What are the tax and liability consequences of adopting common small business structures?

There are many structures a business can take, each changing the extent of liability held by members and how its income is taxed. Small businesses are likely to take one of four common structures: Sole proprietorship, Partnership, Private Limited Company (Ltd), or Limited Liability Partnership (LLP).

Sole Proprietorship:

Also known as a sole trader, a sole proprietorship is an entity that includes no legal distinction between the owner and the business. The business is owned and run by a single person, although there remains the possibility to take on employees. Any earnings of the business are taxed as income, therefore subject to both income tax and national insurance, and kept by the owner after taxation. As the business’ turnover increases income tax becomes much higher than corporation tax (45pc over £150,000 rather than 21pc). As a result incorporation may be a more tax efficient route for a growing business. However the biggest disadvantage that a proprietorship carries is the complete liability maintained by the owner. The consequence of there being no legal distinction between the owner and the business is that any debts incurred by the business are incurred by the owner. That is to say, all personal assets, including housing and any savings, can be put at risk.

Partnership:

A partnership is very similar to a proprietorship but includes multiple members. As with the sole proprietorship all earnings are treated as direct income to the partners. Once again, the partners have complete liability for the business, regardless of which partner is responsible for expenditure. However, a partnership also will require a ‘Partnership agreement’ which should contain, at the minimum, a model for profit and loss distribution, description of each partner’s capital contributions, rules for dissolution and the admission or withdrawal of partners, and other rules such as voting procedures. The distribution of profit and loss can be used to create unequal responsibilities, there can be major and minor partners. The partnership agreement can also be used to prevent partners taking loans, which would be legally binding to all the partners, without a unanimous decision. An interesting point to consider may be that, as a partnership is simply a contract between multiple members, there are no issues with some or all of the members being private limited companies.

Private Limited Company:

A private limited company (Ltd) needs to be incorporated (registered at the companies house). An Ltd has, at the very least, one shareholder, who can also be a director. Unlike an unincorporated business, the company is treated as a separate entity to the shareholder(s) and director therefore liability for any debts the company incurs is limited. The most a shareholder can be called upon to pay is the face value of their shares. Incorporating an Ltd also offers some tax benefits. The profit of the company is taxed through corporation tax (20pc regardless of earnings since 1st April 2015). Employees can be paid salaries before corporation tax therefore facing equal income tax rates to the owner of a sole proprietorship however through shares dividends can be paid offering a more tax efficient alternative. Dividends can be taken out of the company’s profits and face a smaller dividend tax. Even though this dividend tax is taken after the corporation tax, it is more tax efficient to remove money from an Ltd through a small salary and higher dividend and more tax efficient to use an Ltd than operate as a sole trader. Although a private limited company is demonstrably beneficial for both liability and taxation it is far more complicated to create and maintain. Almost all Ltds will hire an accountant, perhaps too much of an expense for a small business startup.

Limited Liability Partnership:

A limited liability partnership (LLP) could be considered a combination of a general partnership and private limited company. An LLP carries the same advantages of liability as an Ltd but is taxed in the same way as a partnership. A partnership agreement is required as in a general partnership. The disadvantage of an LLP compared to a general partnership is the additional administrative duties however this seems a small cost when weighed against the significant safety the structure provides.

Adopting the optimal business structure in a situation is of the utmost importance to maximise the efficiency of a business whilst minimising risk. By developing a basic understanding of the most common structures the business sector can start to become more comprehensible and, if nothing else, the need to consult expert advice from accountants and lawyers should become clear.

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