What is a business entity?

When you’re setting up your own business, it can feel like there are a hundred and one questions you need to ask yourself. Some are pretty obvious from the start – questions like how to write a business plan, how to advertise your business, and how to price a product or service.

But there’s another key issue which may be slightly less exciting to consider as an entrepreneur, but no less important. Namely, what kind of business entity you should opt for.

This will set the right foundation for your enterprise and determine how you manage some vital financial matters. That’s why it’s so important to be aware of the meaning of “entity” in business, the types of business entities you can choose from, and the pros and cons of each.

An entity in business

The term “business entity” refers to the legal structure of any commercial enterprise.

Whatever kind of work you’re engaging in as an entrepreneur – whether you’re running a big, bustling food and drink business or keeping things simple with low cost business ideas you can engage in at home – you’ll need to adhere to the legally-recognised rules of the business entity type you’ve chosen for your enterprise.

The decision you make about your business entity will determine:

• How much you have to pay in tax

• What financial records are required

• Your personal liability when it comes to debts and losses

Beyond these factors, which are set in stone, the type of business entity you operate under can also influence how others regard you – from customers and clients to potential lenders and investors.

So, even setting aside the legal and financial implications, your choice of business entity can impact your business growth strategies and your success going forwards.

What types of business entities are there?

Weighing up side hustle ideas? Or perhaps you have a very definite idea of a major new career path you want to carve out as your own boss? Either way, these are the most common business entity types you’ll want to consider:

• Sole trader

• Partnership

• Private limited company

Sole trader

If you’re running your enterprise on your own, you can choose to operate as a sole trader. This is the simplest business entity, because there is no legal distinction between you and your business. In other words, you are your business.

Being a sole trader means less paperwork compared to other business entities. You aren’t required to register your business with Companies House, and since you’re the one and only boss, you won’t be drawing up contracts regarding how profits are shared. 

That’s not to say you can’t employ people, though. Contrary to popular belief, sole traders can indeed hire staff and appear to all the world like any other type of company. 

That said, the simplicity of this business structure and the lack of legal safeguards it provides when it comes to losses and debts means that it’s typically adopted by small-scale, one-person businesses where overheads and financial risks are relatively low.

For example, if you’re interested in how to start a side hustle as a local painter and decorator, want to set up an online store selling arts and crafts, or are launching a new career as a hairdresser, then being a sole trader might well be the right fit for you.

Advantages of being a sole trader

Easy to set up

This is the most fuss-free of all business entity types, with fewer formal requirements than forming a partnership or setting up a limited company.

The only official boxes you’ll need to tick, as far as the UK government is concerned, is registering with HMRC, submitting your tax and VAT returns, and paying any taxes owed. Any profits generated by the business can be taken by you without any impact on how much you pay in tax.

Minimal accounting requirements

Bookkeeping for small businesses is also a more straightforward affair for sole traders, with fewer tax and reporting obligations. While you do have to retain records of sales, expenses and PAYE records (if you’re paying staff), you won’t have to file additional annual accounts known as statutory accounts, or pay corporation tax.

The relative lack of admin and complexity, compared to other business entity types, makes it easier to always have a clear idea of your finances, what taxes are owed, and how much profit will be going into your pocket.

Privacy

Operating as a sole trader means information regarding your business operations, including when it was set up, your own personal details, and details of company accounts, are not disclosed to the public. You’ll therefore have a far greater degree of privacy as a sole trader compared to a limited company director.

Disadvantages of being a sole trader

Greater financial risk

Since you and your business are one and the same, legally speaking, you’ll be personally financially responsible for any losses or debts incurred by the enterprise. This is known as unlimited liability, and it’s a particularly important consideration if you expect to take out business loans or undertake work which can rack up sudden costs.

For example, if your revenues drop and you can’t pay back the loans, or you have to cover the costs of accidental injury or damage resulting from work you’ve done, you won’t be personally insulated from these business debts. You’ll have to pay out of your own pocket, meaning your savings and other assets could be at risk.

