, without needing to consult other partners. Any decisions or loans that are taken by one general partner affect all partners. So, if one partner incurs a debt, all partners are responsible. This is known as ‘joint liability’ or ‘several liability’.
Partnerships are generally more expensive to establish than sole proprietorships as they require more accounting and legal services.
3. Limited company
Alternatively, you may choose to incorporate a limited company. This simply means registering your business as a limited company with Companies House. If you choose a limited company structure for your business, this is very different from a partnership or sole proprietorship.
Under this structure, the limited company and yourself, the owner, are separate legal entities. The business is therefore its own ‘legal person’ and is responsible for its own finances. Those who own company shares own and control the limited company.
Advantages of the limited company business structure
The distinct advantage of the limited company structure is limited liability. As an owner, you’re not personally responsible for the losses and debt of the business. This is a huge advantage: this structure allows you to conduct business without putting your home, your family and your lifestyle at risk.
Businesses with a limited company structure also enjoy substantial tax benefits. Limited companies are only required to pay 19% Corporation tax on profits, as opposed to the 20-45% Income Tax sole traders pay on their sole trader profits. This offers greater flexibility for tax planning.
If your business is structured as a limited company, your professional status and image will increase. Even though the activities, ownership structure and internal management may be the same, limited companies are held in higher regard than sole traders or partnerships, and as a limited company, you’ll give a better first impression.
The professional, corporate image of the limited company structure adds valuable prestige and credibility to your business. If your business is within sectors such as IT, construction and finance, you may find that companies are only prepared to work with other incorporated companies. Usually, this is due to the higher level of risk involved in the contracts that they award.
As a limited company, your company name is also protected. All company names must be unique and so, no two different companies can register with the same name or names that are very similar. The official name of your limited company can’t be used by another. Sole proprietorships don’t have this protection.
Disadvantages of the limited company business structure
But still, there are some less favourable aspects associated with a limited company business structure. After all, this is only to be expected from a structure that provides so many benefits.
If you structure your business as a limited company, it must be officially incorporated at Companies House, and this costs a registration fee. Companies House must be notified immediately of any changes you make to your company details. You also have to file a confirmation statement (which confirms the accuracy of certain information held on public record) every year with Companies House.
A Company Tax Return must also be sent to HMRC along with annual accounts. This type of business has far more complex and time-consuming accounting requirements; an accountant may need to help you with your tax affairs.
In general, if you adopt this business structure, the administration is far more complex. Any money withdrawn from the company needs to be accounted for accurately and you’d be required to keep official records, including the minutes of meetings and the decisions taken by directors and shareholders. These records need to be accurately maintained and you’d have to make them available for public inspection at your registered office.
Choosing to structure your business as a limited company is undeniably more complex. However, a lot of these disadvantages pale in comparison to the potential savings and professional growth you may experience. Financial protection also remains a considerable advantage, especially for riskier business plans.
Which business structure should I choose?
In the end, even though each business structure has distinct advantages, true success comes from the business itself, not just from its organisation. It’s also good to keep in mind that it’s possible to begin your business journey with one structure and switch to another at a later time. For example, you may decide to begin as a ‘sole proprietorship’ and then expand to a ‘limited liability company’ in the future.
Ultimately, it’s most important that you understand the type of structure you wish to adopt and therefore conduct your business legally and in accordance with tax regulations.