Helping business owners with mental health issues, Start Small but Dream Big
Company formation and structure
When starting a business, one thing that you need to consider is the legal structure that you will use at the time of its formation. There are a number of types, and which you choose will depend upon several factors. These are:
- The type of business
- The number of people involved
- The legal and financial responsibility/risk you are willing to take
- Tax implications
- The ongoing reporting and regulatory requirements
In my opinion, this is the order of importance, although you are welcome to disagree!
Types of structure
Although different countries have slightly different names or options, there are a number of formats that are common to most, if not all. These are:
- Sole trader / proprietor
- Limited Company / Corporation
- Limited Liability Company (LLC) or Partnership (LLP)
- Guarantee Company (Non Profit), known as a Co-operative in the USA
In addition, the United States has an option known as an S Corporation. I won’t be covering this, so for more information, please visit the SBA website.
Each of these formats has its advantages and disadvantages, which we will look at now. Please note that this article mainly refers to the UK tax system and, while there are similarities between countries, there are also differences.
Sole Trader / Proprietor
This is the simplest format and is suitable if you are the only owner of the business (having employees doesn’t preclude you from using this structure).
Apart from registering for tax purposes, there are no other reporting registration or reporting requirements other than filing your tax return once a year. Accounts are simple: simply deduct your expenses from your turnover to calculate your profit and, therefore, your income. This is what is taxed.
The downside is that you and the business are considered one entity. The business owner is liable for any debts meaning that their personal assets are at risk should things go wrong. When applying for credit for the business, decisions will be made on your personal credit rating.
A partnership is a legal entity comprised of two or more owners (this could include a limited company as a ‘legal person’). An agreement has to be reached detailing how the ownership, profits and liabilities are split, and what would happen should one partner leave. One partner must be a ‘nominated person’ to take responsibility for ensuring that all tax returns are completed, and records are maintained.
Taxwise and reporting wise, it is fairly simple. In the UK, the partners are classed as self-employed and required to file individual tax returns, with the individuals’ share of the profits classed as their income.
All partners are equally responsible for debts or liabilities incurred by the business by any partner. Partners are able to act individually on behalf of the business, meaning that they can incur debt without the knowledge of the other partner(s). However, each partner is responsible for the liability. I have personally seen the problems this can cause. In addition, the nominated person also carries the risk of sanctions should the other partners fail to meet their obligations.
A Limited Company is one that is limited by shares. It can be owned by just one person (a Director), and it is classed as a legal entity, and so separate from its owners.
The legal separation of owner from business means that their liabilities are limited to the amount paid, or unpaid, on their shares, so personal assets are protected. Lenders are likely to look more favourably on a Limited Company, as it is viewed as more professional.
In the UK, the income of Limited Companies is taxed at both company and personal levels. Directors are considered both employer and employees, and so have to pay both employee and employer national insurance contributions themselves.
Companies must also submit Company Accounts and a Confirmation Statement (Annual Return) each year to Companies House, which can be complicated and time consuming.
Limited Liability Company (LLC) or Partnership (LLP)
Many professional services companies opt for a Limited Liability structure. It combines the characteristics of a partnership with the protections of a Limited Company. There must be at least two legal persons listed as partners.
Like a Limited Company, the partners’ liability is limited to their share value. The tax system is fairly simple too, with partners paying tax only on their personal income, rather than on the business’ income as well. This structure may also make it easier to secure finance.
Like a Limited Company, accounts must be filed with Companies’ House on an annual basis.
Guarantee Companies are not-for-profit organisations. Any profits arising are reinvested back into the company, to continue the work towards achieving its aims. This structure is frequently used by sports and social clubs, charities, community groups, student unions, workers’ cooperatives, and social enterprises. Members are classed as guarantors, who pledge to contribute a very small amount should the organisation close with debts. Just like Limited Companies, there must be at least one named director, plus one named guarantor, although these may be the same person.
Liabilities are limited to a nominal amount, and shared among the members. The Limited status may help to secure funding more easily.
Memorandum of Association and Articles of Association must be completed and submitted at the time the organisation is registered. There are also annual reporting requirements, as with the Limited Company and LLP.
As discussed above, the legal structure that you choose for your business will depend upon several factors. Once you have thought about these and made an assessment, you can choose the best format for your business. However, whichever option you choose, it is possible to change it at a later date to reflect your changing needs.