While you can mitigate against this by taking out public liability insurance and similar policies to cover worst case scenarios, you may prefer the greater financial safeguards that come with a limited company structure.

May appear less credible

Depending on the type of business you’re running, being a sole trader may make you seem less credible in some people’s eyes.

This is less likely to be an issue if you’re running a B2C (business to customer) enterprise. After all, if someone hires you to paint their bathroom, or do their makeup for a wedding, they probably won’t be remotely interested in whether you’re a sole trader or not.

Your business entity status is more likely to matter if you’re a B2B (business to business) enterprise, because the more rigorous accounting and compliance requirements placed on limited partnerships and companies means that these entity types are often seen as more trustworthy and prestigious by other businesses.

For example, entrepreneurs looking into small business ideas like providing events management, digital marketing or video production services may find it more challenging to attract corporate clients if they aren’t operating as limited companies.

Similarly, sole traders may find it tricker to raise financing from lenders and investors who may regard them as higher risk propositions.

May be less tax efficient

Sole traders are taxed in a straightforward way: you pay a certain percentage of income tax and National Insurance contributions based on the profit you earn in a year. The neat simplicity of this does come with a drawback, which is that you may end up paying more compared to other business entities.  

For example, if you were a limited company director, you could choose to pay yourself through a mixture of salary and dividend payments, with the latter incurring a lower rate of tax compared to the simple salary payments. What’s more, you don’t have to pay National Insurance contributions on dividends.

If you’re only earning a modest income as a sole trader, this difference won’t be relevant, which is why many entrepreneurs are happy to start off as sole traders. However, generally speaking, the more you earn, the less tax efficient it will be to remain a sole trader. Limited companies can also claim a wider range of tax reliefs, such as research and development relief.

How to set up as a sole trader

Whether you’re weighing up how to make money from home or are planning a line of work which will take you out and about, being a sole trader can be a great way to get started in business. And, as we’ve already mentioned, setting up this business entity is a cinch.

All it requires is contacting HMRC to register for tax purposes. The easiest way to do this is online, following the simple step-by-step instructions on the government website for Self Assessment.

You can start working as a sole trader before even doing this. Just remember that you must register with HMRC by 5th October of the second financial year your business has been trading.

Partnership

The partnership business entity is very similar to a sole trader, except that the business is run by more than one person.

Say you’ve been looking into creative ways to make money and are interested in setting up a graphic design company. You have a designer friend who’s keen to get involved, so the two of you decide to set up a business together. This is where a partnership structure may be adopted.

As with being a sole trader, the business isn’t not a legally distinct entity in itself. You and your partner are your business, both entitled to withdraw profits, and both personally liable for any debts or losses.

While this type of business entity is almost as easy to set up as the sole trader structure, there are a few additional steps to bear in mind, which we’ll look at in a moment.

Advantages of a partnership

Easy to set up

Being almost as simple to set up as a sole trader business entity, a partnership is ideal if you’d like to join forces with one or more other entrepreneurs but don’t want to go down the limited company path.

As long as you fulfil your tax obligations with HMRC, which means filing tax returns and paying any money owed on time, you can feel relaxed in the knowledge that the necessary official boxes have been ticked.

Minimal accounting requirements

Another similarity with being a sole trader is that partners won’t have to concern themselves with extra requirements regarding finances, such as submitting statutory accounts. Tax is also more straightforward, requiring less admin on the part of you or your accountant.

Diversified skillset 

Another benefit of forging a partnership is summed up by the classic saying, “two heads are better than one”. More than one person running a business can entail more expertise being brought to the table, with partners complementing each other’s skillsets.

Going back to the example of setting up a graphic design business with a partner, you might be highly experienced when it comes to using design software and coming up with eye-catching creations. However, you might lack know-how regarding social media marketing and customer acquisition.

By pairing up with a partner who is better at that side of things, you can overcome potential vulnerabilities and pain points that might have been there if you were going it alone. (Plus, having someone else there alongside you can alleviate some of the pressure that inevitably comes with running your own business.)

