How to Choose the Right Legal Structure for Your New Business

I’ve updated this on 6 May 2020

Choosing the right legal structure for your new business is one of the most important decisions you need to make.

But I know it can be confusing understanding your options and picking which one is right, especially if working for yourself is new to you. And what works for one business, may not be right for another.

In this guide, I will give you an overview of the main types of UK legal business structures and the pros and cons of each. At the end of this guide, you’ll understand your main options and be able to decide which one is right for you.

The information contained here is for guidance and information purposes only. It should not be relied upon as professional accounting, tax and legal advice. For specific advice relevant to your own situation, always contact a professional. 

The Main Types of UK Legal Business Structures

In the UK there are four main types of legal structures that business owners tend to go for:

  1. Self-employed (or sole trader)
  2. Private Limited Company
  3. Partnership
  4. Limited Liability Partnership

Each one requires different paperwork to set up, offer varying levels of personal protection and tax implications.

Let’s look at each option.

Self-Employed or Sole Trader

Operating as self-employed (or sole trader) is the quickest way to start a new business, all the money you make belongs to you but you are personally liable for all the debts.

Pros and Cons

+ Simplest business structure to set up;
+ No fees to register the business if you choose to DIY it;
+ Minimal requirements compared to other business structures when it comes to reporting to HMRC;
+ Taxes are easier to calculate;
+ All the money left belongs to you once you have paid your bills and taxes;
+ Easy to move to other business structures, like a Limited Company, if your circumstances change.

– You are personally liable for the debts of the business as you are trading as yourself;
– Taxes can be higher depending on your profit;
Harder to raise finance and borrowings from lenders or banks.

Taxes

You’ll be taxed on your business profits and need to pay:

  • Income tax
  • Class 2 national insurance
  • Class 4 national insurance

The amount of each that you pay depends on how much profit you make.

Read more: Tax and National Insurance When You’re Self-Employed

Reporting Requirements

Self-employed and sole traders need to report their earnings for each tax year once a year on a self-assessment tax return due by 31 January. Tax payments are due by this date as well, with a mid-year tax instalment due by 31 July (aka a payment on account).

Who Chooses this Option?

People tend to choose to be self-employed or a sole trader when:

  • They are the only person working in their business (although you can still be an employer);
  • They are in the early stages of starting a new business and want a simple way to get started;
  • They want to avoid the costs of an accountant and are looking for an easy way to DIY their business finance and taxes;
  • Their business profits are not at a level that justifies forming a Limited Company.

How to Register as Self-Employed with HMRC

Limited Company

A Limited Company is a separate business entity from yourself. It is responsible for all the business’ liabilities and owns the trade and profits. To pay yourself from a Limited Company you’ll have to buy shares in the Company, set yourself up as a Director and pay yourself a salary/dividends to extract money.

Pros and Con

+ You are not personally responsible for the business liabilities;
+
Better credibility with lenders;
+
Some customers may prefer to do business with a Limited Company, depending on your business.
+
Depending on your business profits, forming a Limited Company can save tax.

More reporting requirements with both HMRC and Companies House;
A simplified version of your Annual Accounts will be made publically available at Companies House each year;
More complicated to administer and to run tax effectively, meaning you may need to pay for an accountant;
Company Directors should still submit a self-assessment tax return each year;
– Even though a Limited Company is responsible for its own debts, funding options like loans and overdrafts often require directors guarantees making them personally liable for these particular debts.

Taxes

A Limited Company pays corporation tax at 19% on the first £300,000 of business profits.  

You can pay yourself by:

  • PAYE salary which attracts income tax and national insurance;
  • Dividends which attracts dividend tax.

By getting your combination of salary and dividends just right can be incredibly tax efficient.

Read more: How to Pay Yourself From Your Limited Company

Reporting Requirements

A registered Company has the following reporting requirements:

  • Annual Company Accounts with Companies House
  • An annual Confirmation Statement with Companies House
  • HMRC Corporation Tax Return

In addition, any changes to things like registered office, directors or shareholders need to be reported separately.

Who Chooses this Option?

People tend to choose to form a Limited Company;

  • If they deal with customers who prefer to engage with Limited Companies rather than Sole Traders;
  • Their profits are at a level that means running their business through a Limited Company generates tax savings;
  • They make sufficient money to engage an accountant to help them administer their Limited Company;

If you are considering forming a Limited Company just to make tax-savings then try my calculator to help you check what money you will save. Generally, however, accountants don’t tend to recommend forming a limited company until your taxable profits reach around £30,000 per year.

