Chapter 2

Recognising Different Business Types

In This Chapter

Exploring sole traders

Taking a look at partnerships

Figuring out the advantages of limited liability partnerships

Discovering the differences between types of limited companies

All businesses need to prepare key financial statements, but some businesses can make less formal statements than others can. The way in which a business is legally organised greatly impacts on the way it must report to the public and the depth of that reporting. For a small business, financial reporting is needed only to monitor the success or failure of operations. But as the business grows, and more and more outsiders such as investors and creditors become involved, financial reporting becomes more formalised until the company reaches the point where audited financial statements are required.

Each business structure also follows a specific set of rules about what financial information the business must file with government agencies. In this chapter, we review the basics about how each type of business structure is organised, how taxation differs, what must be filed, and what types of financial reports are required.

Flying Solo: Sole Traders

The simplest business structure is the sole trader – a business owned and run by an individual. Most new businesses with only one owner start out as sole traders. Some never grow into anything larger. Others start adding partners and staff and may realise that incorporating is a wise decision for legal purposes. (Check out ‘Seeking Protection with Limited Liability Partnerships’ and ‘Shielding Your Assets: Public and Private Limited Companies’ later in this chapter to find out more about incorporating.)

Anyone who wants to start a business as a sole trader must inform Her Majesty’s Revenue and Customs (HMRC) within three months. Weekly National Insurance Contributions (NICs) will need to be paid and, at the end of the tax year, the sole trader completes a self-assessment tax return. If turnover is expected to exceed the threshold for Value Added Tax (VAT) (currently £64,000 per annum), then VAT registration is also required.

The biggest risk for a sole trader is that the business isn’t a separate legal entity. All debts or claims against the business are filed against the sole trader’s personal property. If you are the owner of a sole tradership and are sued, then insurance is the only form of protection against losing everything you own.

Keeping taxes personal

Sole traders aren’t taxable entities, and sole traders don’t have to fill out separate tax forms for their businesses. Instead, sole traders simply add the self-employment forms about the business entity to their personal tax returns, and this is the only financial reporting they must do.

Sole traders will pay weekly National Insurance Contributions (NICs). NICs are fixed in amount (currently £2.20 per week) and are known as Class 2 National Insurance Contributions. If the trader’s annual profits exceed a set amount (currently £5,225), then additional contributions known as Class 4 Contributions will be payable. These are calculated from the self-assessment tax return and collected along with income tax.

Reviewing requirements for reporting

Financial reporting requirements don’t exist for sole traders. However, if they want to seek funding from outside sources, such as a bank, then the lender is likely to demand financial information. The lender is likely to need a statement of assets and liabilities and a basic profit and loss statement. Depending on the size of the loan, a sole trader may even have to submit a formal business plan stating goals, objectives, and implementation plans.

Even though financial reports aren’t required for a sole trader who isn’t seeking outside funding, completing periodic profit and loss statements lets you keep tabs on how well the business is doing and helps you find any problems before they become too huge to fix. These reports don’t have to adhere to formal Generally Accepted Accounting Principles (GAAP; see Chapter 18), but honesty is the best policy. The only person being fooled is you if you decide to make your financial condition look better on paper.

Joining Forces: Partnerships

Any business started by more than one person is a partnership. The partners share the risks and rewards of being in business but, because more than one person is involved, the business set-up is more complicated than that of a sole trader. Partners have the same requirement to inform HMRC as the sole trader. A useful online interactive tool exists which you can access from the HMRC Web site to identify what you need to do when starting a business. See www.hmrc.gov.uk. Partners have to sort out the following legal issues:

How they will divide profits.

How they can sell the business.

What happens if one of the partners becomes sick or dies.

How the partnership will dissolve if one of the partners wants out.

Because of the number of options, a partnership is the most flexible business structure for a business that involves more than one person. But to avoid future problems that can destroy an otherwise successful business, partners should decide on all these issues before opening their business’s doors.

The biggest risk for a partnership is that all the partners are jointly liable for the debts of the partnership and so are equally responsible for paying off the whole debt. If your partners disappear, you can end up picking up the entire tab.

Partnering up on taxes

Partnerships aren’t taxable entities. Partners are self-employed in exactly the same way as sole traders. Therefore, they will each pay Class 2 and Class 4 NICs. Each individual partner must report their share of the partnership profit in their personal tax return.

Meeting reporting requirements

Similar to the sole trader, a partnership does not have to present its financial reports in any special way because it doesn’t have to satisfy anyone but the partners. Partnerships do need reports to monitor the success or failure of business operations, but they don’t have to be completed to meet GAAP standards (see Chapter 18). Usually, when more than one person is involved, the partners decide among themselves what type of financial reporting is required and who is responsible for preparing those reports.

Shielding Your Assets: Public and Private Limited Companies

Business owners seeking the greatest level of protection may choose to incorporate their businesses as limited companies. The courts have clearly determined that limited companies are separate legal entities, and their owners are protected from claims filed against the company’s activities. An owner (shareholder) in a company can’t get sued because of actions taken by the company.

