Alan Pink considers the rival attractions of the limited company and partnership structures for husband and wife (or civil partner) businesses from a tax perspective.
The decision on how to structure a business can make a huge difference to the amount of tax the business, and the individuals making up that business (e.g. spouses or civil partners), pay each year to HMRC.
What follows is intended to be a kind of ‘toolkit’ for making this decision. It’s important to remember that not all circumstances are the same, and it’s often a question of weighing up the ‘pros’ and ‘cons’ of partnerships and limited companies.
Vive la difference!
The first point to make is that there is a fundamental difference in kind between partnerships and companies.
From a tax point of view, and indeed from a legal point of view (at least in England and Wales), a partnership doesn’t really exist as an entity. A company, by contrast, is a formally constituted legal person, which can own assets, enter into contracts, and run a business in its own name and its own right.
The way this works through into the tax treatment is that profits or losses made by partnerships are actually treated by the tax system as if they were made direct by the partners themselves. So the tax is the same whether you distribute the money out of the partnership’s bank account to the partners or not.
If a company makes a profit or a loss, this is chargeable to tax, or relievable as the case may be, on the company, and there is no immediate impact on the individual directors or shareholders. Tax is only triggered for them as and when money is paid out of the company to shareholders/directors in the form of income, most often by way of remuneration or dividends.
The criteria
So let’s run through the main criteria which are of importance in deciding whether to be a company or a partnership. Not all of these are tax related, because no decision such as this should be made in a tax ‘vacuum’:
1. Limited liability
Until quite recently, if you wanted limited liability (i.e. protection against personal liability for the business’s debts) the limited company was your only option. This is an important consideration in any kind of business where things can go badly wrong and problems come back to bite not just the person responsible for the disaster, but everyone else in the business as well.
This all changed, though, with the introduction of the limited liability partnership (LLP) in 2001. Whilst an LLP isn’t really a ‘partnership’ in the true legal sense, it’s taxed as if it were one. So it is possible to get the best of both worlds (if a partnership is the better structure from other points of view) whilst retaining a very similar level of limited liability to that which a company gives.
2. Accounting requirements
One thing which famously catches people out, when they change from the partnership to the company format, is the need for much greater financial discipline in a company. The company’s money is not the same as the individuals’ money, and confusion on this point tends to give rise to large and unexpected tax bills when the individuals spend the company’s money and this has then to be treated as taxable income received by them. Furthermore, the format of accounts drawn up by a company is governed by a number of strict rules, and also extra disclosures (e.g. transactions with related parties like the directors – a rich field for HMRC enquiries).
A general partnership has no requirement at all to put any financial information on public display at Companies House, whereas companies (and indeed LLPs) have to publish a certain amount of such information.
3. Taking money out of the business
As already commented, there’s a basic difference between the way drawings of money out of the business are treated for tax purposes, between the two business formats. The money in a partnership bank account has effectively already been fully taxed.
By contrast, taking money out of a company (if it can’t be classified as some kind of capital payment, of which the most frequent example is a repayment of a director’s loan to a company) will be treated as taxable income. So the timing and amounts of money taken out of a company can be quite crucial in planning for the individuals’ tax liabilities. This can cut both ways, of course. The company can be a good way of deferring (perhaps long term in some circumstances) the higher personal levels of tax. The company pays tax at 19%, and individuals, on the same level of profits, could be paying tax on employment income at rates of 45% or more. The company, by enabling one to ‘stick’ at the company level of taxation, can provide a very useful deferral, particularly where the money is not going to be extracted from the business.
4. Dividend tax rates
So in the kind of business where profits need to be ploughed back into the business (e.g. wholesalers and retailers, or professional practices which have a large amount of work in progress and debtors) using a company means that those profits retained within the business as working capital are profits which have only borne tax at 19%. If the profits of a partnership business are high enough for the partners to be paying tax at the 40% rate, the retention of capital within the business is very expensive, since high rates of tax have to be paid on the profits before they are retained.
On the other hand, where a business distributes all its profits, a company can actually increase the overall tax. This is because of ‘dividend tax’ which is effectively levied on individuals on top of the normal tax that distributed profits of a company pay. Depending on the type of income and the rates of National Insurance contributions involved, you can end up with less in your pocket if you pass profits through a company, than if you simply receive them direct as partners.
5. Losses
If a business is likely to make start-up losses, there is a strong argument for beginning it in partnership form rather than company form, because the losses can (subject to certain constraints) be offset against the individual’s other income – including income for earlier years.
6. ‘New blood’
Companies can make it very difficult to introduce new people in the future. This is because new equity ownership in the company takes the form of shares, and the issue of shares to somebody is likely itself to be treated as a taxable ‘perk’ of that individual’s employment with the company.
By contrast, a new person coming in as a partner will not generally be treated in the same way.
7. Benefits-in-kind
The tax treatment of non-business use of business assets and facilities is different between the two business formats. Individuals who (for example) are given the use of a vehicle owned by a company, or live in accommodation owned by the company, are chargeable to tax on this on a specially worked out calculation of the value. With cars in particular, this can bear little resemblance to the actual value the company is passing to them.
By contrast, in a partnership non-business use results in a disallowance of a proportion of expenses relating to those assets, but does not result in a direct tax charge on the individual. There’s no substitute for doing the sums here, to see which is better.
8. Capital gains
Capital assets owned by a limited company can give rise to a ‘double tax charge’ when they are sold, once at company level and once at individual level. This can be avoided in some situations by keeping the assets outside the company’s ownership.
9. ‘Company only’ tax reliefs
Finally, there are a number of tax reliefs which are only available if you are carrying out business through a company, of which the main ones are relief for acquiring intangible assets, relief for research and development, and relief for losses on ‘loan relationships’.
Practical point
To conclude, there are so many different criteria to look at making this decision that it will never be a straightforward and simple one. Taking professional advice in individual cases is very important.
