Anyone starting a new business needs to decide which legal structure it will have, and before starting up should carefully consider the issues involved, including their own potential liability for any future business debts, and the tax implications of their chosen structure.
Different types of business such as franchises, co-operatives and not-for-profit organisations (which are not in themselves legal structures) can be set up as sole traders, partnerships or limited companies as appropriate.
What are the main types of legal status?
Sole traders (often referred to as a sole proprietors or sole operators) are treated by HM Revenue & Customs (HMRC) as self-employed for tax purposes and retain all their business profits after tax. A sole trader is personally liable for the debts of the business, which means that their home and other personal assets may be at risk if they are unable to pay the business's debts as they fall due.
Sole traders must register with HMRC for tax self-assessment as a self-employed person. They must complete an annual self-assessment return and pay income tax and Class 2 (and in some cases also Class 4) National Insurance contributions (NICs).
An ordinary partnership, usually simply known as 'partnership', is legally defined by the Partnership Act 1890 as two or more people 'trading in common with a view to profit' and is the format normally chosen for a business that will be owned by two or more sole traders. This kind of partnership does not have to be registered with Companies House.
Each business partner has unlimited liability for the debts of the business. Partners are 'jointly and severally' liable, so each can be held responsible for transactions or contracts entered into by any of the others.
Partners are treated by HMRC as self-employed for tax purposes in the same way as sole traders, and they retain and share all their business profits after tax. They do not all have to be individuals, as a private limited company is treated in law as a 'legal person' that can also enter into partnership.
It is essential, as best practice, to have a partnership agreement (also known as a Deed of Partnership) drawn up by a solicitor before starting to trade. The partnership agreement clarifies each partner's legal position and provides a framework for dealing with any problems that may arise. If there is no partnership agreement, the partnership will be governed by the terms of the Partnership Act 1890.
Private limited company
A private limited company has a separate legal identity to that of its owners, unlike a sole trader or a partnership where there is no distinction. This means that the owners of a company, who are called 'members', benefit from limited liability, and the company itself can own property and other assets, as well as sue and be sued.
A private limited company must be incorporated with Companies House and registered with HMRC. It can be limited either by shares, which means that the members' liability is limited to the money they have invested buying those shares in the business, or by guarantee, which means that the members' liability is limited to the amount they have agreed to contribute to the company's assets if the company is wound up.
Members of a company limited by shares are known as shareholders. Shareholders buy shares issued by the company when it is incorporated and may buy further shares at a later date. The money for the purchase of the shares is invested in the company. Shares in private limited companies cannot be publicly traded.
Directors, who may or may not be shareholders, are appointed to manage the company. Directors must be aged 16 or over but there is no maximum age limit. A person who is an undischarged bankrupt cannot be a company director. Directors are salaried employees of the company and must pay tax and National Insurance under Pay As You Earn (PAYE).
In practice, for most small companies, the shareholders and directors will be the same people. A private limited company can be set up with only one shareholder, who can also be the sole director. Under the Companies Act 2006, private limited companies are no longer required to have a company secretary, although they can still appoint one if they wish.
Limited liability partnership (LLP)
A limited liability partnership (LLP) is a common legal structure for.....