My Bookkeeping Online Blog

Conventional thinking is to use a Limited Company, and it will suit the vast majority of circumstances well.

The benefit of an LLP is that it allows much more flexibility in the allocation of profits. If you are in business with others, or you imagine offering a profit share to staff, it might suit your circumstances better, because adjusting the profits share in an LLP is far simpler than adjusting the share capital percentages in a Limited Company.

This is a brief introduction of how the two legal entities work. This is only intended as a “thought provoker” – I you think an LLP might suit you, I would recommend you run your particular circumstances by your accountant.

Limited Companies

• Distributions are made by way of either:
  • Salary
  • Bonus
  • Dividends
• Salary and bonuses are taxed at source.
• Dividends received are taxed through the personal tax return.
• Issue 1: Rewarding key employees with shares in the company can result in a tax charge
  • If you plan to award shares to an employee as part of his/her employment, it will give rise to a benefit in kind, on which tax must be paid.
  • The company will need to be valued to determine the value of the benefit in kind, which can be time consuming and expensive.
  • To avoid an award of shares being considered a benefit in kind, it would need to be made as part of an approved Share Option Scheme.
• Issue 2: Share option schemes are complicated animals.
  • They are expensive to set up.
  • The rights attached to the shares provided to the employee must be broadly the same as those held by everyone else. Thus it is not possible, for example, to have “Bad Leaver” provisions specific to an employee.
  • Given the two issues, the cheapest solution is often to pay the Benefit in Kind.
• Issue 3: Share transfers are complicated
  • They will require a valuation of the business and often have tax issues attached to them. Therefore the flexibility to reward staff using shares without significant management time and advisor cost is limited.

LLPs

• LLPs were set up in response to demand to have a vehicle that provided the flexibility of a partnership but also with limited liability protection (previously only available to Limited Companies.)
• Distributions are made by way of profit share.
• Profits are taxed in each partner’s personal tax return.
• The great benefit of LLPs is that the method for the allocation of profit is as drawn up in the partnership agreement. Therefore there is complete flexibility to split profits, and to change the profit allocation at any point without triggering a tax charge.
• Issue 1:Tax is charged on profit share, not drawings
  • HMRC will tax a partner in an LLP based on Share of Profit, not Cash Received. Therefore, if cash received is less than profit share (which it usually is), the partners will pay a higher effective rate of tax on drawings.
  • For example, a partner’s share of the profit is £25,000 but, because customers are slow to pay, the partner gets £20,000 cash from the LLP in the year. The partner will be taxed on the £25,000.
  • To mitigate this, the best approach is to set the LLP’s year end at 30 April. This allows the maximum possible amount of time between the partnership’s year end and the payment of the tax on the profits.

 To summarise

In an LLP, it is simple to change the ownership structure to match the evolving needs of your business. This is a big advantage if you wish to have flexible terms with a partner, or incentivise employees but change the structure quickly if things don’t work out.  

The downside of LLPs is the need to pay tax on profit rather than cash drawings. This is best mitigated with a hard-nosed debtors policy, and sensible tax planning.

If you prefer the Limited Company route and want to incentivise employees with shares, I would suggest accepting the cost of paying tax on benefits in kind because you won’t have the cost of setting up an employee share scheme, and you will be able to incorporate specific provisions into the employee share agreement.

Categories:Financial, Running a Business from Home, Start ups