Disadvantages of a partnership

Greater financial risk

The partnership business entity structure shares the same major drawback of the sole trader structure: unlimited liability. There’s no legal distinction between the partners and their enterprise, so if you run into any issues re-paying business loans or covering costly legal issues, you and your partners’ savings and assets will be at risk.

Less independence

As a sole trader, you call the shots completely as a totally independent entrepreneur. This won’t be the case in a partnership structure, where decisions regarding everything from pricing strategies to how to hire employees will have to be made jointly with your partner(s).

Of course, as mentioned above, the partners may all have their own specific skillsets and be in charge of different aspects of operations. Even so, the need for a consensus may cause issues, which leads us to our next potential drawback…

Potential for friction

Disagreements can naturally arise between partners throughout the lifetime of a business. Many will be brief and easily resolved, but there’s always the risk of friction developing – perhaps because you and a partner want to take the business in different directions, or disagree on how to invest resources.

That’s why it’s important to join up with partners whose values and business ambitions align with yours, and who you genuinely enjoy spending time with.

Split profits

Entering into a partnership means sharing the profits generated by your business. This is in marked contrast to being a sole trader, where every penny of profit goes into your pocket.

Hopefully, the advantages of being in a partnership – such as the bringing together of complementary skills, the shared shouldering of responsibilities and general sense of comforting camaraderie – will more than make up for this.

Plus, being in a partnership may lead to more rapid business growth and larger overall profits than you’d have enjoyed as a sole trader. That said, there’s a risk that the sharing of profits can lead to resentment if one of you feels the other partner isn’t pulling their weight.

How to set up a partnership

Forming a business partnership is pretty straightforward, although there are a few steps beyond what’s required of a sole trader. Let’s consider them one at a time.

Draw up a partnership agreement

As the name suggests, a partnership agreement is a legally binding document which lays out the rights and responsibilities of the partners, along with details on how decisions will be made and what procedures will be followed if and when partners withdraw or retire.

Importantly, it will also record the initial financial investments of the partners, and set out how profits will be distributed between the partners.

Having a partnership agreement in place can therefore be vital for avoiding any misunderstandings or disputes later down the line. While it’s possible to download free partnership agreement templates online, you may feel more peace of mind hiring a solicitor to draw up a bespoke agreement for your business.

Register with HMRC

The next step is to register with HMRC for tax purposes. This must be done by 5th October of the second financial year your business has been trading. Every partner needs to register separately in order to submit their tax returns and pay income tax and National Insurance contributions.

One partner, known as the “nominated partner”, is also responsible for registering the partnership itself with HMRC, and submitting an annual partnership tax return which lays out the income and other financial aspects of the partnership.

Private limited company

This is the most complex of the three main enterprise structures. You’ll be setting up the limited company as a separate business entity which is legally distinct from yourself as an individual, and which must pay corporation tax on profits. 

A limited company has at least one director (you), with any profits generated being divided between shareholders. If you’re running the company entirely on your own, you’ll be the sole shareholder, and entitled to 100% of the profits.

Many limited company shareholders prefer to take their money through a combination of an annual salary and dividends – the latter being portions of the company profits which remain left after corporation tax has been paid. Dividends are taxed at a lower rate than salary payments, so you may end up with more money in your pocket.

What’s more, the fact that you and the company are legally distinct means you’ll have limited liability. In other words, you won’t personally be responsible for covering debts, losses or damages the business may incur. 

This alone is often considered a good enough reason to trade through a limited company, especially if your line of work requires investing in equipment and staff, providing business services, or running a customer-facing environment – say, a hospitality business or physical retail premises.

Advantages of private limited companies

Lower financial risk

Perhaps the biggest benefit of operating through a private limited company is the financial protection conferred by the limited liability structure. Say your business gets into debt or is sued by a disgruntled client – you’ll only be under no obligation to cover costs beyond the nominal value of your share in the company (which is typically set at £1).

This is in stark contrast to the sole trader or partnership structure, where you will have to pay for damages or cover debts and insolvency costs yourself.

