While it is frequently assumed that, with a limited company, incorporation brings substantial tax benefits and greater financial protection to directors, this is not always the case. In fact, for some firms, running as a partnership can be the most efficient and rewarding route.
Each firm must assess its particular ambitions in view of current circumstances and decide the most appropriate route. But first, let's recap on some of the basic differences.
A limited company is a legal entity, run by directors and owned by shareholders, who are frequently the same people. The company must publish its annual accounts, although small organisations need only provide a basic financial summary, and for those with a turnover of less than £1m a year, no audit is required.
In contrast, partnerships are owned and run by individual partners, who are personally and jointly responsible for the actions of their fellow partners – which partly accounts for the importance of a partnership agreement or deed. Partnerships do not have to publish or audit their accounts, however large they get.
A few of my clients have set up a limited liability company to run alongside a partnership, each running different types of projects.
This gives maximum flexibility and helps the business to protect itself. It can also ensure succession, as partnerships can dissolve if one partner leaves, whereas a company will continue indefinitely.
Limited liability partnership, or LLPs, which were introduced earlier this year, bring the benefits of limited liability while maintaining a traditional partnership. Not surprisingly, practices of all sizes are considering this option.
The type of work you undertake often dictates whether or not limited liability is required. Typically, if you have regular overseas projects or work for large clients, incorporation may be appropriate from a commercial point of view.
Share ownership can be extended to spouses and children, who can often be paid efficiently in dividends
But limited liability does not protect the proprietors entirely; for instance, personal guarantees may be required if finance is needed. In any event, insurance should always be considered to cover potential liabilities.
Broadly speaking, if you plan to leave or re-invest money in the business, incorporation can offer advantages, as corporation tax on company profit is lower than income tax.
Although income tax rates for partners and directors are the same, directors of a limited company pay national insurance at a much higher rate than members of a partnership, which adds significantly to both the company's and the individual's tax bill. Indeed, if a company and a partnership both paid an architect £65,000 net, the company would have to make 14% more profit than the equivalent partnership.
However, if directors take a lower salary and reinvest more in the firm, limited liability may offer financial advantages. In short, different levels of profitability create a different financial picture and any decision regarding structure requires careful consideration of your current and future objectives.
Many companies also enjoy substantial flexibility to structure an efficient reward package, largely because the roles of shareholders and directors are blurred in owner-managed businesses. Profit can therefore be extracted through a mix of salary, bonuses, pensions, dividends and other benefits to create a tax-efficient package.
Share ownership provides flexibility to company owners. For example, ownership can be extended to spouses and children, who can often be paid efficiently in dividends. Company owners can also promote senior staff to director level, providing a useful incentive without having to devolve ownership of the business.
Shares are another way of rewarding and offering incentives, particularly if you set up an initiative such as the Enterprise Management Incentive Scheme. This is a good deal for employers and employees.
Chris Pomroy is a partner at chartered accountant Smith & Williamson.