Success means different things to different people and for different businesses. Whatever the definition of success, having an optimal operating structure for your business will ensure that income (or any losses) are generated in the right place and the tax profile of the business structure is appropriate for your situation.
A sole trader is a ‘one-man band’ where the trade is owned and operated by one individual. Sole traders are taxed as individuals and profits are attributable to the sole trader only, with profits taxed at the marginal income tax rates.
All decisions about the business are made by the individual and the liability of a sole trader is unlimited, meaning creditors can claim against any business or personal property in the event of non-payment, for example.
The administrative requirements are low, with only an annual self-assessment tax return needed, although accounts may also be required to prepare the tax return.
From an inheritance tax (IHT) planning perspective, Business Property Relief (BPR) may be available where the conditions are met. Where available, BPR reduces IHT payable on the transfer of the business assets to the next generation.
If the trade is loss-making, ‘sideways loss relief’ is available to reduce the individual’s net taxable income. However, there are limits on the amount of loss that can be relieved in this way – broadly the higher of £50,000 and 25% of total income.
A partnership is the sharing of a trade between two or more individuals with a view to profit. It is best practice to have a partnership agreement in place to set out the default apportionment of profits (and losses) along with other rights and responsibilities. The apportioned profits from a general partnership are taxed at each partner’s marginal rate of income tax, much like a sole trade.
As with a sole trade, liability is unlimited, and creditors can claim against any, and all assets of all partners on a ‘joint and several liability’ basis.
Each year, the partnership needs to prepare and file a self-assessment partnership tax return, with each partner including their share of the partnership’s taxable profits (or losses) in their own self-assessment tax returns.
Whilst it must file a return, the partnership itself does not have a tax liability.
Decisions about the business are made by the partners in accordance with the partnership agreement. There is scope for succession planning between generations using the partnership framework; children can be introduced to the partnership in a limited role and gradually increase their responsibility and ownership of assets over time. BPR may be available where the conditions are met, however, specific tax advice should always be sought when establishing or changing partnership shares, as there are numerous tax traps for the unwary, particularly regarding Stamp Duty Land Tax (SDLT) and VAT, but also IHT, income tax and capital gains tax (CGT).
Sideways loss relief is available to the partners actively involved in the business, subject to the same cap as noted above. Sideways loss relief is limited to £25,000 per annum for non-active partners.
Limited Liability Partnership
Unlike general partnerships, Limited Liability Partnerships (LLPs) are regarded as ‘bodies corporate’ and have a legal personality separate from their members. The liability of a member of an LLP is therefore restricted to their capital contribution, plus any further amount they have agreed to pay if the LLP is wound up.
However, LLPs are treated as if they are fiscally transparent – they are not taxable entities in their own right; LLP profits are taxed in the same way as those of general partnerships and all the members are generally treated, for the purposes of income tax and CGT, as carrying on a business in partnership.
Each member of a partnership is an agent and may bind a general partnership. This is in contrast with an LLP, whereby if a member signs a contract in their capacity as a member of an LLP, it will only bind that member, unless they are authorised under the LLP agreement to bind all other members too.
Annual accounts and confirmation statements are required to be filed with Companies House, and each member needs to file a self-assessment tax return with HMRC. Companies House documents are publicly available, offering less privacy for the business owners. However, accounts only need to show certain figures.
As with general partnerships, interests in an LLP may qualify for 100% BPR for IHT. Sideways loss relief claims are subject to the same caps as general partnerships and are also restricted to each member’s contribution to the LLP.
Private limited company
A private limited company is a separate legal entity from the individual owners and is treated as a separate taxable ‘person’. Decisions are made by directors, but profits belong to the shareholders of the company (but are only taxed on the shareholders insofar as profits are extracted by way of a dividend). At company level, profits are taxed within the company at corporation tax rates.
The rate of corporation tax allows for a greater proportion of profits to be reinvested in the business than for sole traders/partnerships. However, a company does add a further layer of taxation, as there will be corporation tax for the company and then tax on any distribution for the company shareholders, and so there may be little or no tax saving if all profits of the business are distributed to its shareholders. Depending on their involvement, an owner may have more control over when distributions arise and therefore the tax year that any profit distribution falls into.
When a business is operated through a corporate structure, the business assets are owned by the company and it is the shares in the company that are owned by the individual shareholders. A shareholder’s liability is limited to the amount, if any, unpaid on their shares.
This offers the business owner an additional level of personal protection for activities involving the general public. However, insurance may be used to manage this risk for a sole trader/partnership.
As for an LLP, annual accounts and confirmation statements detailing the main shareholders, are required to be filed with Companies House, and a corporation tax return must be filed with HMRC.
Succession can be easier with a company because it is much easier to give away shares to family members than interests in an unincorporated business, and this can be done quite simply, and even over several years.
A trust is created by a settlor who transfers assets to the trustees of the trust. The trustees legally own the assets but must use the income and capital of the trust for the benefit of the beneficiaries.
Trusts may be established to retain legal control of a business where the beneficial ownership has been gifted to a beneficiary, such as a child or grandchild, who is not yet ready to manage and fully control the business. Gifting the legal ownership of an asset or business to a trust can assist with the succession of the asset/business within the family.
Trusts can be used in combination with the other structures above. For example, a trust may be a partner in a partnership, or a shareholder in a company. The taxation and legal formalities of trusts can be complicated and there can be a significant ongoing administrative burden associated with having a trust, meaning that they are only viable where the assets involved warrant the additional complexity.
No commentary on structuring a successful business would be complete without a few words on succession. When considering passing on a business, thought should always be given to attaining BPR to reduce the amount of IHT payable. There are several conditions, the main one being that a business must not be wholly or mainly (ie more than 50%) one of making or holding investments. To put it simply, it must be more of a ‘trading’ business than an ‘investing’ one.
In certain cases, a business as a whole can qualify for BPR, including assets which on their own may not qualify for relief, such as residential cottages. The relevant case law is that arising from the Farmer and Balfour cases, and we recommend specific advice is always taken in this regard.