While this is an article about the different types of UK business structures and their tax implications – a word of caution: one shouldn’t put the cart before the horse and put together any business structure which works well for tax purposes but does not meet one’s personal or commercial objectives.
Instead, any planning should be done in reverse.
In other words, your choice out of the many UK business structures available should be driven by the commercial and personal objectives – and not by tax.
Legal versus tax considerations
In addition, one should also take into account other legal and regulatory requirements when considering types of tax structures. For instance, some professions do not allow their members to operate through limited company structures – albeit such professions are now declining in number.
More generally, one should consider whether a structure provides one with limited liability as opposed to unlimited liability. For example, a company or a limited partnership will essentially limit a business owner’s liability to the amount of capital he has invested, assuming that he or she has not acted fraudulently.
However, a sole proprietor or a general partner will not have the same protection. So, if the worst case happens, and a large claim arises, then the business owner’s personal assets may be subject to a claim.
Clearly, this liability to creditors is an important consideration when deciding between the most suitable types of UK business structures.
Overview of the different types of UK business structures and tax implications:
1. Sole trader
As described above, a sole trader will have unlimited liability so they are exposed to creditors subject to insurance.
From a tax and wider financial perspective, this is the simplest of all UK business structures one can operate through, and is often the default.
One does not have any filing requirements with Companies House and one will only need to produce quite basic accounts and fill in the relevant ‘self-employment’ pages on your UK tax return.
The net profit will be added to your taxable income for the relevant year and you will pay personal tax on this income at your marginal rate of tax.
In other words, to the extent that profits fall within the basic rate band, you will pay tax at 20%. To the extent net profit falls in the higher rate, then you will pay 40% income tax and so on and so forth.
National Insurance contributions are also payable by self employed individuals and these tend to be at a slightly lower rate than employees.
A partnership is defined as two or more persons in business together with the view to a profit. A general partnership formed in England and Wales does not have any separate legal identity. As noted above, this means that the losses of the business are, effectively, the losses of the individual partners and they will be due for any financial claims.
A similar treatment applies for tax purposes in that a partnership is transparent. In other words, one ‘looks through’ the partnership and its profits and / or losses are attributed to the partners.
As such, a partnership will not in itself pay any tax. However, there is still a requirement for the partnership to file a tax return. The profits and losses of the partnership will then be attributed to the partners in their relevant shares and will be reported on their personal tax returns on special partnership pages.
Ultimately, this means that a partner in a general partnership is liable for tax in a similar fashion to a sole trader.
Due to the lack of limited liability, most trading businesses are not operated through a general partnership. Instead, opting for the legal protection, but similar tax treatment, of the Limited Liability Partnership (“LLP”). However, some business owners are attracted to the informality of a general partnership – in other words, there is no requirement for filings at Companies House.
3. Member of a Limited Liability Partnership (“LLP”)
An LLP is strictly a corporate body, so that it provides limited liability, but it is generally taxed in the same manner as a partnership.
Please note that the proper terminology is that one is a member of an LLP, rather than a partner.
Again, the LLP must file a tax return but, despite its separate legal identity, still does not have to pay tax. Once more, this is attributed to the members of the LLP and they will pay tax on their share personally.
One objection to an LLP over, say, an England & Wales general partnership, is that it must file certain documents with Companies House. For instance, it must file annual accounts and it must also submit a Compliance Statement (formerly, and confusingly, referred to as the annual return – nothing to do with the tax return!)
Although this is not a major issue, it could often be a barrier for family investment vehicles where such filings might mean that someone searching Companies House could ascertain the family’s wealth or at least part of it.
Accountants and lawyers, who historically were structured as general partnerships, are now usually operated as LLPs. Indeed, one of the main reasons behind the Limited Liability Partnership Act 2000 was to provide accountants and lawyers who like the partnership model, to be able to do so with the protection of limited liability.
LLPs and partnerships are often used where there is an investment activity – e.g. property investment – and returns are likely on the disposal of assets. This is because the capital gains of the partnership are attributed to the members or partners directly and there is merely one level of tax. As we will see for a company, there are two levels of tax.
Depending on the objectives, this second layer of taxation can be problematic. It is a balancing act between the ability to roll up funds at a lower rate, meaning that a greater proportion can be reinvested in the business, against a second charge to tax on personal extraction.
4. Limited Company
Of the many UK business structures, this will be the ‘go to’ vehicle for many people setting-up a new business – whether it is a trading business or an investment structure.
