Startup Accounting 101: How to Choose a Business Structure

business structure

So you have thought of a great new business idea, and you have decided to build a new startup based on it. But now what? What are the key considerations to think about when setting up a new business? I know that there are probably thousands of things on your mind right now, but one of the most important things to consider is which business structure to use for your new startup. In general, there are five types of business structures to adopt in the UK (although there are similar structures in other countries such as Canada, US, and many more): sole trader, partnership, limited liability company (Ltd), limited liability partnership (LLP), and public corporation. Most likely, if you are just starting out your own business, you won’t be forming a public corporation any time soon. This is usually used by more mature businesses to raise a significant amount of public funding on the stock market (think Alibaba IPO). Therefore, that leaves us with four main types of business structures to choose from. Now you must be wondering, what are the pros and cons of adopting each of these business structures and how can you best choose one of them? I know it may seem very confusing right now, but let me break it down for you…

1. Sole trader

This type of business structure is great for those that are working alone to build their businesses, and it’s also highly popular among freelancers. Sole Trader is most commonly used by self-employed people, who offer services as their main way of making money, such as photographers, hairdressers, real estate agents, etc.

Pros:

  • No complicated fees to register as a sole trader
  • Simple to set up (see more details below)
  • Inexpensive to operate
  • Not many regulatory restrictions/rules
  • All income (after tax) belongs to you!
  • Tax deductions available for expenses that relate to business activities

Cons:

  • Liability is unlimited, meaning that you may have to use your personal assets to pay back debt of the business, if the business is insolvent
  • No continuity in the business if the owner can no longer operate it
  • Taxed at higher personal income tax rate once the business grows, because all income from the business is taxed as your personal income

To become a sole trader, you will first need to register with the HMRC, and you will also need to register for a self-assessment with the HMRC in order to start filing your tax returns. See link below for more details about how to do this:

https://www.gov.uk/set-up-sole-trader

This type of structure is most beneficial for single-owner businesses that have low costs and won’t be taking on too much debt any time soon. It is a good structure to use if you want to keep your business structure simple in the beginning.

2. Partnership

If you have a few other people that you trust and would like to set up your new startup with, then adopting a Partnership structure may be the right answer for you. This type of structure is very similar to the Sole Trader; the major difference is that now there is more than one owner in the business. Also, this can be a structure to consider using once your Sole Trader business grows and you want to recruit more people to run the business with you.

Pros:

  • Simple to set up
  • Inexpensive to operate
  • Not many regulatory restrictions/rules
  • Your share of all income (after tax) of the partnership belongs to you!
  • Business can continue to operate if one partner leaves. However, note that you need at least more than two partners in the business in order for the partnership to continue. This is because if there are only two partners and one of these partners leaves the partnership, then the partnership is dissolved.

Cons:

  • Again liability is unlimited, AND you will also be liable for any business debt incurred by your partner(s) as well!
  • Taxed at higher personal income tax rate once business grows

The first disadvantage point is an important one to consider, as it is a risk that most business owners of a partnership worry about. Under this “unlimited liability” type of Partnership structure, any partner is legally liable for all of the other partners’ business debt in the case that the other partners cannot repay the debt by themselves. This means that you need to ensure that you enter into a partnership only with people that you can trust and have the right kind of skills to operate the business with you.

Another important consideration when setting up a Partnership is to sign a partnership agreement between all of the partners. The agreement should specify how you will share the revenue, costs, and liabilities of the partnership. Also, the agreement should provide details for what will happen in the event that one or more of the partners leave the partnership.

From a tax perspective, a Partnership structure is considered as a “flow-through” entity. This means that all income earned in the partnership is passed onto the partners. Therefore, the partnership income is taxed as personal income for each partner. Therefore, depending on how much income the partnership generates, as a partner, you may be taxed at a higher personal tax rate due to the amount of partnership income that you earn.

