This article was written by Michael Buckworth, a partner in Buckworth Solicitors. Buckworth Solicitors is a London based law firm specialising in assisting start-ups on a range of matters. The firm works solely on the basis of affordable fixed fees. Michael worked at two of the world’s best law firms for eight years before setting up Buckworth Solicitors at the start of 2011.

This article was written by Michael Buckworth, a partner in Buckworth Solicitors. Buckworth Solicitors is a London based law firm specialising in assisting start-ups on a range of matters. The firm works solely on the basis of affordable fixed fees. Michael worked at two of the world’s best law firms for eight years before setting up Buckworth Solicitors at the start of 2011.

One of the first decisions faced by an entrepreneur relates to the choice of legal structure. Many start-ups choose the limited company. It provides limited liability, offers tax savings as long as profits are correctly dealt with and is relatively simple to set up and use. But is incorporating necessarily the best route for a start-up?

What are the options?

There are many structures through which businesses can operate including public limited companies, unlimited companies, community interest companies, co-operatives and franchises. However, the four most common business models are registration as a sole trader, formation of a partnership, incorporation of a limited company and incorporation of a limited liability partnership (LLP) at Companies House.

Registration as a sole trader

An entrepreneur can start trading as a sole trader immediately. A sole trader owns and controls 100 percent of his business and is entitled to use any income from the business as he sees fit (subject to paying tax on it).

A sole trader is self-employed. Profits earned by him are taxed as income by HMRC through the self-assessment system. Although a sole trader is required to register with HMRC for self-assessment and complete a tax return each year, there is no requirement for him to publish annual accounts or produce any additional documentation other than that required by HMRC for tax or VAT purposes.

While the profits of the business are small, the tax rates will be low. Even better, sole traders can deduct business expenses including the cost of any office (even if the entrepreneur works from home). However, once profits exceed £35,000, those profits will be taxed at 40 percent; once profits exceed £150,000, those profits will be taxed at 50 percent. Sole traders are also required to make National Insurance Contributions (NICs).

The biggest disadvantage of becoming a sole trader is that the entrepreneur is personally liable for the debts of the business. If the business becomes bankrupt, creditors will seek to seize the entrepreneur’s personal assets. If someone successfully sues the business, the entrepreneur may be declared bankrupt. For this reason, sole traders tend to be small, simple, low risk businesses such as hairdressers, photographers, private tuition providers and coffee shops.

Formation of a partnership

Partnerships represent an extension of the sole trader structure. They are formed when two or more people come together to run a business in their own names. As with sole traders, partners are self-employed and are taxed on income through the self-assessment system. Partners are required to pay Class 2 NIC and Class 4 NIC at 9 percent on profits between £7,225 and £42,475 and 2 percent on profits thereafter.

Partnerships are generally governed by a partnership agreement. It is advisable to seek legal advice prior to drafting a partnership agreement. As with sole traders, liability is unlimited and the partners will be jointly and severally liable for all debts of the business.

Incorporation of a limited company

A company limited by shares is a separate legal person. It can enter into contracts in its own name and (subject to any personal guarantees given by directors or shareholders) the liability of its shareholders is limited to the face (or nominal) value of their shares. A limited company can be wholly owned and managed either by one person or by multiple people. Different shareholders can own different proportions of the company and can have different rights.

An entrepreneur can incorporate a limited company himself without legal advice by completing a form IN01 and signing a Memorandum of Association, each available for free on the Companies House website. A filing fee of £40 (£18 if filed online) is required to be paid to Companies House.

The tax regime applicable to limited companies is more favourable than for sole traders. Small companies with an annual profit less than £300,000 pay corporation tax on their profits at 20 percent. Shareholders can draw money from the company by way of salary or dividend. Salaries are taxed at the recipient’s marginal rate and the Company and recipient will be required to pay NICs.

However, so long as a director shareholder has no other source of income, he can draw a salary of up to £7,225 per year which should be income tax free (by using up his personal allowance). Further at this level no NICs will need to be paid and the company would be able to claim tax relief on the salary.

Dividends are paid from income after corporation tax has been deducted and carry a deemed tax credit of 10 percent. There should be no further tax liability in the hands of the recipient unless he is a higher rate taxpayer in which case tax will be charged at the dividend rate which is a rate approximating his marginal rate of tax.

Limited companies offer flexibility of structure and a beneficial tax regime. However the disadvantage of the limited company is the ongoing compliance burden. Companies are required to file annually with Companies House statutory accounts and a return confirming the directors and shareholders of the Company.

Incorporation of an LLP

LLPs are a hybrid vehicle combining the benefits of limited liability enjoyed by limited companies with the favourable tax treatment afforded to partnerships. As with a limited company, an LLP is a separate legal person and can enter into contracts in its own name. There must be at least two members, but there is no maximum limit on the number of members. Liability of the members is limited to their capital contributions to the LLP. Members can agree different entitlements to profits. However, unlike a limited company, each member of an LLP is self-employed and is taxed on his share of profit.

LLPs must be incorporated at Companies House using form LL IN01 (PDF, 900kb). It is generally advisable to seek legal and accounting advice before incorporating an LLP. Other than in exceptional cases, an LLP agreement governing the management of the LLP and the split of profits will be required. Like limited companies, LLPs are required to file annual accounts at Companies House.