Two types of limited company structure exist:

Private companies: Whilst there is no limit to the number of shareholders in a private company, there will normally be just a handful. Typically, the private company is owned by a small number of people who are all involved in the day-to-day management of the business.

Public companies (PLCs): A company that wishes to offer shares to the public must register as a PLC. All companies listed on the stock exchange are PLCs, but some owner-managed companies are also PLCs. That is, a company does not have to issue shares to the public just because it’s a PLC.

Before incorporating, the first thing a business must do is form a board of directors, even if that board includes spouses and grown-up children on the board. (In a new rule brought in by the Companies Act 2006, directors must be at least 16 years of age.) Boards can be made up of both owners and non-owners. In private companies, the shareholders and directors are likely to be one and the same people but, as a company grows bigger, it often needs to raise money from outsiders.

Before incorporating, a company must also decide how many shares each of the shareholders will have. Private companies aren’t allowed to sell their shares on an open exchange. Even selling shares privately to friends and investors may fall foul of the strict rules that exist in this area.

A limited company’s veil of protection makes a powerful case in favour of incorporating. However, certain obligations come with incorporating, and the required legal and accounting services can be costly. Many businesses don’t incorporate and choose instead to stay as sole traders or partnerships to avoid these additional costs.

When a company is first set up, its constitution is laid down in its Memorandum and Articles, which must be placed on public record at Companies House. Model Articles exist, and they can be adopted by any new company. The Articles set out the rules for the internal management of the company and cover matters such as rights of shareholders, rules for transfer of shares, rules for conducting meetings, and the appointment and removal of directors.

Paying taxes the corporate way

Limited companies are separate tax entities, so they must file tax returns and pay taxes or try to find ways to reduce them by using deductions.

You sometimes hear that company profits are taxed twice – once through the corporate entity and once as dividends paid to its owners. This is not true. If the shareholder is a basic rate tax payer then there is no further tax to pay when he receives his dividends. A higher rate tax payer will pay the extra tax – as is right and just!

Getting familiar with reporting requirements

Public reporting is achieved by placing records on file at Companies House. All companies must file an Annual Return giving:

The address of the company’s registered office

The type of company it is and its principal business activities

Details about the directors and company secretary

A statement of capital

Details about names and addresses of the members (shareholders) of the company

Companies must also keep Companies House informed about a range of matters such as a change in the directors or the Articles of the company or if a charge is given over the assets of the company.

Companies must also file a copy of their Financial Statements drawn up in accordance with the rules appropriate for their business. (For more details, see Chapter 3.)

The records at Companies House are available to be searched by the public. The easiest way to do this is to log on to the Companies House Web site www.companieshouse.gov.uk. Basic details of registered address and nature of business are available free of charge. Alternatively for a small fee, you can get copies of the Annual Return and/or the latest financial statements. While most of this information is available from the Investor Relations pages of the Web sites of large companies, Companies House is the only source of this information when dealing with smaller companies.

Seeking Protection with Limited Liability Partnerships

A partnership or sole proprietorship can limit its liability by using an entity called a limited liability partnership, or LLP. This business form actually falls somewhere between a limited company and a partnership or sole trader in terms of protection by the law. (For more on these business forms, see the sections earlier in this chapter.)

LLPs are quite a new business vehicle in the UK. Created by the Limited Liability Partnerships Act 2000, LLPs are growing rapidly in popularity. LLPs have a number of the benefits of the limited company – the partners (or, more properly, the members) are taxed in the same way as the partners in a partnership.

The benefits of the LLP stem from the fact that it is a separate legal entity; the LLP is treated like a single person. It can enter into contracts and hold property and continues in existence despite a change of membership, such as through the death of a member. A third party enters into a contract with the LLP rather than with an individual member. By contrast, in a partnership, the third party contracts with a partner as principal and on behalf of the other partners.

The upshot of this is that, in the traditional partnership, negligent advice by an individual partner will result in all the partners suffering their share of the loss arising from a court action – even to the extent that they can lose their homes and personal possessions. In the LLP, the members who were not party to the giving of the advice are protected. It is the LLP itself which will be sued – although the individual member who gave the negligent advice can still suffer an action under the law of tort.

Taking stock of taxes

LLPs have their cake and eat it, too: They get the same legal protection from liability as a limited company, but don’t have to pay corporate taxes. In fact, HMRC treats LLPs as partnerships. (See the earlier section ‘Shielding Your Assets: Public and Private Limited Companies’ for more on these topics.)

Reviewing reporting requirements

Reporting requirements for LLPs are broadly similar to those of limited companies with some slight differences in the format of the main performance statements. LLPs classified as small enjoy the same exemptions as limited companies. We cover these matters in more detail in Chapter 3.

To shield themselves from liability, many large legal and accounting firms incorporate as LLPs rather than as limited companies.