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Business Structures: The risks of getting it wrong: Part one

A new client approaches you – they’ve got a plan together, have selected a trading name and are eager to join the business world.

This is where the role of a professional adviser can make an invaluable difference to a new venture, helping prospective business owners determine the most appropriate business structure, be that LLP, sole tradership or a partnership. Getting the right structure in place is essential to building a solid and workable foundation for a business going forward.

Sole traders

As a sole trader, for example “Amy Smith trading as The Widget Fixer”, then whilst your client will be one of millions of such businesses in the UK, they will be on their own. It allows freedom to run a business, make your own decisions and own all assets. It is an informal structure, requiring a comparatively low amount of administration. It can suit one person that wants to be their own boss and employ others if they choose, which can be a good fit for a budding entrepreneur or someone who wants a lifestyle business.

The downside for sole traders is that the buck stops with them. A sole trader has no legal personality separate from its owner. If a successful claim is made against this type of business, and it is not covered by insurance, then the owner’s liability is unlimited and their personal assets will be on the line. Losing a dispute can therefore have serious consequences for clients, and they should be advised to manage this risk from an early stage of any dispute.

Partnerships

Amy Smith and Oliver Jenkins are like-minded business people, and may instead benefit from setting up as a partnership, “The Widget Fixer”. Partnerships are formal relationships between at least two people carrying on a business in common with a view to profit. The statute governing partnerships goes back to the 19th century. Usually partners will enter into a joint agreement that deals with shares of profits and losses and what to do if a partner joins or leaves. Without an agreement or some clear evidence, it will be assumed that partners share profits and losses equally. Again, there is a comparatively low amount of administration and the partnership’s results do not need to be made public. These have been traditionally popular with business such as doctors’ surgeries and other professional practices.

A disadvantage is that a partnership also does not have a separate legal personality. This means that if a successful claim is made against the partnership, the partners’ liability will be unlimited and their personal assets will be at risk of being disposed of to satisfy creditors. It is vital that everything is set up appropriately, so there are no disputes over how the partnership makes its decisions, shares profits or, equally importantly, losses.

Limited liability partnerships

Partnerships should be contrasted with Limited Liability Partnerships (LLPs). LLPs are governed by statute and have the organisational flexibility of partnerships. Amy and Oliver could therefore set up as “The Widget Fixer LLP”. LLPs do have a separate legal personality, which means that the LLP owns the assets and the partners (or members) run the business but now have limited liability based upon the amounts they have committed as capital. This is subject to any separate arrangements between the partners.

LLPs do have to register with Companies House and publish their results, so the administrative burden is greater. If a client doesn’t get the division of assets, drawings and liabilities properly drawn, and decision making and direction of the LLP clear, the members of the LLP could be heading for a ruinous dispute. If they can, and have a dispute resolution structure in place, then the litigation risk is greatly reduced.

It should be stressed that nothing is forever, and business structures can change; a sole trader can decide to go into partnership with others and then to convert to an LLP or another entity, like a limited company, or the reverse.

Above all, if you are advising those on the path to setting up a business, it is vital to guide them to go with a structure that is not merely tax efficient for them but which works best for their business; it can be costly to start off on the wrong foot. Identify the things that could go wrong right at the outset, help set a mechanism in place for dealing with these, and you can help people tackle a challenging process and begin their business ownership journey.

Limited companies account for around a quarter of all UK businesses; we will look at these and other structures in more detail next time.


Stuart Evans, commercial litigation partner and specialist in business disputes at law firm BLM

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