Chris Thorpe outlines some of the factors to consider when choosing how to operate a business.
When operating a business or deciding how to operate one, there are several ways that a business can be operated.
Sole trader and partnership
A sole trader is the simplest model – the one-man band, with the individual and business being one and the same. In this case, the individual is taxed on their profits as earned income at their marginal income tax rate, irrespective of what is drawn. There are no accounts to file, nothing to tell Companies House, no dividends or salary to declare – all they need to do is tell HMRC and file a self-assessment tax return. From 2026, a turnover of £50,000+ will require taxpayers to file those returns through Making Tax Digital. From 2027, a turnover of £30,000 will attract such an obligation.
A partnership is an extension of the sole trade; multiple sole traders coming together with a view to making a profit (per PA 1890, s 1(1)). Partnerships are transparent for tax purposes (i.e., the partners hold the underlying assets and are subject to income tax and capital gains tax on their individual profit or capital shares). They are generally not separate legal entities either – they are essentially bare trusts. The profit shares, being shared amongst multiple people, means the income tax burden can be spread in a more efficient manner. The flexibility and simplicity of a partnership make it a very popular vehicle.
The same applies if the business (usually professions such as law and accountancy) becomes a limited liability partnership (LLP) – introduced into Great Britain in 2001 and Northern Ireland a year later; these are treated as ordinary partnerships for tax purposes but are body corporates (i.e., separate legal entities) and give their ‘members’ (as partners of LLPs are called) the same protection of limited liability as enjoyed by company shareholders. Which brings us nicely to…
Limited company
At the other end of the spectrum is the limited company, a body corporate which can hold property in its own name, enter contracts, and sue and be sued. The shareholders are the owners with directors managing the business; with small businesses, the two are usually one and the same. For owners, dividends can be withdrawn from the company with directors usually taking an officer’s fee; directors of owner-managed businesses will often be employees of their company, allowing a larger salary to be drawn and a tax-efficient pension.
Whilst the company’s profits are subject to corporation tax, personal tax is only chargeable on shareholder-directors on those withdrawals made, which can be controlled and done so in a tax-efficient manner with some planning.
Which one?
Tax will be a major factor in deciding whether to set up as a sole trader, or ‘incorporate’ as a company. Deciding whether the tax burden of a sole trader is more than that combined of a company and shareholder-director will often depend on how much profit is taken out of a company and exposed to that double taxation.
However, tax will not be the only factor; for example, only limited companies can qualify for research and development relief, or segregation of a business for regulatory, commercial or succession planning purposes may also point to a limited company being the preferred choice.
Practical tip
Whilst the tax tail must never wag the dog when making business decisions, clearly, tax will still be a major factor. The needs and circumstances of the business and owners should be carefully considered in the round, but as a very rough rule of thumb, the decision whether to move from sole trade or partnership to a limited company tends to start from asking ‘how much profit will be retained?’
