In an ideal world every fresh-faced entrepreneur would have a thorough grip on the UK tax system and know exactly which business structure will suit their business venture. Unfortunately, it’s not always quite that simple.
Confusing legislation and loopholes mean many entrepreneurs enter the business world underprepared and vulnerable to HMRC fines and investigations. This is why starting your business with a distinct understanding of the differences of each business structure is vital.
Business structures are one of the most crucial aspects of forming a business. They will determine how you trade, how other businesses interact with you and most importantly, how you’re taxed.
If you’re looking to set up a company you need to be aware of all the implications of each business structure in regards to profits and loss, tax, liability and how accounts are filed.
Here is a run-down of each of these aspects in regards to the most popular business structures; sole trader, limited company and a partnership.
Sole trader is one of the most common business structures, not only because it’s the easiest and cheapest to set up, but because there is also a lot less red tape to work around in the long run. A sole trader is defined by one individual being responsible for the business.
While becoming a sole trader seems the easiest way to set up a business, sole traders’ are fully liable for any business losses. There may also be certain businesses that refuse to operate with sole traders for multiple reasons, one of which may be for fear of being within IR35.
As a sole trader you will pay Income Tax on all earnings above the Personal Allowance rate (£11,000 for 2016/17). The rates for Income Tax are 20% on income up to £43,000, 40% on income between £43,001 and £150,000 and 45% on income over £150,000.
As well as Income Tax, sole traders must also pay Class 2 and Class 4 National Insurance Contributions (NICs).
Sole traders must file an annual Self Assessment tax return to HMRC in order to have their Income Tax collected. This must be submitted by January 31st to avoid any fines.
Limited companies are a great option for entrepreneurs who don’t want to be liable for any losses the company experiences. They are also a more flexible and tax efficient structure than a sole trader, handy for businesses that expect to grow quickly.
Before setting up as a limited company you will need to decide who the directors and shareholders of the company are and choose a company name that is not already taken.
While it costs slightly more to set up as a limited company than as a sole trader, it may be worth the extra expense. Directors of a limited company are viewed as a separate legal entity from the business and therefore their personal assets are not at risk. However, there are exceptions for circumstances regarding the law, such as fraud or if personal guarantees were made.
While the company pays 20% Corporation Tax on taxable income, directors are treated as employees, and therefore pay Income Tax and NICs as an employee would. Directors who are also shareholders may also be paid through a combination of salary and dividends to reduce their tax NICs liability.
As the director of a limited company you must complete a Company Tax Return to be submitted within 12 months of the end of the company’s financial year to HMRC. You will also need to complete a set of annual accounts (also known as statutory accounts) which will be filed with Companies House.
If a sole trader or limited company doesn’t sound like the right business structure for you, you may instead benefit from becoming a partnership. Setting up a partnership is a simpler process than setting up a limited company and it is easy to start up and close down a partnership as the tax process is straightforward.
There are three types of widely recognized partnership; general partnership (GP), limited partnership (LP) and limited liability partnership (LLP). LLPs are often the most popular form of partnership due to the extended protection they offer members, although the suitability to your own business will be dependent on a number of factors.
Partnerships require two or more individuals to share ownership of the company; including profits and losses.
Partnerships are often advised as a structure best suited to businesses whose net profit is under £28,000. Above this amount and it is usually more tax efficient to trade as a limited company.
In a partnership you are not protected from debt liability, meaning personal repossession is a possibility in the face of the business’ debt. However if you are a member of an LLP, partners have limited liability and are not personally liable for business debts.
As a partnership you will not be required to submit abbreviated accounts or confirmation statements (formerly annual returns) to Companies House.
Partnerships are required to complete an annual Self Assessment tax return known as a ‘partnership tax return’. One partner becomes the ‘nominated partner’ and is responsible for handling all of the tax returns and keeping the business records.
Your Unique Tax Reference Number
If you choose to become either a limited company or a partnership, you will require a Unique Tax Reference Number or ‘UTR’. This will be your reference number to refer to in any correspondence with HMRC.
HMRC will assign your UTR number within a few days of your company being formed, and will confirm it in writing within 28 days.
Registering for VAT
If your company turnover exceeds £83,000 in the 2016/17 tax year, no matter which business structure you operate under, you will need to register for VAT.
Which structure is right for you?
The right business structure for you will depend entirely on how your company plans to operate and the clients you plan to trade with.
Factors such as the type of business, the number of people becoming members, tax liabilities, profit distribution and your personal preference all contribute in your decision to pick a business structure.
You should consider the industry you’re in and first create your business plan before you set in stone your business structure. This way you can decide which will best suit your needs.