Comparison between a partnership and a private company
First of all, it is important to realize that the major distinction between trading as a limited liability company and as a sole trader or partnership. For instance, the shareholders are protected against company failure, in that their liability to creditors is limited to their share capital. If they are not trading with limited liability, then in the event of the failure of the business, all of the sole trader or partners’ personal assets are available for the payment of creditors.
This is the usual reason given for incorporation - ie to protect the assets of the individual(s) behind the company in the event of the failure of the business. However, this “protection" is often illusory. Often, the major creditor of the business will be the bank. In general, they will not advance money to a company without the personal guarantee of the directors/shareholders (usually one and the same for most small companies). If the business does fail, then the guarantors will be expected to repay the bank. In addition, as these guarantees are usually “joint and several", the bank will generally first pursue those who appear to have the greatest personal worth and leave the director/shareholders to settle amongst themselves who will bear what share of the liability. Furthermore, suppliers often treat new companies with a certain lack of trust, and refuse to extend any credit until they have established a satisfactory track record of payments for goods supplied.
3 Another common reason for incorporation is where there is to be an outside investor, who puts in money in return for a share of the profits. This person would be foolish to become a Partner in the business, as he would inevitably be exposed to personal risk, when often he would have little or no control over the day to day running of the business. In such cases, it is usual to form a company, as this gives far greater flexibility in the allocation of shares, and protects shareholders that do not have any managerial involvement in the business from personal liability. In addition, with careful planning beforehand, it is possible for individuals who each have less than a 30% stake in the company to gain tax relief on their investment at 20% of the amount invested by using the Enterprise Investment Scheme. Furthermore, so long as the company adheres to certain criteria, the qualifying shareholders can gain exemption from Capital Gains Tax when they eventually sell their shares, provided that they hold onto them for at least 3 years.
4 TAXATION: The taxation regime for companies is markedly different from that related to unincorporated businesses. Broadly, each year the first £10,000 of taxable profits in a company is taxable at 10%, the next £40,000 is taxable at 22½% and the next £250,000 of taxable profits in a company is subjected to tax at 20%. However, if a two-person partnership made profits of £300,000, the majority would be taxed at 40%. Against this, it is important to note that the salary taken from a company will be subjected to both employer and employee National Insurance, and this burden will be far in excess of that which would apply on the equivalent amount of Partners’ drawings. This problem can be overcome to a certain extent by taking dividends. In general though, it is not worth incorporating for tax reasons alone, unless the profit per partner is at least £50,000 per annum, and a significant amount of this sum is left within the business to fuel its expansion.
5 The final main reason for incorporation is where there is a significant risk of a knockout claim being made against the business. For example, in areas such as construction, there could be claims made against the business by a customer in respect of construction defects. Similarly, for software used in mission critical applications, there could be significant exposure to claims that the software was not fit for its purpose. In view of the potential size of the claims against the profit that they deliver, such claims could be terminal for the business. Again, in an unincorporated business, if the claim is successful, the assets of the principals will be on the line. However, if the business is incorporated, there is far less likelihood of these being at risk. Note that where there are intellectual property rights involved, it is often sensible to have more than more company, with the top company holding the IPR and the subsidiary exploiting those rights.
6 If a company is formed, it is important to remember that a company is a separate persona in law. This means that the assets of the company belong to the company, not to its directors or shareholders. You cannot therefore just treat the assets of the company as your own, and dip into them as the fancy takes you. This contrasts to the position with an unincorporated trade, where the assets belong to the principals.
7 Under current legislation, a company requires an audit (unless its turnover is less than £1,000,000), whereas an unincorporated business generally does not. This has been recently increased to this level and is widely expected to increase still further, although no date for any further increase has yet been announced. For the average small company, an audit will add around at least £500 to the accountancy costs.
8 The main perceived disadvantage of setting up a company is that information on the finances of the business are then placed in the public domain. Copies of the annual accounts must be filed with Companies House within 10 months of the year-end. Small companies (essentially those with a turnover of less than £2.8 million and fewer than 50 employees). They can file abbreviated accounts which do not give a profit and loss account and give far less other disclosure, although this reporting relaxation is expected to be taken away within 12 months or so. In addition, details of the shareholders and directors also need to be filed at Companies House. This contrasts with an unincorporated business, where there is no requirement to file anything in the public domain.