How to choose the right business structure

When you start a business, there are several different ways you can choose to operate. Each option has different tax treatments and rules, so choosing wisely for your needs is important.

Even if you’ve been self-employed for some time, it’s often the case that as your business grows and changes, the most appropriate structure changes too.

The three main options are sole tradership, partnership, or setting up a limited company. Depending on the size of your business, how much you’ll earn, and what kind of industry you’re in, there are different pros and cons to each approach.

Here we explain the main difference between the three, and how to work out which will be the best fit for you.

Sole trader

Sole traders own their businesses outright, and do not have any partners. In this set up, you’re responsible for all the decisions and your company are legally considered as one entity. It’s the most straightforward and most common structure used by self-employed individuals and small businesses. You get to keep all of your business’ profits after you’ve paid income tax on them, but you’re also personally responsible for any losses.

Tax rules

Sole traders must pay:

• Income tax on all profits at the marginal rate.
• Class 2 and Class 4 National Insurance
• VAT – if you earn more than £85,000 per year (you can choose to register for VAT if you earn less than this)

The advantages are:

• it’s quick and easy to set up
• less admin than with a limited company
• you keep all your profits after income tax
• you can start trading immediately, subject to any insurance or licences you need
• you can still employ staff
• you retain complete control of your business
• your accounting can be more straightforward – HMRC calculates your tax after you submit an annual tax return.

The disadvantages are:

• you are personally responsible for your company’s debts - in the worst-case scenario, you could be made bankrupt, and your personal assets (such as your home) sold to pay your creditors
• you are personally responsible for any legal issues your company has
• you may be missing out on tax advantages – you can’t defer profits to future years, for example and you can’t claim dividends.
• It is harder to pass on the business through inheritance or sale
• You must keep records of your business income and expenses. HMRC lists everything you’ll need to track

If you decide to set up as a sole trader, ensure you notify HMRC within three months of beginning trading. You may also need business insurance to cover your venture – see our guide to insurance for traders and local businesses for more details.

If you’re thinking of starting up as a sole trader, HMRC has a helpful step-by-step guide to walk you through the process and everything you need to do.

Partnerships

Partnerships can operate in a similar straightforward way to a sole-trader structure – only there is more than one owner involved. Each owner is jointly responsible for the debts and bills of the business. If one or more partners leave the business, then the remaining partner(s) are responsible for all debts. Partners also share the profits from the business, with each partner paying tax on their share.

A partner isn’t always a real person. For example, a limited company counts as a ‘legal person’ and can therefore be a partner.

Find out more about setting up a partnership in the HMRC guide.

An alternative partnership structure, which provides more protection against personal bankruptcy, is a limited liability partnership (LLP). This is a more complex business structure and must be registered with Companies House, where all basic business information must be on public record – much like a limited company.

You need to have a have an LLP agreement that says how the LLP will be run. This should include details explaining:

• how profits are shared
• how decisions are made and who needs to agree on them
• the responsibilities of each member
• how members can join or leave the LLP

You also need to follow certain rules about naming your partnership, and you will need a registered address.

Again, the government has a helpful guide which lays out all the steps you must take when setting up a limited liability partnership.

Some businesses start out as a simple partnership, but then choose to change status to a limited company or a limited liability partnership.

Whether you plan to run your business as a simple or limited liability partnership, you should ensure you have a partnership agreement in place to create the correct legal framework for the business.

You can use an off-the-shelf template, which you can find online, but it’s probably a good idea to take legal advice. See our article on how to find a lawyer for more information. It’s important that all partners share the same goals for the business and will work together to achieve them.

The advantages of a partnership are:

• you share the responsibility
• you share the risk
• you have access to the skillset of each partner

The disadvantages of a partnership are:

• you will lose some measure of control over your business structure
• if the partners’ business goals are not compatible, it can lead to a difficult working environment
• You may be missing out on valuable tax advantages that you would get by incorporating

Limited company

A limited company is legally separate from the individuals who set it up, so it is responsible for its own debts. If things go wrong, it’s the company that goes bust, not you – as long as you can establish that you have run the operation legally and in good faith.

Limited companies can also add to your credibility if you’re dealing with other businesses. On the downside, you are required to submit annual accounts to Companies House, and there is an increased level of administration and government regulation to deal with.

Limited company directors must pay:

• Income tax
• Dividend tax
• National Insurance

You can read more about your responsibilites as a company director on Companies House. 

The company must pay

• Corporation tax
• VAT – if it earns more than £85,000 per year (you can choose to register for VAT if you earn less than this)
• National insurance contributions
• Pensions (if you employ people)

The advantages of limited-company status are:

• the separation of your personal and business finances – you won’t go bust if your business goes under
• increased credibility with other businesses – limited-company businesses can be seen as more substantial than sole traders, partly because of the complexity involved in setting up and running them
• the ability to keep profits within the business. This can reduce your tax bill, as corporation tax on profits is generally lower than income tax for individuals or partners
• you can reduce your tax bill by paying small salaries and high dividends, which aren’t liable for National Insurance contributions
• it can be easier from a legal or a tax perspective to sell an incorporated business when you retire or die than it is to sell a sole trading or partnership structure
• you can raise money from outside shareholders via the Enterprise Investment Scheme, which gives tax breaks to investors in small unquoted companies.

Disadvantages of limited-company status are:

• you will have to register the business and pay annual fees to Companies House
• increased administration and government regulation
• your business’s accounts may be more complicated and costly to produce, requiring auditing, even if your turnover is low
• you business accounts will be public
• you have to make National Insurance payments both as an employer and as an employee if you draw a salary above £153 a week.

If you’re considering setting up a limited company, use the government’s step-by-step guide. There are lots of things to remember, from choosing a company secretary, to identifying people with significant control over the company. You’ll also need to keep records, but gov.uk has a helpful list of what’s needed. It may be worth employing an accountant to carry out the set up process for you, and to file company accounts when needed.

You can also register for email reminders from Companies House to help you keep on top of when your company’s accounts and confirmation statements are due. Plus other useful tips. 

Review your business structure

Remember to keep your business structure under review as it develops. It’s relatively straightforward to switch from sole-trader status to a partnership or a limited company. However, you may wish to consultant an accountant before taking this step. If you don’t already have one, see our article on finding an accountant for tips on finding one that suits your business.

If you do change your business structure, you will need to amend all paperwork to reflect the changes, and also your website, in line with The Companies (Trading Disclosures) Regulations 2008 and e-Commerce Regulations.

Any Which? Trusted Trader changing its business structure will need to sign a new agreement with us, as a new legal entity. Which? Trusted Traders would also need to see its accounts after six months of trading activity.

It’s a good idea to clearly state the name you were formerly trading under on your Which? Trusted Trader profile page, so consumers can see any change of legal entity.