For the sake of completeness, a company has its own separate legal entity. It can enter into contracts in its own name and the owners, or shareholders, only have the cash they have put up on the subscription for shares (and perhaps shareholder loans) at stake. This is known as the ‘veil of incorporation’.
The veil of incorporation will protect the business owner who unfortunately experiences claims during the normal course of business. He will not have his house on the line. However, this ‘veil’ may be pierced if he is trading fraudulently.
Companies differ from the types of structure described above in that they pay tax in their own right. Specifically, they pay corporation tax on net profits. This is at historically low levels and is highly competitive when compared to other jurisdictions.
At the moment, the corporation tax rate is 19% and is scheduled to fall further to 17%. There has been a suggestion that this southward movement will continue following Brexit, though this has not been confirmed, and the remaining EU member states have made noises about the UK not entering into such ‘fiscal dumping’.
This means that a company is very efficient where one is reinvesting proceeds back into the business as one can reinvest 81% as opposed to, say, 60% or even 55% where the higher personal tax rates have eaten into the profits of sole proprietors, partners or members of LLPs.
However, if one is extracting profit personally, then one is subject to personal tax on such funds. The taxation implications will depend on the form of the extraction. Generally speaking, a dividend is more tax efficient with further effective tax of 7.5%, 32.5% and 38.1% depending on whether the dividend falls in the basic rate band, higher rate or the additional rate of tax.
It should be noted that there is a dividend allowance of £5k at present though this, after a brief time on the statute, is expected to be sliced to £2k going forward.
Where one rolls up profits in a company then it is generally more efficient from a tax perspective. However, where one is extracting most of the value for personal use then there is little in it from a tax perspective.
Again, the objectives of the individual are key.
Of course, the shares in a company can be sold. Such a disposal, hopefully at a gain, will be subject to capital gains tax assuming the individual is UK tax resident. For shares, this is now 20%. If the company is a trading, then the vendor might qualify for Entrepreneurs’ Relief which equates to a 10% effective rate of tax.
5. Hybrid arrangement
It is possible to among the UK business structures available to have the ‘best of both worlds’, to allow a level of income to be paid to individuals as members (say for personal expenditure) with additional funds rolled up within a corporate partner or member.
The same can be achieved by allowing capital gains to accrue to individuals – who might benefit from a lower overall level of tax on such a return – but with income arising to a company that pays tax at the lower rates of corporation tax.
One needs to be careful in putting together such a structure following changes in Finance Act 2013 which sought to clamp down on the artificial use of such ‘mixed partnerships’. However, these changes do not prevent such an arrangement as long as one plans carefully.
Another of the many types of structures is the trust.
Trusts are often thought of as overt tax avoidance vehicles. However, this is no longer true.
Most new trusts are created for asset protection purposes and not for tax avoidance. Essentially, trusts allow a person to make a gift (it is generally the decision to make the gift which creates the tax point) but they want to retain control over the underlying capital of the gift.
In other words, a beneficiary may enjoy the income produced by the assets, but the Trustees own the capital preventing a beneficiary from disposing of it.
There are different types of trust:
These are simple nominee agreements and the income and gains belong to the beneficiary absolutely. As such, they are taxable on the beneficiary.
Interest in possession / life interest trusts
Again, the beneficiaries have an absolute interest in the income (i.e. it is theirs by right). As such they are taxed on the income and gains as they arise.
In a discretionary trust, no beneficiary has a fixed right to income or gains. The trustees will have discretion over who benefits, when, how and to what extent. The trustees will pay tax at the Rate Applicable to Trusts (“RAT”) which, save for a small tax-free allowance, the income would be subject to tax at 45%. The Trustees will also pay tax on capital gains at the normal rates of tax for individuals. A trust will get a reduced capital gains tax annual exemption.
It would be unusual for a business to be carried out by a trust, though some businesses are operated in such a manner.
However, it is not uncommon for trustees to be managing a portfolio of investments. Additionally, it is very common for a trust to hold shares in a family business, with the Trustees perhaps controlling the succession to the next generation.
Enterprise Tax Consultants can advise on the tax implications of all types of UK business structures.
As stated above, one should consider the objectives of the business or investment activity and your need or desire to enjoy the profits that it produces. Once you have a clear idea of what this looks like one can put one’s mind to what types of structures are fit for purpose.
If you are unsure as to your position in relation to the tax implications of UK business structures, we can assist.
Contact us for a no-obligation initial conversation with an experienced tax adviser.