Furthermore, you will also become a self-employee when you join a partnership. In the UK, for self-employed individuals, if your annual revenue is above £5,965, then you will have to pay Class 2 National Insurance at the rate of £2.80 per week (this will be abolished after tax year 2016-2017, so you won’t have to pay any national insurance if your annual profit is below £8,060). If your annual revenue is above £8,060, then you will have to pay Class 4 National Insurance. Class 4 National Insurance is charged at 9% on profits between £8,060 – £43,000, and 2% on profits over £43,000. National Insurance is usually paid through your self-assessment. See link below for more details:

https://www.gov.uk/self-employed-national-insurance-rates

3. Limited Liability Company (Ltd)

Limited Liability Company is a slightly more complex business structure than the previous two mentioned. In order to become a Limited Liability Company, you will need to first register with Companies House. See link below on where and how to register:

https://www.gov.uk/register-a-company-online

As part of the process of setting up a Limited Liability Company, you will also need to figure out the shareholder ownership structure between you and your co-founders (if there are any). In this type of structure, each owner becomes a ‘shareholder’ of the company, who holds a pre-determined % of the total shares of the business. Based on the % of shares each owner has, the dividends that the company will pay out in the future will be allocated to each shareholder accordingly. Therefore, it is important to have a shareholder ownership structure that will best compensate each owner for the work/value that he/she contributes to the company. This may involve countless hours of negotiations with your team to determine the ‘fairest’ way of dividing up ownership of the company and how the value that each owner brings will be measured and evaluated.

Pros:

  • Liability is limited based on the % of shares that you own in the company. Therefore, you won’t have to worry about using your personal assets to pay back company debt!
  • Tax benefits: a private company is taxed at the corporate tax rate rather than at the personal income tax rate. (The corporate tax rate in the UK is 20%, whereas personal income tax rate goes up to 40% or higher when your total income goes above £43,000 per year) If the shareholder also receives a salary from the company, then that amount will be taxed at the personal income tax rate.
  • More credibility: investors usually prefer to invest in Limited Liability Companies as compared to the first two types of businesses, because there are more financial information disclosures required by the regulators for this type of business structure.

Cons:

  • More complex administrative processes to set up the company
  • On-going reporting of financial performance of the company required by regulatory bodies to file annual statutory financial statements and other reports with Companies House

On a side note, there are two types of Limited Liability Companies in the UK – 1) limited by shares, or 2) limited by guarantee. Limited by shares is the most common type as discussed in this section. Limited by guarantee is more commonly used by charitable foundations. Guarantee is basically a promise to pay for the business’ debt when necessary.

Overall, the Limited Liability Company structure is probably the most popular type of business structure used by many startups. It’s great to use if you want to prepare for future growth in your business and to attract investors soon.

4. Limited Liability Partnership (LLP)

Last but not least, the Limited Liability Partnership (LLP) is another business structure option to choose from. It is a hybrid of the previously discussed Partnership and Limited Liability Company structures. Therefore, it combines some of the benefits of both.

Unlike the Partnership structure, the partners of an LLP can choose whether or not to have limited liability in the partnership (partners who choose to not have limited liability are called ‘General Partners’). As a Liability Liability Partner, your exposure to the liabilities of the business will be limited to only your ownership share in the business, so you will be personally protected from any business financial risks. Moreover, you are also protected from being legally liable for any business debt incurred by the other partner(s). However, given that it is still a form of Partnership, each partner will be taxed at the personal tax rate on the total income that they generate from the LLP.

Pros:

  • Liability is limited for Limited Liability Partners, so your exposure to financial risks of the company is limited to your ownership of the business, and you won’t be liable for any debt incurred by the other partner(s) as well.
  • There is flexibility in structuring the partnership interests for each member, so you can decide how each member will be compensated based on the amount of work that they contribute to the partnership.
  • More credibility: LLP is commonly used for professional services companies, because it can be used to recruit more professionals to join the firm by giving them partnership interest (i.e. accounting firms, law firms, etc.).

Cons:

  • Income is taxed at the personal tax rate for each partner.
  • Similar to the Limited Liability Company structure, there are on-going reporting requirements by regulators for an LLP to file annual statutory financial statements and other reports.

In summary, an LLP is a great type of business structure to use if you are forming a professional services firm, or if you would like to build a partnership where the partners want to have the option to limit their financial exposure to liabilities of the business.

There you have it, four different types of business structures to choose from for your new startup! As you can see, each structure has its advantages and disadvantages, therefore it is highly important for you to assess what type of business you want to build, who are the owners of this business, and what are the owners’ needs. Once you have these figured out, you will be able to choose the right type of business structure to best suit your startup’s needs!

Stay tuned for more startup accounting knowledge…

Leave a Reply