To put your business on a proper footing with HM Revenue & Customs and other authorities, you need to make sure that it has the right legal structure. It's worth thinking carefully about which structure best suits the way that you do business, as this will affect:

• the tax and National Insurance that you pay
• the records and accounts that you have to keep
• your financial liability if the business runs into trouble
• the ways your business can raise money
• the way management decisions are made about the business

There are several structures to choose from, depending on your situation. This guide will help you understand the differences between them.

If you are not sure which legal structure would best suit your business, it's a good idea to get advice from an accountant or solicitor.

Self-employment

To be a sole trader, a partner, or a member of a limited liability partnership as an individual rather than a company, you must be self-employed - and registered as such with HM Revenue & Customs (HMRC). This does not mean that you can't also do other work as an employee, but the work you do for your business must be done on a self-employed basis.

If you are not sure whether this work counts as self-employment, ask yourself these questions:

• Do you present your clients with invoices for the work that you do for them?
• Do you carry out work for a number of clients?
• Are you responsible for the losses of your business as well as taking the profits?
• Can you hire other people on your own terms to do the work that you've taken on?
• Do you have control over what work has to be done, how the work has to be done and the time when and place where the work has to be done?
• Have you invested your own money in your business or partnership?
• Do you provide any major items of equipment which are a fundamental requirement of the work you carry out?
• Do you have to correct unsatisfactory work in your own time and at your own expense?

If you can answer "yes" to most of these questions then you are probably self-employed already, and should let HMRC know this immediately if you have not already done so. You may be fined £100 if you fail to register within three months of becoming self-employed. There is no fee for registration.

See our guide on how to set up and register as self-employed for a checklist of all the steps you'll need to take.

If you answer "no" to most of the questions above, you will normally be an employee.

Sole trader

Being a sole trader is the simplest way to run a business, and does not involve paying any registration fees. Keeping records and accounts is straightforward, and you get to keep all the profits. But you are personally liable for any debts that your business runs up, which can make this a risky option for businesses that need a lot of investment.

Set-up

• You need to download and complete form CWF1 to register as self-employed from the HM Revenue & Customs (HMRC) website (PDF).

Management and raising finance

• You make all the decisions on how to manage your business.
• You raise money for the business out of your own assets, and/or with loans from banks or other lenders.

Records and accounts

• You have to make an annual self-assessment return to HMRC.
• You must also keep records showing your business income and expenses.

Profits

• Any profits go to you.

Tax and National Insurance

• As you are self-employed, your profits are taxed as income. You need to pay fixed-rate Class 2 National Insurance contributions (NICs) and Class 4 NICs on your profits. 

Liability

• As a sole trader, you are personally responsible for any debts run up by your business. This means your home or other assets may be at risk if your business runs into trouble.

Partnership

In a partnership, two or more people share the risks, costs, and responsibilities of being in business. Each partner is self-employed and takes a share of the profits. Usually, each partner shares in the decision-making and is personally responsible for any debts that the business runs up.

Unlike a limited company, a partnership has no legal existence distinct from the partners themselves. If one of the partners resigns, dies or goes bankrupt, the partnership must be dissolved but the business may not need to cease.

A partnership is a relatively simple and flexible way for two or more people to own and run a business together. However, partners do not enjoy any protection if the business fails.

Set-up

• Each partner needs to download form CWF1 to register as self-employed from the HM Revenue & Customs (HMRC) website (PDF).
• It's a good idea to draw up a written agreement between the partners. For further advice, consult an accountant or solicitor.

Management and raising finance

• Partners themselves usually manage the business, though they can delegate responsibilities to employees.
• Partners raise money for the business out of their own assets, and/or with loans. It's possible to have 'sleeping' partners who contribute money to the business but are not involved in running it.

Records and accounts

• The partnership itself and each individual partner must make annual self-assessment returns to HMRC.
• The partnership must keep records showing business income and expenses.

Profits

• Each partner takes a share of the profits.

