Legal requirements

When setting up as a business the most common options are to: work as a sole trader, work as a partnership, join or form a limited liability partnership, or establish a limited company. However, if you plan to run a non-profit making venture that delivers social benefits you may want to consider alternative structures.

In brief

• Setting up as a sole trader
• Partnerships
• Limited Liability Partnerships
• Establishing a limited company
• Social enterprises
• What to do next

The simplest way to start a business is to register with Her Majesty's Revenue and Customs (HMRC) as self-employed. Unless you then go on to set up a formal legal entity, such as a Limited Liability Partnership, you will then operate as a sole trader.

Setting up as a sole trader is straightforward. There are no legal costs and your only obligation is to file an annual tax return. However, you must inform both your tax office and the Contributions Agency, another branch of HMRC, that you are self-employed.

The tax office will send you a tax return every year while the Contributions Agency will send you a quarterly National Insurance bill. It's important to note that this will not cover your entire National Insurance liability. The balance will be worked out when you fill in your tax return.

"Setting up as a sole trader is straightforward"

As a sole trader you can reduce your tax bills by setting business expenses against overall income.

For instance, if income is £40,000 a year and you have allowable expenses of £5,000, you will only be taxed on the remaining £35,000 profit. However, you will have to satisfy HMRC that you genuinely are self-employed.

The chief test is that you work for a range of clients and charge for work done on a case-by-case basis. If you were on a retainer for a single customer, HMRC could well conclude that you are an employee in everything but name and insist that you are taxed at source by your client through the PAYE system.

PROS

• One of the easiest ways to set up a business is as a sole trader
• You can set expenses against your overall income
• You are your own boss.

CONS

• There is no separation between your finances and those of the business. If the business makes a loss and/or you incur large debts, then you alone are liable
• No matter how successful you are as a sole trader your business will be difficult to sell, as the venture has no independent legal status.

When two or more people decide to establish a business, the most straightforward structure is a simple partnership. Essentially, forming a partnership is not dissimilar from setting up as a sole trader; the principal difference is that more than one person is involved.

Legally, a partnership exists whenever two or more people agree to work together. There is no requirement to draft a legal agreement (although this is certainly desirable) or to register the business at Companies House. However, all parties must inform the HMRC that they are self-employed and must file self-assessment tax returns at the appropriate time. The taxman will also require an additional self-assessment form covering the partnership itself.

"Legally, a partnership exists whenever two or more people agree to work together"

A partnership may involve a number of financial arrangements.

For instance, the partners may agree to fund a business venture with their own capital and take money out in the form of regular salaries or a percentage of the profits.

In order to avoid conflict, it is advisable to draw up a legally-enforceable agreement that sets out terms.

Unless such an agreement exists, the law assumes that all partners have equal rights (in terms of profit and salaries) and equal responsibilities within the structure.

Partnerships are not required to pay corporation tax, but employers' tax and National Insurance must be paid on salaries.

It is important to emphasise that partnerships have no legal status as companies in their own right. As is the case with sole traders, the finances of the business remain inextricably tied to the finances of the individuals who run it and if the venture fails, it is the partners (not the business) who are responsible for paying any outstanding debts.

PROS

• Partnerships are simple to set up
• There is no need to register with Companies House or file accounts
• Unlike limited companies, there is no corporation tax to pay.

CONS

• The partners are liable for all debts
• Partnerships can be difficult to sell, as the business itself has no legal status
• The law assumes all partners have an equal share in the business. This may not be the case; therefore, a watertight legal agreement is required, setting out the exact terms of the partnership.

As with a partnership, a Limited Liability Partnership (LLP) is essentially a legal entity that brings together a group of people who are registered as self-employed. The minimum requirement for a partnership is two people but there is no upper limit to the number of partners. Each partner retains self-employed status and is responsible for filing his or her tax return every year. However, unlike partnerships, all LLPs must be registered at Companies House and file corporate accounts every year. A legal agreement should exist that defines the terms of the partnership.

"An LLP is essentially a legal entity that brings together a group of people who are registered as self-employed"

Each LLP must have at least two designated members. Essentially these are managers who are responsible for control of the partnership. They have similar responsibilities to company directors.

Under LLP rules, partners share profits. However, an LLP can also take on staff as employees who will be paid in the normal way. As such, an LLP is responsible for administering and paying tax and National Insurance on behalf of its employees. This includes employers' tax and National Insurance.

LLPs as legal entities are liable for the repayment of money owed to creditors, but the exposure of each individual within the partnership is limited. In other words, if an LLP has run up losses and can't pay its debts, it is the firm itself rather than the partners who are liable. For that reason, partners are in a safer position than sole traders. However, partners are expected to behave responsibly and as individuals they can be sued for negligence. Designated members are at particular risk.

PROS

• Partnerships are flexible structures. New partners can be taken on as the business grows, and they offer protection to members if the business fails
• Partnerships must keep and file detailed accounts, making them much more saleable than sole trader businesses should one or more partners decide to cash in
• Partnerships are not subject to corporation tax.

CONS

• The paperwork can be time-consuming. Filing accounts, for example, can become increasingly complex as partnerships grow.

Unlike those of a sole trader or a partnership, a limited company's finances are completely distinct from the finances of the individuals who own and run it.

All limited companies must be registered as incorporated at Companies House. The easiest way to do this is to find a company creation specialist who will handle the legal paperwork and run a search to ensure that your proposed company name is not already in use by a similar business. Your local Business Link or Chamber of Commerce should be able to help you find a company formation specialist. Alternatively, many are listed in the Yellow Pages or can be found online.

"A limited company's finances are completely distinct from the finances of the individuals who own and run it"

To incorporate, your company must have at least one director (aged over 16). In the past there was also a requirement to have a company secretary to take responsibility for vital administration, such as filing accounts. This is no longer required; however, company secretaries continue to play an important role in many businesses.

Directors are employees of the company and, like all staff, must pay personal income tax and National Insurance. In addition, the company itself will pay corporation tax, employers' tax and National Insurance. Shareholders, who may also be directors, can take dividends when profits are made. These will also be taxed.

PROS

• A limited company can raise money by selling shares
• Shares in limited companies can be sold when shareholders want to cash in
• A limited company provides a good platform from which to grow a business
• There can be tax advantages to incorporating rather than remaining as a sole trader

CONS

• If you run a very small business a sole tradership or partnership may be a better option
• Incorporation will incur legal charges
• Director responsibilities can become a burden
• Filing annual accounts, tax and VAT returns can be a complex business. You have the additional responsibility of administering employee tax and National Insurance.

Most companies start life as private limited companies. However, many go on to become Public Limited Companies (PLCs) and as such their shares can be traded on the stock market.

"Some businesses are established to provide goods or services that have a recognisable social benefit"

Not all businesses exist to make a profit. Some are established to provide goods or services that have a recognisable social benefit. While these operate along similar lines to conventional businesses (taking cash from customers/clients to fund provision of products/services) any surplus cash generated is reinvested rather than paid out to shareholders or banked by the owner.

There is no single structure for a social enterprise. They can be run as trusts, unincorporated partnerships, Community Interest Companies (CICs), industrial and provident societies (IPSs), community benefit societies (known as, ‘BenComs'), or even as limited companies (with a social purpose).

All of these structures have their own characteristics, so your choice needs to fit your objectives. If you are planning to create a social enterprise, you should seek advice on the best course of action for you in terms of ease of setup, tax breaks, governance requirements and the responsibilities of founders.