Summary
- Choosing the right business structure – sole trader, partnership, or company – directly affects your liability, tax obligations, and administrative responsibilities.
- Only companies have separate legal personality, meaning sole traders and general partnerships expose owners to unlimited personal liability for business debts.
- Directors of companies face significant legal duties, and breaching these can result in serious civil or criminal consequences.
- This article is a plain-English guide to business structures in England and Wales, written for business owners considering how to structure their operations.
- It has been prepared by LegalVision, a commercial law firm that specialises in advising clients on business structures and corporate law.
Tips for Businesses
Consider your exposure to risk before choosing a structure. If personal liability is a concern, a company offers the strongest protection. Ensure any partnership has a written agreement in place. Directors should understand their legal duties. Review your structure as your business grows, as circumstances change.
There are different ways to structure a business, including becoming a sole trader, partnership, or company. Choosing the right business structure is a crucial decision that impacts various aspects of your business, including liability, taxation, and administrative responsibilities. Each structure offers unique benefits and drawbacks, and understanding these can help you make an informed decision that aligns with your business goals and risk tolerance. This article will explain these three concepts, what these terms mean, how they differ from one another, and what they mean for your business.
Limited Liability and Business Structures
If your business benefits from limited liability, it simply means that the business owner (i.e. you) is not liable for the business’s debts. Limited liability is closely connected to the concept of legal personhood. It refers to the presumption that unless there is an agreement that says otherwise, Person C is not responsible for Person A’s liability to Person B.
Importantly, the law treats companies as having a legal personality. Much like natural people, they can:
- own property;
- enter into contracts;
- assume liabilities;
- enforce rights against other persons through the law; and
- account to other persons for obligations and liabilities owed to them.
This distinction and the concept of limited liability are essential when considering which business structure to choose. The next section considers each of the three business structures.
Sole Traders
A sole trader is anyone who does business without taking proactive steps to trade through another business structure. In other words, sole traders are the default business structures for individuals running their own businesses.
Limited Liability
Sole traders do not benefit from legal personhood or limited liability. Therefore, your business is not a separate entity from you. Accordingly, you remain liable for all of your business’ debts. It does not matter if you keep separate business bank accounts or keep your business property separate from your personal property.
Other Considerations
As a business structure, a sole trader is beneficial for small businesses with limited risk. Besides accounting to HMRC for your taxes, you do not have any particular administrative responsibilities.
Likewise, you pay income tax at your personal rate — not the company tax rate. For most businesses with a single owner and no employees, provided the business is not engaged in high-risk activities, a sole trader may be sufficient.
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Partnerships
There are three main kinds of partnerships:
- general partnerships (GPs);
- limited partnerships (LPs); and
- limited liability partnerships (LLPs).
We will only look at GPs in this article.
However, you should note that GPs and LLPs differ. As the name suggests, LLPs benefit from legal personhood and limited liability, whereas GPs do not. In addition, you must incorporate LLPs through Companies House, whereas GPs arise automatically under certain conditions.
Creating a GP
Like sole traders, GPs arise automatically. That is, if certain conditions are fulfilled, the law will imply a GP on a business regardless of whether you intended for a GP to exist. These conditions are:
- where two or more people engage in an enterprise; and
- that each party acts in such a way as to share in the enterprise’s profits and losses.
This has two practical effects:
- you cannot have a partnership if you are the only owner; and
- you cannot claim a partnership with another person if the other person does not share in the profits (i.e. is treated as an employee and paid a wage).
Limited Liability
A GP is not its own legal entity and, therefore, does not benefit from limited liability. Consequently, the rules regarding personal liability for a business’ debts apply to GPs as they do for sole traders.
Additionally, you are liable for your partners’ conduct. For example, if a partner does something in the course of business that results in causing harm to someone else. Then, each of the other partners can be sued in their personal capacity.
Ownership
Importantly, ownership is quite complicated because a partnership has more than one owner (i.e. two or more partners). However, your partnership cannot own property because it is not a legal entity. Generally, the law regards that the partner owning property holds it in trust for all other partners.
