Legal Structure of a Business

According to Government statistics there are 5.9 million private sector businesses in the UK; of these:

• 5.82 million businesses are small businesses (0 to 49 employees).
• 35,600 businesses are medium-sized (50 to 249 employees).
• 7,700 businesses are large (250 or more employees).

Small and medium-sized enterprises (SMEs) account for three fifths of the employment and around half of turnover in the UK private sector. 76% of private sector businesses did not employ anyone aside from the business owner(s).

These ‘no employees’ businesses comprise sole proprietorships and partnerships with only a self-employed owner-manager(s), and companies with one employee, assumed to be an employee-director.

Figures from the Department for Business, Energy and Industrial Strategy state that 16% of all SMEs operate in the construction industry; professional, scientific and technical activities account for 15% of all SMEs; whilst 10% are in the wholesale, retail trade and repair sector.

Private sector businesses are not evenly distributed across the UK. Based on head office location, rather than location of specific branches/sites, London and South East England have considerably more businesses than any other UK country or region of England.

What is the legal structure of a business?

Identifying the right legal UK business structure is a crucial part of a business start-up. When you start a business, the structure you choose will have significant implications on the amount of tax you pay, the degree of your personal liability should the business fail, the amount of administrative work involved and even your ability to raise finance.

As your business structure clearly defines your legal responsibilities, it is essential to put the time into researching which structure is the best fit for you.

The legal business structure is something you need to decide at the outset, although you can change it later on if required. All business structures have advantages and disadvantages, depending on factors such as the size of your business, the nature of your business and your future plans for the business.

What are the main types of legal business structures?

There are three main legal forms of businesses in the private sector:

• Sole proprietorships or sole traders.
• Partnerships.
• Companies.

Sole proprietorships are the most common legal form of a business. At the start of 2019 the UK private sector business population comprised 3.5 million sole proprietorships (59% of the total), 2.0 million actively trading companies (34%) and 405,000 ordinary partnerships (7%).

The Office for National Statistics (ONS) figures state that just over three quarters of UK private sector businesses are non-employers, and the majority of these are not registered for either Value Added Tax (VAT) or Pay as you Earn (PAYE) taxes.

Partnerships are probably the simplest way that two or more people can get together to run a business. This way of running a business is very old, and the law governing it dates back to the Partnership Act 1890, which defines a partnership as “the relation which subsists between persons carrying on a business in common with a view to profit”.

This Act was followed by the lower profile but still used and relevant Limited Partnerships Act of 1907, but it was then almost a century before the next major piece of partnerships legislation arrived in the Limited Liability Partnerships Act of 2000.

HM Customs and Revenue (HMRC) records suggest partnerships account for around £150 billion of turnover a year and that around 7% of UK businesses are partnerships.

The majority of UK partnerships are small businesses, with 55% having business turnover under £75,000. However, there is a significant group of slightly larger business partnerships, 41%, that have turnover of between £75,000 and £1 million, and a very small number of major professional service firms operate as partnerships.

There are two types of company business structure that have limited liability:

• Private limited companies (Ltd).
• Public limited companies (PLC).

These businesses exist separately from their owners, who are known as shareholders. Employees are employed by the Ltd or PLC, and assets such as buildings or machinery, are owned by the Ltd or PLC.

This separate legal existence is known as incorporation. Any legal action is taken against the business and not the shareholders. Shareholders are only liable to lose the amount of money they have invested in the business therefore their liability is limited.

In addition to these main business structures there are a growing number of business organisations that are not in business for the money; instead their focus is on social or ethical objectives.

These include charities, co-operatives and social enterprises, which between them provide a wide range of goods and services and reinvest their profits into creating positive social change.

Why does the legal structure matter?

Getting your business structure right is important. One business structure is not necessarily better than another, but each has its own advantages and disadvantages.

Choosing the correct structure is an important decision as it will affect the way that your business is organised, your and your business’s legal obligations and tax position, filing requirements and your personal liability to third parties.

When thinking about which business structure will work for you, it may be helpful to consider the following:

• Who owns the business?
• Who do you want to manage the business?
• What is the tax position of each structure?
• How risk averse are you?
• Is personal liability a potential issue?
• What are the costs involved in setting up and running the structure?
• What formalities do you want to deal with?
• Is a structure with increased formalities worthwhile at this point in your business’s lifecycle?
• Are you happy for certain information to be made public?
• Are exit strategies important to you, for example, are you likely to want to sell your business in the future?

What is the legal business structure of a sole trader?

