Anyone wishing to run a business in the UK has a wide choice of ways to organise it. Each possible structure has its own advantages and disadvantages. This post gives an overview of the three basic types of business structure that are commonly used.
Sole Trader – “One Man Band”
This is the simplest form of business.
A sole trader owns and runs his or her business directly – he or she is “self-employed”. All the risks and rewards are his directly, and all the decisions about the business are his.
If things go well he or she owns all the profits that have made (after having paid tax on them!).
However, if things go badly the sole trader is liable for all the debts of the business. We call this “unlimited liability” – if the sole trader’s business fails, his private property can be taken to pay off the debts of the business. In other words, even his personal wealth outside of his business is at risk.
In summary, there is no real distinction or ‘barrier’ between the individual and his or her “one man band” business.
Where two or more people own and run a business together, they are generally referred to as operating in partnership.
Like a sole trader, all the risks and rewards belong to the partners – but the crucial point is that, in an ordinary partnership, EACH partner is JOINTLY liable for ALL of the partnership’s debts.
If things go wrong, any money owed by the partnership business can be recovered from the partners themselves – and if one of them has no money to pay, the other partners will have to pay that person’s share of the debts as well. Like the sole trader, a partner’s liability is “unlimited” – even non-business personal wealth is at risk.
Note that the Scottish treatment for partnerships differs from the rest of the UK in some aspects of partnership law (although this makes little difference in terms of partnership taxation).
There are also some more specialised forms of partnership that can restrict a partner’s potential exposure or liability, which we shall cover in more detail below.
A Limited Company is a “legal person”. This means that it exists independently of its owners – its shareholders – and it can make contracts, and be sued for its debts in its own name and on its own behalf.
Here, the word “Limited” means that the shareholders’ liability is limited to the money they have invested in their shares. If things go wrong then, in the vast majority of cases, the worst that can happen to the shareholders is that they will not get their money back – though as we shall see, this is not always the case.
One of the key consequences of this legal distinction is that a company’s money does not automatically ‘belong’ to the shareholders in the way that it does with one man bands and ordinary partnerships, as noted above. Even if you own all of the shares in your own company, its assets – including its cash – are primarily the legal property of the company. How the company decides to transfer its wealth to its owners, etc., is what we shall look at in more detail, in the coming chapters.
Types of Partnerships
There is really only one kind of sole trader, but there are different kinds of partnership.
The basic type of partnership is defined by the Partnership Act 1890, and involves “persons carrying on a business in common with a view of profit”.
A partnership is not a separate legal person from its members, and for tax purposes it is “transparent”. In other words, the partnership itself does not pay tax – each partner pays tax on his or her share of the profits.
(In Scotland, a partnership is a legal person, but for tax purposes, it is treated in the same way as an English partnership, and is “transparent” like them).
In some cases, although two people may agree to share the income from a project, they are not strictly a partnership because they are not carrying on “a business in common”.
In such a case, the activity is commonly referred to as a “joint venture”.
HM Revenue and Customs (HMRC) will sometimes claim that this is the case where one or more jointly owned properties are rented out, and this can have significant tax consequences.
We have noted above that the partners in a partnership are jointly liable for the business debts.
There are, however, some varieties of partnership where this does not apply, and these are detailed in the following sections.
A “Limited Partnership”
A “Limited Partnership” is one where one or more of the partners has his or her liability limited to the capital he contributes to the partnership when he joins – like a shareholder, the worst that can happen to him is that he loses the money he invested, unlike an ordinary partner who might lose everything.
There are special rules for such partnerships:
- At least one of the partners must be a “general partner” who has unlimited liability, as with an ordinary partnership, and is responsible for running the business.
- A limited partner is not allowed to withdraw any of his capital from the partnership until he leaves the firm.
- A limited partner is not allowed to take part in running the partnership’s business, or to make contracts, etc., on behalf of the firm – if he does, he loses his limited liability and becomes an ordinary partner.
- There are restrictions on how much tax relief such partners can have for any losses made by the partnership, and they cannot get tax relief for the interest on any money they borrow to invest in the partnership.
Such partnerships are rather specialised entities, but they can have their uses.
Case Study – A “Limited Partnership”
Mary wants to set up a new business, and her Aunt Sally is prepared to invest 60% of the capital needed to help her, in exchange for a fair share of the profits.
She doesn’t want to have “unlimited liability” so the obvious solution seems to be a company, but Mary would rather not incur the expense of setting up and running one.
Instead, the new business is set up as a limited partnership, with Mary as the General Partner and Sally as the Limited Partner.
This way, Sally has limited liability, as she would have had with a company.
In other words, a limited partner must be a “sleeping partner” – that is, a partner who does not get involved in running the partnership.
A Limited Liability Partnership (also referred to as an “LLP”)
This is a relatively new sort of business entity, which was made possible by the Limited Liability Partnership Act 2000.
Unlike a normal partnership, it is a separate legal person from its members, but for tax purposes it is basically “transparent” like an ordinary partnership – each partner pays tax personally on his or her share of the partnership’s profits.
As the name implies, the partners in an LLP have limited liability, like shareholders in a company.
LLPs have proved popular with large professional firms such as accountants and solicitors, but as a general rule they are not appropriate for the smaller property investor or trader, being rather cumbersome to administer.
The idea of LLPs was that they would combine the advantages of a company (limited liability) with those of a partnership (informality and flexibility).
Some would say, however, that they also combine the disadvantages!
Except for unusual situations like the above Case Study, where someone wants to invest but not to be actively involved, the most suitable form of partnership for the property investor is likely to be the traditional or general Partnership Act type, as described above.
Read More Like This.