Tax and National Insurance

• As partners are self-employed, they are taxed on their share of the profits. Each partner needs to pay fixed-rate Class 2 National Insurance contributions (NICs) and Class 4 NICs on their share of the profits. 

Liability

• Each partner is personally responsible for all debts run up by the partnership as a whole. This means their homes or other assets may be at risk if the business fails.

Limited liability partnership (LLP)

A limited liability partnership (LLP) is similar to an ordinary partnership - in that a number of individuals or limited companies share in the risks, costs, responsibilities and profits of the business.

The difference is that liability is limited to the amount of money they have invested in the business and to any personal guarantees they have given to raise finance. This means that members have some protection if the business runs into trouble.

Set-up

• There is no restriction on the number of members, but at least two must be "designated" members - the law places extra responsibilities on them.
• If the LLP reduces in number and there are fewer than two designated members then every member is deemed to be a designated member.
• LLPs must register at Companies House.
• It's a good idea to draw up a written agreement between the members. For further advice, consult an accountant or solicitor.

Management and raising finance

• Usually the members manage the business, but can delegate responsibilities to employees.
• Members raise money out of their own assets, and/or with loans.

Records and accounts

• The LLP itself and each individual member must make annual self-assessment returns to HM Revenue & Customs (HMRC).
• All LLPs must file accounts with Companies House.
• A "shuttle" annual return (form LLP363) will be sent to the members before the anniversary of incorporation each year. It needs to be completed and returned to Companies House with the appropriate fee.

Profits

• Each member takes an equal share of the profits, unless the members agreement specifies otherwise.

Tax and National Insurance

• Members of a partnership are taxed on their share of profits and pay the tax and National Insurance contributions (NICs), according to their business structure.
• An individual will pay income tax and NICs, and a limited company member will pay corporation tax.

Liability

• Every LLP must have at least two designated members. Read the list of extra legal responsibilities placed on designated members at the Companies House website.

Find further information for businesses in Northern Ireland at the Companies Registry website.

Limited liability company

Limited companies exist in their own right, distinct from the shareholders who own them. This means their finances are clearly separated from the personal finances of their owners.

Shareholders may be individuals or other companies. They are not responsible for the company's debts (unless they have personally guaranteed a bank loan, for example). However, they may lose the money they have invested in the company if it fails.

Main types

• Private limited companies can have one or more members eg shareholders. They cannot offer shares to the public eg on the stock exchange.
• Public limited companies (plcs) must have at least two shareholders and can offer shares to the public. A plc must have issued shares to a value of at least £50,000, before it can trade. View the guide to company formation at the Companies House website.
• Private unlimited companies - these are rare and usually created for specific reasons. Legal advice is recommended before creating one.

Set-up

• Must be registered (incorporated) at Companies House.
• Must have at least one director (two if it's a plc) and a company secretary, who may also be shareholders.

Management and raising finance

• A director or board of directors make the management decisions.
• Finance comes from shareholders, borrowing and retained profits.
• Public limited companies can raise money by selling shares on the stock market, but private limited companies cannot.

Records and accounts

• Accounts are filed with Companies House.
• A "shuttle" annual return (form 363s) will be sent before the anniversary of incorporation each year. It needs checking, amending and returning to Companies House with the appropriate fee.

The directors and secretary are responsible for notifying Companies House of changes in the structure and management of the business.

Profits

• Profits are usually distributed to shareholders in the form of dividends.
• From 1 April 2004, distributions to individuals by companies with taxable profits subject to a zero rate of corporation tax, are subject to a minimum of 19 per cent corporation tax.

Tax and National Insurance

• Companies pay corporation tax and must make an annual return to HM Revenue & Customs (HMRC).
• Company directors are employees of the company and must pay Class 1 National Insurance contributions as well as income tax on their salaries.
• If your company or organisation has any taxable income or profits, you must tell HMRC that your company exists and that it is liable to tax.

Liability

• Shareholders are not personally responsible for the company's debts, but directors may be asked to guarantee loans to the company.