May be more tax efficient

Although a limited company must pay corporation tax, the overall amount you personally end up paying in tax with this kind of business entity can work out lower than if you were a sole trader or partner.

That’s because you (or your accountant) will be able to calculate the exact combination of salary and dividend payments that will keep tax and National Insurance contributions as low as possible.

You can even choose to defer withdrawing (and paying tax) on some of your profits by keeping them in the company account until a future financial year – a handy option if you’d prefer to take a lower income and minimise your tax burden.

By contrast, sole traders and partners have no option but to pay income tax on the total amount they make in a year.

May appear more credible

There’s no denying that being a private limited company can make you appear more “high status” in the eyes of potential customers and clients. Although it’s important to emphasise this won’t be the case in all instances.

For example, being a sole trader is very much the “done thing” in certain sectors, and you won’t raise any eyebrows if you’re a builder, decorator, taxi driver or personal trainer and operating as a sole trader. Similarly, architects, doctors and lawyers frequently form partnerships.

However, if you’re providing products and services to other businesses, you may find it easier to attract clients if you’re a limited liability company, since it proves your business is being thoroughly monitored and your accounts will be a matter of public record. Indeed, many corporate clients will only ever hire the services of limited private companies.

In the same way, you’ll find it easier to garner investment and business loans, and succeed with small business crowdfunding, if you’re a private limited company.

Diversified skillset

The private limited company entity structure allows you to run your business alongside fellow directors and shareholders. So, as with the partnership structure, you can reap the benefits of additional skills and expertise being brought by other people. It can also reduce the pressure of running things single-handedly as a sole trader.

Disadvantages of private limited companies

More complicated to set up

There are more legal requirements for starting a small business when it’s a private limited company compared to other business entities. You’ll need to register your business with Companies House for a small fee, submit legal documents regarding how your company will be run, and register for corporation tax.

More general admin

Beyond the initial set up, running a limited company is more complex than a sole trader or partnership. You’ll be required to submit detailed annual/statutory accounts to HMRC, keep records of meetings, and produce vouchers and board meeting minutes whenever dividends are distributed.

You’ll also need to carefully consider each and every withdrawal from the company’s business account, as it may affect what you’ll owe in tax in that financial year. Many limited company directors opt to hire an accountant to handle these matters.

How to set up a private limited company

While creating a private limited company is a more nuanced process compared to other business entities, the good news is that you can do it online in fairly short order. Here are the main steps to follow:

Choose your company name and address

Unlike a sole trader or partnership, you’ll be formally registering your company name with Companies House, so you’ll need to check the register to see if the name is already taken. It must end in “Limited” or “Ltd”, or “Cyfyngedig” or “Cyf” if you’re located in Wales.

You’ll also need to select an official company address where correspondence from Companies House and other official bodies can be sent. This can be your home or office address, but bear in mind that it will be freely visible to anyone who looks your company up on the Companies House register.

If you’d rather keep such details private, you can pay a third party company for the use of a registered address, or even ask your accountant for permission to use their address.

Prepare legal documents on the running of your company

You’ll need to submit two documents. One is a memorandum of association, which is a legal statement by the founding members of the company, asserting their wish to form the company. This document is created automatically when you register your company online.

The other document is known as the articles of association, which lays out the agreed rules on how your company will be run – for example, the responsibilities of directors and how decisions will be made. You can use standard wording available on the government website, or upload your own during the registration process.

Register with Companies House

You can register (or “incorporate”) your company with Companies House through a user-friendly online portal. You’ll be registered for corporation tax at the same time.

A small fee will be charged, and it usually takes less than 24 hours for registration to be processed. You’ll be sent a certificate of incorporation, which will include your company name, date of incorporation and unique registration number.

Business entities compared

Let’s sum up some of the key points defining the three main business entity types in the UK.

Disclaimer: The contents of this page are intended for informational purposes only and should not be construed as professional advice. For matters requiring legal or financial expertise, it’s recommended to seek guidance from qualified professionals.