How to Form a Limited Company

Partnership

This UK business structure is similar to that of being self-employed or a sole trader. But it allows two or more people to co-own the business, with each partner being personally responsible for the debts of the Business.

To avoid problems, it is advisable to put together a partnership agreement that formalises:

  • How profits will be split;
  • How costs will be split;
  • Any other important business arrangements between the partners.

Pros and Cons

+ Once the partnership agreement has been drawn up, setting up a partnership is quick and easy;
+ Partnerships are free to set up if you choose to DIY it;
+ Minimal reporting requirements;
+ You share the costs and responsibilities of your new business with someone else;
+ You have someone else to put in start-up capital;
+ Simpler to close down if the partnership does not work out.

You risk being made liable for debts you are not aware of or did not agree to;
Running a new business with someone else can be difficult especially if you have never worked together;
You have to share your business profits;
Depending on your business profits, a partnership may not be the most tax-efficient business structure.

Taxes

The Partnership itself needs to fill out it’s own tax return summarising how much money the business has made.

Example Partnership Tax Return

Then each member of the Partnership must report their portion of income and expenses on their own self-assessment tax return, paying the same taxes as a sole trader:

  • Income tax
  • Class 2 national insurance
  • Class 4 national insurance

The amount of each that you pay depends on your portion of the partnership business profits.

Read more: Tax and National Insurance When You’re Self-Employed

Reporting Requirements

You will need to let HMRC know that you are in a partnership and nominate the partner who will be responsible for the partnership tax returns and administration.

Each partner will need to report their portion of earnings for each tax year once a year on a self-assessment tax return due by 31 January.

Tax payments are due by this date as well, with a mid-year tax instalment due by 31 July (aka a payment on account).

Who Chooses this Option?

People generally opt to set up a Partnership when they:

  • Go into business with someone else;
  • Want to have a formal arrangement for sharing profits with someone they work with.

How to Register a Partnership

Limited Liability Partnership (LLP)

An LLP is a separate business entity from the partners. Similar to a Limited Company it offers the partners legal protection because they are not personally responsible for the business’ liabilities.

LLPs must have a minimum of two partners.

Pros and Cons

+ Limited Liability status protects the partners personal assets;
+ Partners can have different levels of responsibility;
+ LLPs are registered at Companies House, meaning other partnerships are prevented from using the same name for their LLP.

Annual Accounts will be made publically available at Companies House each year;
Each partner pays income tax on their portion of the profits which means, depending on how much money they are making they could end up paying more tax than if they formed a Limited Company instead.

Taxes

Each member of the Partnership must report their portion of income and expenses on their own self-assessment tax return, paying the same taxes as a sole trader:

  • Income tax
  • Class 2 national insurance
  • Class 4 national insurance

The amount of each that you pay depends on your portion of the partnership business profits.

Read more: Tax and National Insurance When You’re Self-Employed

Reporting Requirements

A registered LLP has the following reporting requirements:

  • Annual Company Accounts with Companies House
  • An annual Confirmation Statement with Companies House

In addition, any changes to things like registered office or partners need to be reported separately.

Who Chooses this Option?

People generally opt to set up a Limited Liability Partnership when they:

  • Go into business with someone else;
  • Want to have a formal arrangement for sharing profits with someone they work with;
  • Want to legally protect their personal assets and make the business responsible for its own debts.

Wrapping Up

Choosing the right legal structure will save you tax but jumping in to the wrong one could mean you end up have more administration than you can handle and have to pay an accountant.

If you are unsure what legal structure is right for you or are working with business partners, then seek professional advice to help you decide what is right for your new business. 


New Here? Learn how to set up the financial side of your business with these easy to understand guides and resources:

  • Sole Trader or Limited Company? – Download my free calculator to check which business structure would help you to pay less tax;
  • Tax Records and Bookkeeping – Understand what tax records you’ll need to keep and how to set up your own bookkeeping system;
  • Self Employment Taxes Explained – Learn what taxes you’ll pay, how much and when;
  • VAT Guides – From registration to de-registration, VAT schemes and thresholds, these guides will take you through the basics every UK small business owner needs to know;
  • Invoice Template – Free template and step-by-step guide so you can get paid by your clients.
Anita Forrest
About Anita Forrest

Anita Forrest is a Chartered Accountant, spreadsheet geek, money nerd and creator of www.goselfemployed.co - the UK small business finance blog for the self-employed community. Here she shares simple, straight-forward guides to make self-employment topics like taxes, bookkeeping and banking easy to understand.