A simple and agile business structure, but it can incur a lot of personal risk. Sole traders are individuals who run a business on their own with no separate legal personality or limitation of liability and no legal formalities or administration or filing requirements.

There is no separation between the management and ownership of the business, the sole trader owns all the assets personally and has full control over the business. Sole traders often rely on their own savings and perhaps secured business loans to start their business.

Costs to set up as a sole trader can be fairly minimal depending upon the type of business you are establishing; however, this business structure exposes you to more personal risk than other business structures, so it may not be suitable for a high-cost start-up.

A sole trader is considered to be ‘self-employed’. This means you must register with HM Revenue and Customs (HMRC) for self-assessment as soon as you start trading as a sole trader. You will pay income tax, make National Insurance (NI) contributions through self-assessment and will be individually responsible for paying these.

A sole trader gets the benefit of the personal tax-free threshold; however, you will be taxed at basic and higher tax rates for the profit you generate. As your profit increases, it may cease to be beneficial to remain as a sole trader.

A sole trader runs the business as an individual in their own name, although many choose to use a trading name for the business.

However, even with a trading name the business is not a separate legal entity. Sole traders receive 100% of any profit but also bear 100% of any loss and are responsible for all debts and liabilities of the business.

This means that you are personally responsible for any debts incurred by the business. This is sometimes referred to as unlimited liability. As a sole trader, you have personal liability for any business debts and any contractual obligations. An example of this might be leasing premises for a business on a two-year lease, the business fails within the first year, however, the sole trader is liable for the ongoing costs for the length of the lease.

If the sole trader defaults then the creditors can ask the courts for payment or to seize and sell personal assets to pay the money owed. These assets can include personal property, cars, in fact anything of value.

There is minimal red tape for a sole trader, there is no need to register the business with Companies House, there are no incorporation or ongoing filing requirements and your business accounts can remain private. A sole trader, however, may wish to register for VAT and some trades may require other regulatory obligations to be fulfilled. You can set your own policies and working practices and employ staff within UK employment law.

Because you can make decisions alone, it can be quick and simple to make changes to the business to adapt to changing circumstances, for example, you can change your pricing structure or change the products or services that you offer, adding new products or services or removing those you don’t have faith in.

This ability to make swift decisions and implement them quickly can be a key advantage for a sole trader in a competitive, quickly changing market. As well as being the sole decision maker, a sole trader will generally be close to their customers and can therefore be sensitive to the needs of their clients, attuned to their requirements and able to react quickly and decisively to them. A sole trader can build up trust and confidence based on personal service.

However, there are some organisations that can’t or won’t do business with sole traders; many businesses will want the extra reassurance that comes with being incorporated as a limited liability company.

As a rule, banks and other investors are wary of dealing with sole traders, again because it is a risky business structure, so raising finance to expand may prove difficult.

Winding down and closing your business as a sole trader is a relatively simple affair. A sole trader business can be wound down by settling any liabilities, collecting monies due, keeping or selling any physical or proprietary assets, distributing any residual monies to the owner and finally notifying HMRC.

What is the legal business structure of a partnership?

Partnerships are often found in professions such as solicitors, architects, accountants and doctors, but can be found in any type of business activity. They are a streamlined set-up for business partners who know and trust each other well.

Partnerships fall into three categories:

• Ordinary or traditional partnerships.
• Limited partnerships.
• Limited liability partnerships (LLPs).

Before setting up any partnership there are a number of important things to work out before you start your business.

These include:

• The percentage ownership of each partner.
• Who contributes what into the partnership, and whether those assets belong to the partnership or not if the business is later sold or wound up.
• How profits and losses will be allocated.
• How decisions will be made at meetings, and possibly whether any partner has a casting vote or more say on a particular matter.
• The principal duties of each partner.
• The limits of authority of each partner who makes decisions by themselves, for example you might agree that no partner can borrow or make an order for more than £1000 without the agreement of the others.
• The procedure for admitting a new partner.
• The procedure for removing a partner from the partnership, or what happens when a partner decides to leave.

Ordinary or traditional partnerships

An ordinary or traditional partnership does not have any legal existence distinct from the individual partners. If a partner resigns, goes bankrupt or passes away, the partnership will need to be dissolved; however, the business can continue.

Using this type of partnership is a reasonably easy and fast method for two parties or a group of people to set up, own and manage a business. There is no upper limit on the number of partners permitted to join the partnership.

An ordinary partnership is similar to the sole trader structure, except that there are at least two business owners. Each partner registers as self-employed and submits a separate tax return; the tax and NI obligations are similar to those of a sole trader.

