Here are some of the most common ways to structure a new business and the key benefits and drawbacks of each one.
Sole Trader – “The Simple Option”
A sole trader is usually someone who owns and operates a business personally. This is a very simple form of legal structure and most new businesses are set up this way. The sole trader model is most suitable for small “one-woman” businesses, such as make-up artists, professional coaches, and independent contractors.
- Easy: Operating your business as a sole trader is quick and easy. This makes sole trading an ideal structure for start-up businesses that are finding their feet.
- Inexpensive: There are no fees to register as a sole trader and all of the profits you make belong to you alone, after tax. The ongoing costs of running a business in this way are lower than those of running a company.
- Control: The sole trader structure provides the business owner with more freedom to run her business how she sees fit, which may be vital in a fast-changing market with competitors always seeking to steal market advantage.
- Personal liability: On the downside, running a business as a sole trader means that you are personally liable to pay off any debts of the business using your personal funds. This makes the structure riskier as your personal assets are at risk and may be seized to satisfy a business debt or legal claim filed against you.
- Limited access to finance: As a sole trader, raising money for your business can be difficult. Banks are reluctant to make business loans to sole traders, so you may have to rely on your own savings, personal loans, or loans from family and friends to grow your business.
- Perceptions: A sole trader may not appear as credible as a company. The public perception of sole traders is often of smaller, less established, and less financially secure businesses than their limited company counterparts.
- Limited expertise: Inevitably “one woman” businesses rely heavily on the expertise of the owner, who may not have the necessary skills or time to manage every aspect of the business successfully.
Limited Company – “The Safe Option”
A private company limited by shares is a common form of business structure. A company is an independent legal entity, separate from its owners, allowing the company to own property and enter into contracts in its own name.
- Credibility: Companies are often viewed as more legitimate and trustworthy than other business structures. They suggest that the business has permanence and is committed to effective and responsible management. Companies are required to comply with strict regulations and tax requirements in order to operate successfully and a company will continue indefinitely, even if one of the shareholders sells her shares or dies.
- Limited liability: A company can own assets and buy property in its own name. Its owners (the shareholders) are not personally responsible for paying off the company’s debts – if things go wrong the most that they stand to lose is usually the face value of their shares (i.e. their contribution to the company) plus any unsecured loans made to the company. In addition, the company can sue or be sued in its name.
- Finance options: If you want to raise finance for your business, lenders may be more likely to provide funds to a business that is structured as a company. In addition, a company can sell stock to investors in order to raise funds.
- Potential tax advantages: The tax regime may be more favourable to a company than to a sole trader. Limited companies pay corporation tax on their profits, and the corporation tax rate may be lower than the income tax rate applicable to a sole trader. However, the business owners will still have to pay income tax on any salary taken from the business.
- Regulation: A company is formed under the laws of the country or state in which it is registered and each jurisdiction has its own set of regulations that must be complied with. Broadly speaking, business owners must register the company with the relevant authority, keep records about the company (for example, details of the shareholders), and submit accounts and tax returns each year, amongst other things. There are also regulations outlining the duties and responsibilities of company directors.
- Cost: With this added regulation and the ongoing administrative requirements, come significant costs. It is often much more expensive and time-consuming to set up and run a company in comparison to partnerships and sole traders, and expert legal and tax advice may be required. However, there are a number of relatively inexpensive online resources to assist business owners who wish to incorporate a limited company without legal help.
Partnerships – “The Niche Option”
A general partnership is an association between two or more people who share the management and profits of the business. It is an extension of the sole trader model, for example, when two friends wish to work together to build the business. However, to work effectively, the partners will need to think carefully about how the liabilities, ownership, and profits of the business are split between them and what happens if one partner wants to leave or dies. Once agreed, these matters should be set out in a written partnership agreement.
Partnerships are the least common type of legal structure for businesses and things can get very messy if the business partners fall out. It is also possible to set up a limited partnership (in which members are excluded from being personally liable for the debts of the business) but these are complex structures particularly suited to professional services companies, such as law firms and accounting firms.
- Teamwork: A partnership has the benefit of two or more heads. Working as a team, the partners may be able to achieve more together than they could on their own.
- Inexpensive: As with the sole trader model, partnerships are not costly to set up and run.
- Control: Partnerships are more flexible and less highly regulated than companies, but the partners will need to reach agreement with each other on important decisions to take the business forward.
- Personal liability: As is the case for a sole trader, a partnership cannot enter into contracts or own assets in its own name. Instead, the business owners sign contracts and own assets personally on behalf of the partnership. This means that the partners are responsible for all the debts owed by the business, irrespective of which partner incurred the debt. This makes partnerships a particularly risky business structure for business owners.
- Limited access to finance: Partnerships are less highly regulated than companies and as a result may be considered less credible to investors and lenders.
Choosing the right legal structure for your business is not a decision to be taken lightly. It will have an impact on how much you pay in taxes, the amount of paperwork your business is required to complete, the personal liability you face for your business’ debts and your ability to raise money. You need to carefully consider the unique needs of your business and its owners, and identify your long-term business and personal goals.