Find further advice and guidance for businesses in Northern Ireland at the Companies Registry website.

Franchises

Buying a franchise is a way of taking advantage of the success of an established business. As the "franchisee", you buy a licence to use the name, products, services, and management support systems of the "franchiser" company. This licence normally covers a particular geographical area and runs for a limited time.

The way you pay for the franchise may be through an initial fee, ongoing management fees, a share of your turnover, or a combination of these.

A franchise business can take different legal forms - most are sole traders, partnerships or limited companies. Whatever the structure, the franchisee's freedom to manage the business is limited by the terms of the franchise agreement.

Set-up

• This depends on the business structure that the franchisee chooses for their business - usually a sole trader, partnership or limited company.

Management and raising finance

• Franchise agreements usually set out how the franchised business should be run, although they may allow some flexibility. Franchisers usually provide management help and training to franchisees.
• Normally the franchisee must find the money needed to start up the business, but franchisers may sometimes loan some of this.

Records and accounts

• These depend on the business structure that the franchisee chooses for their business. As well as the usual legal requirements, franchisers often expect franchisees to show them detailed financial records.

Profits

• Franchisees often pay a share of their turnover to the franchiser, which brings down the overall profits.

Tax and National Insurance

• These depend on the business structure that the franchisee chooses for their business.

Liability

• These depend on the business structure that the franchisee chooses for their business.

Social enterprises

A social enterprise is a business with primarily social objectives whose surpluses are principally reinvested for that purpose in the business or in the community, rather than being driven by the need to maximise profit for shareholders and owners.

They are businesses distinguished by their social aims. Examples of social aims are job creation and training, providing community services and "fair trade" with developing countries. There are many different types of social enterprises, including community development trusts, housing associations, worker-owned co-operatives and leisure centres.

Social enterprises may take a number of different business structures - companies limited by guarantee, companies limited by shares and industrial and provident societies are the most usual.

On 1 July 2005, a new type of limited company - the Community Interest Company (CIC) - was introduced. CICs are businesses that operate with a social purposes and use their profits and assests for the benefit of the community rather than for private advantage. They are not subject to the same regulations as charities, nor do they have the same tax advantages. CICs are registered at Companies House in the same way as other limited companies. However, they are regulated by an independent Regulator of Community Interest Companies, who approves all applications for CIC status. Find out about Community Interest Companies on the CIC website.

Download information on the various legal forms available to social enterprises from the Bates, Wells & Braithwaite website (PDF).

Set-up

• This depends on the business structure of the social enterprise. If it's a limited company, limited partnership or Community Interest Company, it must register at Companies House. See details of how to register at the Companies House website.
• Industrial & provident societies must register with the Financial Services Authority. Find out how to register at the Financial Services Authority website.
• Find out about setting up a social enterprise on the Social Enterprise Coalition website.

Management and raising finance

• Social enterprises often have a democratic management style, with a number of different "stakeholders" taking part in decision-making. These may include employees, users of the enterprise and specially appointed trustees.
• As well as raising money like other businesses, many social enterprises get grants or loans from public organisations.

Records and accounts

• These depend on the business structure of the social enterprise.

Profits

• Profits are principally reinvested in meeting the social objectives of the enterprise or used to benefit the community.

Tax and National Insurance

• Depends on the business structure of the social enterprise. Some social enterprises can claim charitable status, which reduces the amount of tax they have to pay.

Liability

• Depends on the business structure of the social enterprise.

Overview of legal structures

Sole trader

The advantages of being a sole trader include independence, ease of set up and running, and that all the profits go to you.

The disadvantages include a lack of support, unlimited liability and the fact that you are personally responsible for any debts run up by your business.

Partnership

One of the advantages of being in a partnership include its ease of set up and running. Also partners can bring a variety of skills and experience to the business.

On the other hand, problems can occur when there are disagreements between partners, there is ulimited liability, and, as a partner, you are personally responsible for any debts that the business runs up.