Ordinary partnerships are governed by the Partnership Act 1890 and many partnerships will have a partnership agreement. This sets out the various rights and responsibilities of individual partners, including stating any specified split of profits, decision-making processes and the procedure to take in case a partner leaves the partnership.

A mechanism for dealing with disagreements between the partners or deadlock situations should also be covered in the partnership agreement.

An ordinary partnership set-up is simple and very flexible, and there is no requirement to publish company accounts. An ordinary partnership has no incorporation or ongoing filing requirements, although it may be registered for VAT.

They are ‘transparent’ for tax purposes, and tax liability falls on the partners who are taxed on their share of the profits or losses of the ordinary partnership. Any profits will be shared between the partners and all of the partners are personally responsible for any losses, debts and liabilities of the business.

As a result, a third party could reclaim the whole of any debt from one single partner, in other words creditors may claim a partner’s individual assets to pay back debts, including debts built up by another partner. Should a partner leave the partnership, each of the partners left within the partnership may be jointly liable for the total sum of any debts incurred by the partnership as a whole.

There are a number of advantages of the ordinary partnership structure over that of a sole trader. These include a wider range of skills, greater availability of capital, shared decision-making, and pressure is likely to be reduced with different partners having separate key roles. However, capital can still be limited, with the same problems of raising external capital that a sole trader has.

Also, the more partners there are, the more money there may be available from their combined resources to invest into the business, which can help to fuel growth, and together their borrowing capacity is also likely to be greater.

In an ordinary partnership, the partners both own and control the business. As long as the partners can agree how to operate and drive forward the partnership, they are free to pursue that without interference from any shareholders. This can make a partnership business potentially more flexible, with the ability to adapt more quickly to changing circumstances.

Unless a formal partnership agreement has been drawn up, an ordinary partnership business can easily be dissolved at any time: this gives each partner the freedom to choose to leave if they wish to.

Partnership agreements need to be legally dissolved. If a partnership agreement has to be dissolved on the death of a partner this can cause complications in re-establishing the partnership.

Limited partnerships

A limited partnership is registered in accordance with the Limited Partnerships Act 1907. An English limited partnership must be formed between two or more persons and must carry on a business in common with a view of making profit.

Unlike an ordinary partnership, a limited partnership has two categories of partner:

• One or more general partners who manage the business of the partnership and are liable for all debts and obligations of the firm.
• One or more limited partners who do not participate in the management of the partnership and who have limited liability for the debts and obligations to third parties beyond the amounts they have contributed.

Limited partnerships must be registered at the Registrar of Companies, Companies House. Until registered, both types of partners are equally responsible for any debts and obligations incurred. It is usual to register immediately after the partnership agreement has been signed.

Most limited partnerships are limited to a maximum of 20 partners and each partner must separately register for self-assessment with HMRC. However, under section 717 of the Companies Act 1985 there are a number of exceptions to this rule; they relate almost exclusively to professional partnerships.

Limited liability partnerships

Limited liability partnerships (LLPs) are a popular choice for large partnerships providing professional services, for example, firms of accountants, architects or solicitors. A limited liability partnership does not have shares or shareholders, but instead has members.

An LLP is a body corporate with a legal personality separate from its members, primarily governed by the Limited Liability Partnership Act 2000. LLPs must also comply with various regulations, such as the Limited Liability Partnership Regulations 2001 and the Limited Liability Partnerships (Application of Companies Act 2006) Regulations 2009. These regulations modify and apply parts of the Insolvency Act 1986 and the Companies Act 2006 to be relevant for LLPs.

As an LLP, you must complete the registration process with Companies House. You should also consider creating an LLP agreement with the other partners. This document sets out how the business will be run, the rules for sharing power and the rules for sharing profits. LLPs must nominate a minimum of two designated members who will take on legal responsibilities such as filing the annual accounts. You will be required to file accounts and send an annual return to Companies House.

Accounts will be made public by Companies House, which means anyone can view them. There is substantial paperwork to complete, therefore, employing an administrator to manage this may be appropriate.

Each partner within the LLP must register as self-employed and file an individual tax return. The LLP itself will also file a partnership tax return, showing income and expenditure as well as detailing how profits and losses have been allocated between the members.

If the LLP employs people, it will need to operate a Pay as you Earn (PAYE) payroll scheme, make regular returns and pay income tax and NI that are deducted from the pay of employees to HMRC. If the LLP needs to register for VAT or chooses to register voluntarily, it will also need to submit regular VAT returns and make payments of VAT to HMRC.

