Chris Thorpe looks at partnerships and companies and considers which business model might be best.
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A sole trader looking to expand their business might be weighing up the ‘pros’ and ‘cons’ of a partnership or a limited company. They are very different, with not only very different tax consequences, but functions as well.
Partnership
A partnership is essentially two or more sole traders coming together for a common venture. It is governed by the Partnership Act 1890, with the tax rules mostly contained within a Statement of Practice (SP D12, dated January 1975).
Partnerships are transparent; they do not have their own legal identity, so the individual partners are subject to income tax on their own profit shares (irrespective of drawings, and with Class 4 National Insurance Contributions) and shares of capital profits or losses for CGT. The partnership does not pay tax; however, The partnership does report the business profits on its own tax return, with its own unique tax reference number, but the profits or losses are assigned to the individual partners who record their shares on their own tax returns. However, partnerships can have their own VAT and payroll numbers.
Besides a separate tax return, there are no other reporting requirements for general partnerships, there is no obligation to file accounts nor any reports with Companies House. Unlike with a limited company or a limited liability partnership (LLP; see below), nothing need be made public.
One issue with partnerships, just like with sole traders, is that there is no protection from legal claims from third parties – the partnership itself is not sued; it is the individual partners who are subject to potentially unlimited joint and several liability.
Limited companies
A company is a separate entity from its owners (the shareholders); the business is conducted by the company and the profits or gains belong to this body corporate and are subject to corporation tax. Accounts must be submitted to HMRC and Companies House; and the register of shareholders or persons of significant control must be sent to the latter.
If the owners wish to get their hands on the profits, they must declare them through dividends, pay them as salaries or bonuses through a payroll, or perhaps charge the company for the use of personal assets – all of which will have personal tax consequences.
Dividends attract a lower rate of personal income tax (plus a £500 dividend allowance) but are not deductible for the company as they are paid out of taxed income through the company’s distributable reserves. As well as shareholders who own the company, the business is run by directors, who are often also shareholders with smaller businesses, but not necessarily. Directors can receive an officer’s fee, but also a larger salary via an employment contract. The tax impact should be considered between the individual shareholders or directors’ burden and that of the company. Personal tax is only incurred when profits are withdrawn, whereas for partnerships the profits are fully taxed, irrespective of what happens to them.
As well as this different tax treatment, a company offers protection to its owners. The company is a separate person and assumes the risks, sues, and gets sued and insulates the owners from any personal liability. The potential damage to them is ‘limited’ to their investment.
Best of both?
A limited liability partnership (LLP) is treated exactly the same as an ordinary partnership for tax purposes but is a separate legal entity, so it offers the protection of a limited company to its partners (or ‘members’, as they are properly known).
Practical tip
The two deciding factors between companies and partnerships are generally risk and profit extraction. If a business has an increased danger of third-party liabilities, a company or LLP might be a good option from which to operate it. However, for tax purposes, if the bulk of the profits are to be paid out to the owners, operating through a company will lead to double taxation with corporation tax on the profits and income tax on the dividends or salaries; but if the desired drawings are lower than the profits, a company might be preferable as partners are taxed on the profits regardless of what happens to them.
