What type of business is right for me?

Deciding whether to operate as a sole trader, partnership or limited company is not always easy. Many factors are involved – including your tax position, who else is involved and the kind of business you are in – and there is rarely a clear-cut answer. This guide raises the issues involved to help you make a more informed decision.

Ease of starting up

To start a business as a sole trader, there are just a couple of simple steps to get going. You need to inform the Inland Revenue and Contributions Agency that you are self-employed. If you are going to trade under a name other than your own, you must put your own name on your headed paper as well.

Starting as a partnership is almost as easy, though it is wise to draw up a proper agreement first. If you don’t, you will be bound by the terms set out in the Partnership Act 1890. This has drawbacks. For instance, under the Act a partner can withdraw from the business without giving notice and demand payment for their share.

You could, however, consider the relatively new business entity of the limited liability partnership (LLP). This is a hybrid between a company and a partnership. This gives you personal protection, as with a limited company, but you retain the tax advantages of a partnership. You will need to have an agreement as to how the partnership operates and you must register an LLP with Companies House.

There are several advantages to creating a separate legal entity by ”incorporating” a business as a limited company or an LLP. This has a life of its own and lives despite the resignation, death or personal bankruptcy of either its management or shareholders. It also means that shareholders enjoy limited liability for debts generated in the course of business. Moreover, setting one up is quicker, cheaper and easier than you might imagine. It is also the ideal vehicle for expansion, since it is easy to raise capital by selling shares to outside investors.

Credibility

Sole traders and small partnerships often feel at a disadvantage when negotiating with big corporations. Many people feel that trading as a limited company gives them extra credibility. Sometimes it does, but business culture has changed in the last decade and nowadays many organisations happily work with sole traders so long as they can provide strong evidence of competence and skilled back-up.

Limiting your exposure

A sole trader has unlimited liability for all the money the business owes. The same goes for a partnership – each partner has unlimited liability for all the partnership’s liabilities, even if they were run up without your knowledge and regardless of how the profits are shared.

By definition, in a limited company, shareholders’ liability is limited to a certain figure. Provided you haven’t traded fraudulently, personal assets such as your home are safe. In an LLP, the same applies.

However, directors and members of LLPs are often asked to give personal guarantees for overdrafts and other financial liabilities, often with their house as security.

Professional indemnity

If you sell knowledge or skills, you could face enormous claims should something, however unlikely, arise later because your work was bad, negligent or mistaken.

It may be hard to imagine a situation where you might be liable for hundreds of thousands of pounds. However, the overall effects of a small mistake on a large project could be out of all proportion to your contribution.

You will need adequate professional indemnity insurance. Sole traders need to take out a range of insurance policies as much as any limited company. However, one drawback of being a sole trader or partnership is that, even having taken out professional indemnity insurance to cover you for a certain amount, you could still find yourself liable for more. As a limited company or LLP, shareholders’ or members’ liabilities are fixed.

Also, any problems and subsequent claims can often take many years to emerge and, unusually for insurance, you have to be covered at the time of the claim, not when the work was done. So an individual has to keep paying premiums for years, possibly even into retirement, whereas a company may simply cease trading with the owner’s retirement.

Your accounts

While your accounts as a sole trader or partnership must be accurate, how you present them is not defined, though the self-assessment tax return provides one format. Some self-employed people turning over relatively low amounts only have to supply three-line accounts to satisfy the tax inspector.

As a limited company or LLP, while you don’t need to have your accounts audited if your turnover is below a certain threshold, you must still file your accounts at Companies House within 10 months of your year-end or you will be fined. Small companies can choose instead to file a shortened balance sheet and special auditor’s report.

National Insurance Contributions (NIC)

As a sole trader or partner, you pay Class 2 NIC plus Class 4 NIC, which is a percentage of your taxable profits up to a certain threshold.

If you form a limited company, you will become an “employee” of your own company. As an employee, you will pay Class 1 NIC. In addition, the company – your employer – must pay Employer’s NIC.

Self-employed people are not eligible for some benefits – for example job-seeker’s allowance or an earnings-related pension.

Tax and profits

Sole traders pay income tax on profits (which includes any salary or drawings you take out of the business). Partners are taxed on their share of the profits (and salary) as if they were a sole trader.