The key advantage that an LLP provides over a traditional partnership, is that of limited liability of the members. The liability of each member is limited to the value of their investment in the partnership. That means the members’ personal assets won’t be at risk, unless they are guilty of wrongdoing or have provided personal guarantees.

What is the legal business structure of a private company?

There are currently over 3.5 million limited companies incorporated in the UK. With over two million registered at Companies House, private companies limited by shares are the most frequently used type of company in the UK.

They are more commonly referred to as private limited companies and must have the word ‘Limited’ or the abbreviated suffix ‘Ltd.’ at the end of their name. A limited company has one or more directors, has its own bank account(s), pays its own kind of tax, corporation tax, can be bought and sold in the form of shares, and must be registered at Companies House.

The Companies Act 2006, fully effective from 1 October 2009, made a number of changes making it easier to run a limited company. It is very easy to start a limited company and it can all be done online in just a few hours. However, if you choose not to use ‘limited’ in your company name you must register by post.

The company will usually be registered within 24 hours of receipt of your application, if you do it online; postal registrations can take up to 10 days. It costs £12 to register your company online, and postal registrations normally cost £40, though you can pay £100 for a same-day postal registration if you wish.

The cost of incorporating, that is the name given to the creation of the new limited company, is an allowable expense against corporation tax. When you incorporate a business at Companies House and it is entered onto the register, it becomes separate from the person who owns or manages it – it becomes a legal entity in its own right.

Once you have registered your company, a ten-digit Unique Taxpayer Reference (UTR) will be posted to your company address within a few days. You will need this, so keep it safe. You will also receive a ‘certificate of incorporation’, confirming that the company legally exists. This document also includes the company number and date of formation.

You can set up a limited company in which you are the sole employee and only director. Your company must have at least one director and at least one shareholder, that is you, but it can have several directors and/or shareholders.

Directors collectively agree decisions for the company, must follow its rules and have ultimate responsibility for filing the accounts and ensuring the company pays its corporation tax. Shareholders typically vote on decisions at shareholder meetings, with one share equalling one vote, so majority shareholders have more influence.

A shareholder with more than 25% of the shares is a ‘person of significant control’ (PSC).

As a director you will have some legal responsibilities, including managing accounts and informing other shareholders if you stand to benefit personally from any company transactions.

At the end of your financial year you must report key information to HMRC and Companies House. This ensures that the company pays the tax it owes, and also provides accurate information about the company to its shareholders, investors, creditors and the general public.

You will need to file a company tax return annually, by the deadline given to you by HMRC. You will also need to register for PAYE if the company pays any salaries, including your own as director. Your company may also need to register for VAT, or you may wish to do this even if you don’t have to.

There are two main ways in which you as director can take an income from your company. You can take a salary, or you can pay yourself dividends out of company profits.

Most directors choose a combination of the two, as this can be the most tax efficient. The advantage of a salary, however, is that it entitles you to various other benefits such as the state pension and maternity/paternity benefits and doesn’t require the company to be in profit to pay you, although it is taxed at a higher rate.

One of the main reasons why this particular type of company set-up is so popular is that the amount for which shareholders are liable in the event that the company is wound up is limited to the reserves of the company.

Most contractors choose to operate as companies, as it reduces the risk that their clients will have to treat them as employees for tax and legal purposes. It also protects contractors from heavy personal losses if they are sued by clients.

Forming a company also opens up more ways to fund your business through private equity funding; that is, selling shares in your business.

The formation of a private limited company can suggest that the business has permanence and is committed to effective and responsible management.

It gives both suppliers and customers a sense of confidence and many companies, particularly larger businesses, will not deal with an entity that is not a limited company. Incorporating a business can therefore open up new business opportunities that would not otherwise be available.

What is the legal business structure of a public limited company?

A public limited company (PLC) is a limited liability company, formed in a similar way to a private limited company under the Companies Act 2006, that has chosen to raise capital by offering its shares to the general public.

They both have constitutional documents under the Act, that is, a memorandum and articles of association that have to be filed at Companies House and govern the way the company is run. The shareholders have limited liability for the debts of the business.

There are slightly different requirements for a public company than a private company, for example, a public company must have at least two directors and a company secretary, whereas a private limited company is only required to have one natural director and there is no requirement to have a company secretary.

UK company law says that a PLC must have the PLC designation after the company name and minimum share capital of £50,000.

