If you have decided to start your own business recently then this question has probably not even crossed your mind yet, but from a legal standpoint it is quite an important issue. The legal form that your business takes will affect how much tax you have to pay, determine who can invest in your business and also could have consequences for your personal financial security.
There are three main aspects to choosing a legal form. The first of these aspects (and arguably the most important one) relates to your level of liability should anything go wrong. Corporations are viewed as legal entities which are separate from the people who own them. This means that only the assets of the corporation can be taken to pay company debts and not personal assets such as your house.
The second aspect is whether or not the legal form you have chosen will mean that you end up paying taxes twice – firstly on the profits of the business and then again on the personal income you receive from the business.
Finally, you must consider whether you plan on receiving investment into your business because some corporate structures are quite restrictive and would be unsuitable if you are expecting a large number of investors or some foreign investment.
Here is a brief rundown on the main legal forms that small businesses usually take, but it is always sensible to check with a professional before you make any final decision. Your choice may also be limited depending on which industry you plan to enter.
Sole Trader: This is the easiest type of business to set up and that is probably the greatest benefit of operating as a sole trader. The downside to this is that the business is not considered a separate legal entity from you so any lawsuit against the company would leave you at risk to lose everything. You are also taxed on all profit irrespective of whether you have drawn it from the business or not.
Partnership: This consists of two or more individuals joining together to run a business. Although the business is a separate legal entity, you are liable for all debts in a similar way to a sole trader (except they will be shared with your fellow partners). Any member of the partnership can sign contracts or obtain credit on behalf of the other partners. It is important to have a written partnership agreement when you first go into business together that will detail the minutiae of the role and authority of each partner, along with how profits will be shared and what happens if things go wrong. All individuals are taxed on their share of the partnership profits in a similar way to the sole trader.
Limited Liability Partnership (LLP): This requires a more formal approach to business and therefore generates a lot more red tape than the previous two legal forms. LLPs are a separate legal entity registered at Companies House which also means that your accounts have to be filed with them and are viewable by anyone. However, you benefit from having limited liability and are taxed the same as a normal partnership.
Limited Company: This is a separate legal entity with most of the legal rights of an individual, meaning lawsuits will generally be against the company and not you. A limited company needs permission from Companies House to use their proposed name and must adopt and file the Memorandum and Articles of Association – these govern its rights and obligations to shareholders and directors. It must also file annual tax returns with the Inland Revenue like an individual, but limited companies benefit from a low starting rate of tax.