Limited liability partnership (LLP)

LLPs retain the flexibility of a partnership as opposed to the rigid structure of a limited company, and your personal liability is limited. There is also no restriction on the number of members, but at least two must be "designated members" - the law places extra responsibilities on them.

However, the formation of an LLP is more complex and costly than that of a partnership and problems can occur when there are disagreements between other members. If the partnership reduces in number and there are fewer than two designated members then every member is deemed to be a designated member.

Limited liability company

A limited liability company provides reduced exposure to meeting the company's debts. This means that your personal risk will be restricted to how much you invest in the business and any guarantees you have given in order to obtain financing.

But you should remember that this type of company also brings a range of extra legal duties, including the maintenance of the company's public records eg filing of accounts.

Community Interest Company (CIC)

This is a new legal structure that is similar to a limited company, designed to allow social enterprises to use profits and assets for the benefit of the community. They are more lightly regulated than charities, but do not have the tax advantages of charitable status. However, charities can set up a CIC as a subsidiary. CICs can be limited by shares, by guarantee or can be a public limited company. Find out about Community Interest Companies on the CIC website.

Franchise

The major advantage of a franchise is that it takes advantage of the success of an established business and support networks.

Its disadvantage is that your freedom to manage the business is limited by the terms of the franchise agreement. Also franchisees often pay a share of their turnover to the franchiser, which brings down overall profits.

Social enterprises

Social enterprises are businesses that trade for a social purpose and represent a diverse and growing range of business activity across the UK. Find out about social enterprises on the Social Enterprise Coalition website.

Here's how I chose the right legal structure for my business

John Kerr

Kerr Print and Stationery

John's top tips:

• "Take professional advice on the best way to set up your business - don't assume that you need to form a company."
• "Think about how your business relationship will work in practice before you go into partnership."
• "Consider if your structure is still the right one when circumstances change -you don't have to stick with the structure you chose when you started up."
  

After 10 years as the general manager of an office supplies company, in 2001 John Kerr decided that he wanted to run his own business. Initially, John went into partnership with a former colleague. After a series of disagreements they agreed to go their separate ways, and John has a new business partner.

What I did

Talk to a solicitor

"Originally I'd planned to take on my colleague as an employee. But he wanted to share in the management of the business, which seemed fair enough, so we talked to a solicitor about the choices.

"Setting up a partnership was the simplest option, and would avoid the extra costs of setting up and administering a company. The solicitor pointed out that we would both be personally liable for any business debts, but as we weren't planning to borrow this wasn't a big issue for us."

Start the business

"The solicitor said that we needed a partnership agreement, and helped us draw one up. Preparing the agreement was a chance for us both to think about how we wanted to run the business and what our responsibilities would be.

"Apart from that, the official side of starting the business was very straightforward. We each registered as self-employed and for VAT with HM Revenue & Customs and told them that we were going into partnership. At the same time, we set up a computerised accounting system and lined up an accountant to handle our tax returns. With our systems set up, we were ready to get on with building the business."

Reorganise the business

"Unfortunately, we soon realised that we didn't work together well. We each had our own ideas on what we should be doing, and it wasn't helping the business at all. A few months after we started, my partner left the business.

"As it happened, there was someone else I wanted to bring into the business anyway. Reorganising the partnership was straightforward, but I did check with the solicitor and tell the accountant. It seems to have worked out well enough. Turnover of our business has more than doubled in the last three years, so we must be doing something right!"

What I'd do differently

Think through the working relationship

"When we set up the original partnership, the solicitor made a point of talking about the problems we could face if we disagreed on how to run the business. The partnership agreement was supposed to be a way of overcoming that risk, but we just didn't put enough thought into it. We were excited about starting our new business, not thinking about things going wrong. With the benefit of hindsight, I can see that it was always going to be difficult for me to adjust to sharing decisions with someone who used to work for me."

Download this case study and 20 like it in our free book, "Here's how I started up my business" (PDF)