Partnership Agreements
Most partnerships will begin with a formal partnership agreement. A partnership agreement is a contract that sets out the terms of the relationship each partner owes the other. One of the benefits of a partnership is that you and your partners can all refine the terms to your liking. In this respect, it is more flexible than a company, which must abide by company law.
However, absent of any formal partnership agreement, the law will imply its own terms to each of the partners, including:
- the obligation to treat each partner fairly;
- to act in the best interests of the partnership;
- to share in the profits and losses equally; and
- to reimburse any partner for any personal loss.
Administrative Burden
Similar to sole traders, you do not have to register your GP with the government. While you do have a general duty to keep the partnership’s finances in good standing, the extent of any administrative burden will depend on what terms are in your partnership agreement.
The partnership’s income is taxed based on the profits each partner takes. That is, your account to HMRC individually, and the partnership itself is not taxed.
Companies
There are a few different types of companies. However, the most common one is the private company limited by shares, simply called a private limited company.
The company’s founders must incorporate the business as a company to bring it into existence. This is done by filing certain forms with Companies House. You can also purchase a company off the shelf and transfer the business assets to the company.
Limited Liability
A private limited company benefits from limited liability. It is its own legal person. Therefore, neither its shareholders nor directors will be liable for its debts unless there is unlawful conduct.
What Does “Limited by Shares” Actually Mean?
When a company is “limited by shares,” it means each shareholder’s financial risk is capped. You can only lose the amount you paid for your shares, nothing more.
For example, say you buy 100 shares at £1 each. If the company fails and cannot pay its debts, you lose your £100 investment. Creditors cannot chase you for the company’s remaining debts.
This protection disappears in certain situations. If a director trades while knowing the company cannot pay its debts, a court can hold them personally liable. This is called wrongful trading under the Insolvency Act 1986.
Banks also sometimes require directors to sign a personal guarantee before lending to a small company. If you sign one, you give up your limited liability protection for that specific debt.
Ownership and Management
A company is owned by its shareholders (also called members). A share represents a portion of ownership in the company. Accordingly, the company structure is suitable for business growth because you can issue shares in exchange for cash.
Most shareholders are entitled to vote on important matters and receive a portion of any post-profit dividends the directors authorise.
Unlike a partnership, the company’s owners do not necessarily manage the company. Instead, directors manage the day-to-day and are the individuals who act on the company’s behalf. For small businesses trading as companies, founders will usually be both shareholders and directors.
The Company Constitution
To incorporate a company, you must adopt a constitution, including the associations’ articles. The articles set out the terms that will govern the company, including the rights of shareholders and the responsibilities of directors.
Company law also governs companies. Where there is a conflict between the company’s constitution and certain matters of company law, company law takes priority.
Administrative Burden
Companies have a substantially higher administrative burden compared to the other two business structures. The burden falls on the company directors. Indeed, the law imposes numerous duties on company directors. If a director breaches one or more of these duties, they risk substantial civil and criminal liability.
Also, your business must file annual company accounts. Any time the shareholders approve a change to the company’s constitution, the directors must notify Companies House.
Key Takeaways
Sole traders, partnerships, and companies are different business structures. A business structure is a legal framework under which a business operates. In other words, the law treats each business structure differently because they operate through different legal frameworks. There are other business structures that businesses can use in addition to these three. Still, the vast majority of small and medium businesses in England and Wales either trade as a sole trader, partnership, or company. Each has its advantages and disadvantages. The business structure right for your business will depend on your particular circumstances.
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Frequently Asked Questions
A sole trader is anyone operating a business where they are the sole owner and have not incorporated the business into its own legal person. As such, they have unlimited liability for the business’ debts and obligations.
The most common type of company is a private company limited by shares. This business structure has its own legal personality, meaning it can own assets, enter into contracts, sue and be sued. A company’s shareholders are its ultimate owners, but the shareholders are not liable for the company’s obligations in excess of their shareholding in the company.
A partnership is any business structure where the law treats the owners as partners. The most common form is a general partnership, which is an unincorporated business structure with unlimited liability. This means that you can be sued for your partners’ conduct and that the partnership itself does not own any assets.
Yes, a sole trader can hire employees. However, you remain personally liable for all business debts and obligations, including those arising from your employees’ actions in the course of their work.
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