Business Entities – Which Is Best? (Part 1)

Lee Sharpe sets the scene in the first of a series of articles on the different types of business entity and how they may be taxed differently.

This is the first of a series of articles, which will look at the fundamentals of taxing different business entities, such as:

In the first of the series, we shall look at how these different entities are defined, and how they ‘tick’. 

This is essentially being in business on one’s own account. It enjoys the most flexibility and essentially bears the least administrative burden. Self-employed individuals can be found in practically all areas of business, such as law, finance, medicine, construction and other services.

A self-employed individual pays income tax on the profits he or she makes, and is normally able to offset trading losses against future trading profits, or potentially against other income or gains made personally. 

The word ‘trade’ is important in this context. People can receive income through passive investment activity such as holding shares, or letting property. These are still taxable but do not merit the ‘sole trade’ or ‘self-employed’ badge, and are generally less favoured in the tax system.

Once the individual has earned profits, he or she can draw on them at any time – they ‘belong’ to the individual. It is important to note that tax is paid on the business profits, and not the amount withdrawn – the business owner’s ‘drawings’. There is no direct tax benefit to refraining from drawing down all the profit, or taking only a small amount and leaving the rest in the business: the trade is taxed on the same level of profits, as they arise. Any undrawn profits that have accumulated over the life of the trade belong to the individual, and may be drawn at any time, including on cessation, without further tax cost. 

As a point of general law, a self-employed individual is not distinguished from his or her business, and if the business is sued, then it is effectively the business owner – the trader – who is liable, putting his personal wealth at risk. 

Partnerships (including limited liability partnerships)

The Partnership Act 1890 basically says that a partnership exists when a group of people (which may include companies as well as individuals) carries on a business in common, with a view to making a profit. 

This would seem a quite natural definition, but it is worth pointing out that the Act goes on to say that merely having a common or joint ownership in property does not create a partnership. While this may make sense in the case of a jointly held bank account, HMRC also says that most jointly held property income does not ‘make’ a partnership. This is perhaps disputable in the example of an actively managed property business, but would have to be argued on the facts of a particular case.

Basically then, there is significant overlap between a general partnership and people trading in concert. Partners are often referred to as being ‘self-employed’ because they are, for tax purposes, deemed each to be running an individual trading activity, effectively as a fraction of the overall partnership’s business. This is how the tax regime deals with people joining or leaving a partnership; they are treated as if they had commenced or ceased their own trade, within the partnership’s overall activity. This approach in turn allows the partnership to continue even as its membership may change completely over time. 

Again, partners are taxed on their share in profits, rather than the amounts they actually take out of the business. Partnerships are very common in the legal, medical and finance professions, but may also be found in most other occupations, e.g. as family businesses.

General partnerships can also offer very flexible arrangements. But a partnership agreement can provide internal rules and regulation – and protections to partners in case of dispute. 

Partners in a general partnership are deemed to be ‘jointly and severally’ liable for the partnership’s debts. In essence, this means that each individual partner can be responsible for the entirety of a partnership’s debts, simultaneously with all the other partners. A partnership agreement can set out who is responsible for what, but essentially, third parties who sue the partnership are pursuing each individual partner simultaneously. Perhaps understandably, partners have sought to limit their individual risk over the years and, historically, ‘limited partners’ have on an individual basis risked only their capital invested, basically in return for restricted profit share, rights and tax reliefs. They are quite rare so we shall not go into them in detail. 

Limited liability partnerships (LLPs) are relatively new. Partners (they are strictly ‘members’ in an LLP) are able to limit their liability to the capital they have invested – unlike sole traders or partners in a general partnership, they are not at risk of losing all of their personal wealth as well, if the business is sued. They are popular in the legal and finance professions. 

Strictly, an LLP is a ‘body corporate’, like the limited company we shall look at next. Like limited companies, an LLP is required to have a formal constitution and to file periodic returns and accounts to Companies House. LLPs are required to put much more information about themselves in the public domain than are general partnerships. This is basically to reassure potential creditors who arguably bear a greater risk if they are unable to sue individual members if the LLP fails.

For tax purposes, however, LLPs are almost always treated as general partnerships, i.e. with each partner/member having his or her own trade within the overarching partnership business. The only exceptions are when an LLP is being wound up, or if it ceases to carry on a business for profit.

A limited company is generally formed by shares. It is a separate legal entity and may take legal action (or be sued) in its own name. Such companies are very popular because the owners’ liability is limited to the shares they hold: if the company is sued and ends up unable to pay its creditors, then the shareholders lose only the value of their shareholding (the exceptions to this rule are very rare, and beyond a basic introduction). Given their separate legal status, it is understandable that they are taxed in their own right, according to the corporation tax regime. 

Some important points to bear in mind about companies:

This introduction has hopefully served to outline the basics of the main business entities from a tax perspective. We shall go on to look at them in more detail, in the months to come.