Business structure is important for tax purposes.
4.3 million people in the UK made the jump into self-employment. If you’re looking to join them, you might be wondering how to start your new business.
You’ll need to weigh up the pros and cons and decide if launching a startup is right for you. Then one of the first things to think about is how will you pay tax?
This requires you to choose a structure for your new business. The three most popular options are sole proprietorship, general partnership or limited company.
Last year, operating as a sole trader was the most common structure. Around 3.2m sole traders accounted for 56% of the UK’s entire private-sector business population. There were 2m actively-trading companies and 384,000 general partnerships. These make up 37% and 7% of the business population, respectively. You can also be a limited liability partnership.
The vast majority of those sole proprietors are genuine one-man bands; that’s to say they don’t have any employees (in an official capacity, at least).
It is worth being aware of the key options on the table when you start a business. You can also change your business’s structure whenever you like, although that can prove costly.
Sole proprietorships
Being a sole trader means there’s no legal distinction between your business and your own personal finances.
You will be solely responsible for any losses the business makes during the tax year. This currently runs from 6 April to 5 April the following year, as well as any of the business’s bills.
It will also be down to you to keep accurate records of any income and expenses from the tax year. This will be important when Making Tax Digital for income tax comes in from April 2024.
For tax liabilities, your business profits will be assessed for income tax where not covered by the personal allowance. This is £12,570 in 2021/22. At the moment need to file a self-assessment tax return relating to the previous tax year. This is due on or before midnight on 31 January.
Any amount of business turnover which exceeds the personal allowance up to £50,270 will be charged income tax. This is charged at the basic rate of 20% and doesn’t include any expenses.
The slice of business profits worth £50,271 up to £150,000 will be taxed at 40%. Any excess profits above £150,000 will be taxed at the additional rate of 45%.
You will also need to pay National Insurance contributions (NICs) above certain thresholds. Class 2 NICs are currently fixed at £3.05 a week, unless the profits are less than £6,515. Class 4 NICs are charged at 9% of profits between £9,569 and £50,270 and 2% on profits above £50,270.
General partnerships
Ordinary business partnerships share many things in common with sole proprietorships. They’re both usually registered as self-employed and liable for income tax and NICs at the same rates and thresholds.
The key difference is that two or more people manage the partnership. This is instead of to one individual in a sole proprietorship.
Partners split any profit in a pre-agreed ratio, and the same ratio determines responsibility for any losses the partnership makes.
Business partners’ tax reporting obligations are slightly different to sole traders, however. When registering as an ordinary partnership, you have to ‘nominate’ a partner. They will be in charge of submitting the partnership tax return.
This SA800 form simply asks for details of the partnership’s income in a tax year. That should include income from trades and professions, interest or alternative finance receipts from banks, building societies or deposit takers. This should all be reported on or before midnight on 31 January following the end of the tax year.
After the profits have been allocated, each partner needs to file their own personal tax return through self-assessment. They will need to report their profit share.
Limited liability partnerships
Limited liability partnerships (LLPs) are similar to ordinary partnerships from a tax perspective. However, they are similar to companies from a legal perspective. This is because the partners’ liability is limited to the amount of money they invest in the business.
You can incorporate an LLP to run a business with two or more members. A member can be an individual or a company; the latter’s known as a ‘corporate member’.
An LLP agreement will set out the members’ responsibilities and share of the profits. Like ordinary partnerships, each member pays income tax and NICs on their share of the profits. But they are not personally liable for any debts the LLP incurs.
Much like a limited company, an LLP must be registered at Companies House and with HMRC. You will have to arrange for the annual accounts to be prepared and filed.
Incorporations
If you choose to incorporate your business, you will probably go down the limited company route. This is a legal structure for businesses in which the liability of a shareholder is limited to their own investment.
Limited companies are governed by rules and regulations in the Companies Act (2006). One of which means you must register with Companies House.
Private-sector companies are usually limited by shares which are issued among its shareholders. These are not traded on public stock markets.
Companies pay 19% corporation tax, on any taxable profit they make during their accounting period. Taxes on income, dividends and NICs can all come into play for you personally. This depends on how you decide to pay yourself.
If you have a limited liability, you will have more responsibilities than if you were a sole trader.
Umbrella companies
Working through an umbrella company might be best for you. This would be an option if you’re on a short-term contract or just trying out the world of freelancing.
An umbrella company sits between you (the contractor) and your end-clients. The umbrella company will employ you and be responsible for handling all your employment taxes.
If you’re a contractor or freelancer, this offers peace of mind. The umbrella company pays your taxes and chases late payments from clients. It can also offer benefits like sick pay and annual leave.
You simply do the work, fill in a timesheet, your end-client authorises it and invoices the umbrella company. They then deduct your taxes and its fee before paying you.
What’s the best option for you?
Being a sole trader offers the most control over your business. It is both easy and cost-effective to set up. However, you will be liable for any debts it racks up.
What can be said about sole traders also applies to partnerships. Having more than one person in charge in a partnership has the potential for disputes.
LLPs have elements of a being in a business partnership and running a limited company. If you go down this route, you must start trading within a year of registering your LLP. Otherwise, you face being struck off.
Limited companies offer you less personal financial risk, with the protection of limited liability. In addition, they have the flexibility to pay yourself in tax efficient ways. However, there can be significant set-up costs and your annual accounts and financial reports will be in the public domain.
Umbrella companies suit freelancers and contractors and can ensure you stay on the right side of the IR35.
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