There are also more complex accounting and reporting requirements for a PLC. If a PLC is listed on a stock exchange, for example, but not limited to:

• the London Stock Exchange;
• the New York Stock Exchange (NYSE);
• NASDAQ, an American stock exchange based in New York City;
• the Tokyo Stock Exchange, abbreviated as Tosho or TSE/TYO; or
• the Bombay Stock Exchange (BSE).

There will be further reporting, corporate governance and disclosure requirements placed on it, so that potential buyers can understand the risks of their investment.

The biggest advantage of forming a PLC is that it grants the ability to raise capital by issuing public shares. A listing on a public stock exchange attracts interest from hedge funds, mutual funds and professional traders as well as individual investors. That tends to lead to increased access to capital for investment in the company than a private limited company can accrue.

Another advantage is that a PLC can offer investors a certain amount of liquidity in that investors can sell their shares fairly quickly, particularly if the shares are trading on a stock exchange.

If a PLC is planning to expand its business, it can issue shares to the public to fund activities such as:

• Buying property.
• Paying off its debts.
• Starting a new project.
• Engaging in research and development (R&D).
• Creating a new line of business.

However, PLCs are vulnerable to hostile takeovers, that is a takeover of one company called the target company by another called the acquirer. The takeover is accomplished without the agreement of the target company’s management.

Instead, the acquirer approaches the company’s shareholders directly or fights to replace the management by acquiring shares to get the takeover approved. PLCs are also liable to instability in share valuation as the company is at the mercy of the financial markets, meaning that the value of the company can go up or down.

How should you choose?

Choosing the right legal structure is a necessary part of running a business, whether you are just starting out or your business is growing.

Choosing the right legal structure for your business starts with analysing your business goals. By defining your goals, you can pick the legal structure that best fits your business.

As your business grows, you can change your legal structure to meet your business’s new needs.

Some of the questions to ask yourself might be, am I looking for a business structure that:

• Is easy to set up?
• Has low costs?
• Is easy to run?
• Has flexibility?
• Provides privacy?
• Is tax efficient?
• Provides personal protection?
• Has scalability?
• Is suitable for the future?
• Is easy to exit?

Don’t take this very important decision lightly, and don’t make a choice based on what somebody else has done. Carefully consider the unique needs of your business. You may want to seek expert advice before settling on a particular legal business structure.

Changing to a different legal business structure

Although it is important to get your business structure right from the start, remember that things may change in the future and what is right for you as you are starting out may not be the structure that the mature version of your business needs.

Many famous companies started as sole proprietorships and eventually grew into multimillion-pound businesses, for example, Ingvar Kamprad owned IKEA as sole proprietor building a global furniture business from a single general goods store in rural Sweden.

Many small businesses and self-employed people start out as sole traders because it is the easiest legal structure to set up, especially when you are keen to get going with your new venture or you want to test the market. As the business grows, some small business owners make the change from sole traders to limited companies.

Here are some key steps you will need to take if you are changing your business from a sole trader to a limited company:

• Decide whether you will be the sole director or whether you want to bring in others.
• Tell HMRC your legal structure has changed; this is very important because changing legal structure affects the amount of tax you need to pay.
• Choose a name for your limited company.
• Register your business with Companies House – to do this you will need to create your memorandum and articles of association.
• Set up a new business bank account for your limited company.
• Tell your insurer your legal structure has changed.

It is important to take professional advice about the best option for you and your business if you are considering changing the legal business status.

Why change your business structure?

As businesses grow, evolve and change, it may make sense to change the legal structure of your business. In the vast majority of cases, small businesses change from a simple business structure such as sole proprietor or ordinary partnership to a more complex one such as a limited company or limited liability partnership.

The main reasons small businesses consider changing their business structure are:

• Increasing the number of employees – Employees come with liability and business owners want the protection offered by a limited company or LLP, rather than being personally liable.
• Protection from liability – In addition to the liability that comes with employees, businesses may be liable for injuries to customers, for loans, business debts and for other issues. By switching to a more formal business structure, business owners can protect their personal assets from that liability.
• Allowing outside investment or finance – Anyone who wants to buy a portion of a business as a shareholder, become a partner or lend large sums of money is going to require a formal business structure to protect their investment. A formal business structure such as a limited company or LLP involves setting out clear rights and responsibilities at the outset.
• Expanding client base – Many larger organisations will only do business with limited companies or LLPs; this is usually due to the level of risk involved in the contracts they award.

In conclusion

It is not always easy to decide which legal business structure to choose, as you need to consider your business’s financial needs, risk and ability to grow. Give it careful analysis in the early stages of forming your business, although you can always change the legal business structure if you need to.