Types of business structures: how to choose the right one for your business

What is a business structure?

By ‘business structure’, we’re talking about the legal structure of a business. The main types of business structures are sole trader, partnership, and company.

Choosing a business structure for your small business affects your admin burden, your business’s taxation, legal status, daily operations, and your personal liability.

Types of business structures

Here’s a comparison of the different types of business ownership.

What is a sole trader?

A sole trader is a single-owner business. It doesn’t have to be a single-worker business, though, so you can hire staff.

Advantages of being a sole trader

It’s easy to set up as a sole trader and your tax obligations are simple: you just declare income and expenditure on your personal tax return.

Here’s guidance on choosing accounting software for sole traders.

Disadvantages of being a sole trader

A sole trader doesn’t have any special legal status, so the owner is personally responsible for what the business does. If the business gets into debt or legal trouble, so does the owner, so you need insurance.

What is a partnership?

A partnership business structure is one that’s owned by two or more people. There are no rules about how ownership is divided – one partner can own 99% of the business. You need to choose a ‘nominated partner’ who is responsible for managing the partnership’s tax returns and keeping business records.

Advantages of a partnership

It’s easy to set up as a partnership, although you should have an official document that sets out the agreement between the partners. Your tax obligations are pretty straightforward, too:

• The partnership files a return that sets out the partnership’s income, expenses, and any tax refunds
• Each partner declares their share of business profits on their personal tax return.

Disadvantages of a partnership

If the business gets into financial or legal strife, the partners do too. You could also get into difficulty if one of the other partners does something wrong.

What is a limited liability partnership?

Two or more partners own a limited liability partnership (LLP) and benefit from greater legal protections than people in conventional partnerships and sole traders.

Advantages of an LLPYou won’t necessarily get into legal or financial trouble if one of your partners makes a mistake – your accountant or lawyer can give you the lowdown. Your tax obligations are straightforward, too, as you deal with business income on your personal tax return.

Disadvantages of an LLP It can be more expensive to set up an LLP and you must comply with partnership and corporate laws, so admin isn’t easy. It can also be more difficult to attract investors as they don’t have the same asset protection they have by being a limited company (see below).

What is a limited company?

A limited company (identified by the ‘Ltd’ abbreviation in the company name) is legally separate from its owner (or owners), so you’re less exposed to its legal or financial issues. Unlike LLPs, they can be established with just one member.

Advantages of a limited company

You get some legal and financial protection if things go wrong – your accountant or a lawyer can give you more information. Shareholders may be paid in dividends, giving you more control over your personal income from the company each year, and more options for lowering your tax bill. It’s also easier to raise money as you can sell shares in the company.

Disadvantages of a limited company

It'll cost you more to operate as a company than as a sole trader or a partnership, and there’s also more admin. You’ll need to know how the company will operate before you get started, and you’ll have to regularly submit paperwork to Companies House.

The risks of not choosing a business structure

If you don’t formally choose a structure for your business, you may face:

1. Unlimited personal liability: Your personal assets – such as your home or savings – could be seized to satisfy business debts or legal judgements. Here’s more about personal liability.
2. Tax implications: Your personal income and business income will be treated as the same, so you might pay more tax than you need to.
3. Difficulty raising capital: Potential investors and bank lenders might be discouraged if you don’t have a formal business structure.
4. Limited growth potential: Have visions of expanding? To make significantly higher sales? Your scope may be limited without the right business structure.

What happens if you don’t choose: default business structures

If you don’t choose a structure, your business will operate as a sole trader by default. This means you’ll be personally liable for your business’s debts and legal issues, with no legal distinction between you and the business.

Choose the right business structure for your small business

Here are the things to think about when choosing between the various business entity types.

Understand your liability risks

Think about what it means to be responsible for your business’s debt. You need to balance the risk of personal responsibility with other factors. For example, while sole traders are exposed to more financial risk, a limited company comes with some disadvantages like higher costs and admin.

Consider your control and decision-making preferences

How many people will be running the business? Will you want to grow your leadership team and number of owners? For instance, when weighing up the benefits of a corporation versus a partnership, consider how you’d like to distribute power and responsibility.

Work out your funding needs

Even the smallest businesses need cash to get started. Limited companies can issue shares, making it easier to raise capital, while other business types may struggle to secure large loans in the early years of trading.

Plan for future growth

You need to be flexible to meet the evolving needs of your business. Maybe you’ll want to sell it one day? Maybe it’ll diversify or double in size? Your structure must give you room to develop, so think about how different legal structures for businesses compare – for instance, corporations let you transfer ownership and manage growth more easily.

Can you change your business structure?

Yes – you’re not locked into one structure. Many businesses start out as sole traders or partnerships and grow into companies. You might change your business structure if the business grows and you take on more complex projects with more financial or legal risk.

Simplify your business finances with Xero

Choosing the right entity for your business is just the start of building your company.

Xero software streamlines your financial admin so every step of the process is faster – whether it’s sending invoices, managing cash flow, or creating customised reports.

Automatic calculations always put the latest numbers at your fingertips, while Xero’s cloud-based platform means everything you need is in one secure, accessible place. Less admin means more time for the rest of your business. That’s why small businesses love Xero.