When considering the best vehicle through which to operate a business, tax is a major consideration which can affect that decision, but it’s not the only one; practical and legal issues should be considered as well. A limited company is a ‘body corporate’ (i.e., a separate legal person). The company owns the assets, the profits, it conducts the business, pays its own taxes, employs its own people, can sue and be sued, etc. This ‘veil of incorporation’ insulates the business (and the inherent risks) from its owners, thus limiting their personal liability. Directors are appointed to run the business and the owners may appoint themselves as such; they are treated as employed individuals, like any other employee of the company, but subject to stricter rules under company law. General partnerships are not separate legal entities (except in Scotland); partners have unlimited liability and are subject to ‘joint and several’ liability (i.e., they are all equally responsible for the partnership’s liabilities).
What About The Tax Differences?
(a)Partnerships
A partnership is defined (in Partnership Act 1890, s 1) as ‘the relation which exists between persons carrying on a business in common with a view to profit’, and for tax purposes it is just that; multiple sole traders coming together. As with the legal position, the partnership is not a separate taxable person (i.e., it is transparent). The partnership completes its own tax return with its own unique tax reference number, but does not actually pay any tax. The partners’ individual profit shares feed into their own personal tax returns and they pay income tax and (currently) Class 2 and 4 National Insurance contributions (NICs) thereon. Likewise, disposals of partnership assets are assessed on the partners for capital gains tax purposes based on their capital stakes (represented by their capital accounts). Beyond submitting partnership tax returns to HMRC there are no other formalities, with no need to involve Companies House. Limited liability partnerships (LLPs) apply ‘body corporate’ treatment to partnerships, but generally with the same tax transparency as ordinary partnerships.
(b) Partnership Agreement
One thing which is not necessary for a partnership, but is highly recommended, is a partnership agreement drawn up to outline the partners’ wishes and how the partnership should be run. In the absence of such an agreement, the Partnership Act 1890 prescribes a framework for the partnership to operate within; for example, the partnership dissolves on the death of a single partner, each partner has equal management and profit rights, and no interest on capital.
(c) Companies
Limited companies are not transparent; they are subject to corporation tax on their own account (at a main rate of 25%, or 19% for profits under £50,000); if the owners (shareholders) withdraw post-tax profits as dividends, they are subject to income tax at rates of 8.75%/33.75%/39.35%, so lower than that on self-employed partners’ profits and directors’ salaries; also, dividends are not subject to National Insurance contributions. However, because dividends are paid after corporation tax, there is an element of double taxation on the same profits. Companies alone are also able to benefit from research and development (R&D) and patent box reliefs. Whereas a partner is taxed on their profit share irrespective of whether they withdraw those profits, a director-shareholder is only subject to personal tax to the extent that those profits are actually withdrawn – which can be carefully controlled. Companies can therefore accumulate profits without incurring personal tax liabilities.
Practical Tip
Deciding whether to operate as a partnership or company will depend on several factors, e.g., potential claims for research and development relief; the ability to restrict personal tax liabilities, combined with lower corporation tax rates usually means greater overall tax savings especially if profits are retained within the company. Having limited liability may be reason alone to operate through a company, but the simplicity and flexibility of a partnership will often suffice; especially as LLPs can offer the best of both worlds.