Sole traders and partners complete self-assessment tax returns and pay the Revenue in instalments in January and July. This can sometimes cause a cash-flow crisis if they have failed to put enough money aside for the payments.

In limited companies, company directors pay income tax on their salary through monthly PAYE deductions, while nine months after the end of the tax year the company pays corporation tax on the profits left in the business. Shareholders can take dividends.

Selling assets

If you sell an asset for a profit, as an individual, sole trader or partner, you become liable for capital gains tax after a certain level.

In a limited company, directors would be wise to consult with shareholders before selling major assets. The capital gain is chargeable to corporation tax. There is no annual exemption, though indexation still applies. Directors can only withdraw money from the company in the form of salary or, if they are also shareholders, dividends. Either way, they pay tax on top, though dividends do not attract NIC.

Losses

If you are starting a business and are likely to make a loss in your first year(s), you will be better off starting as a sole trader or partnership if you have another source of income. This is because there are three ways to offset losses. You can deduct losses from:

• Your future profits in the same trade.
• Other income or capital gains in the past three years if your losses occur in the first four years of business.
• Capital gains or income in the year of the loss, and either the year before or the year after, depending on when you started your business. This includes personal income.

As a limited company, there are reliefs available to set trading losses against all profits (including capital gains) of the same accounting period, and the previous 12 months. If these reliefs are not used, losses may be carried forward to set against future trading profits from the same trade.

Raising finance

Loans and overdrafts and other sources of capital can be available to all types of business. However, for a big cash injection in a partnership you could find a new partner who would bring in extra capital.

Limited companies may find it easiest to raise capital for growth because they can sell equity either to a business angel or a venture capital fund, as well as use the more conventional routes of overdrafts and loans. They can also more easily offer their assets as security for a loan raised.

Selling out

When it comes to selling a business, a limited company, being a separate legal entity, makes it easier to sell.

Sole traders and partners can obviously find a new partner, but there are other implications to this, including trust and whether you can work well together. It is not uncommon for people to incorporate their business when they are thinking of selling – simply because this makes the process easier.

The main benefit of trading as a limited company is that it gives you protection if anything goes wrong. However, it involves more paperwork and legal responsibilities. The tax situation can be extremely complex and specific to your circumstances, so consult an accountant.

How to set up a limited company

If you decide to set up as a limited company, you have three options:

• Do it yourself.
• Buy an existing company “off the shelf” from a specialist agency.
• Consult a solicitor.

Do it yourself

To register a new company, you only have to send four bits of paper to Companies House:

• The ‘Memorandum and Articles of Association’ of the company;
• Companies House Forms 10 and 12;
• A cheque for £20 payable to Companies House.

You can obtain Forms 10 and 12 from Companies House, which also supplies a range of useful booklets on company formation and the rights and duties of companies.

Form 10 is a statement of the first directors and registered office – the new company’s official address. Form 12 is a legal declaration that you need a solicitor to witness. Most solicitors charge a nominal fee for this service.

The Memorandum and Articles of Association (M&A) are the company’s constitution. They are complex legal documents. However, model M&As are available from legal stationers for a few pounds. (Look under “Legal Stationery” in the Yellow Pages or on the Web.) All you have to do is fill in a few basic personal details. The most important of these is the principal activity of the business. Make this fairly wide-reaching in case you want to change direction later.

Send everything to the relevant Companies House. In a few days, you will receive your Certificate of Incorporation. You now own a private limited company with all the rights and duties that go with that.

Buy a company

You can buy a company that already exists but has never been used. These “off the shelf” companies are formed in large numbers by specialist agencies. You can buy them for as little as £70, but an additional fee is required if you wish to change the name.

The founder directors and shareholders of the company, who are employees of the agency, simply resign in your favour. You do not have to worry about getting a solicitor to witness anything.

The advantage is that you do not have to wait for Companies House to send you the Certificate of Incorporation. You can start trading with the company the same day.

Prices vary so shop around. It is also worth asking what comes with the package. Some offer company books, seals, and other nice but non-essential accessories. (Look under “Company Registration Agents” in Yellow Pages or on the Web.)

Consult a solicitor

If you are planning to take a lot of money through your new company, or if it is part of more complex legal arrangements, you would be well advised to consult a solicitor who specialises in company law.

This takes time and money, but it really is better to be safe than sorry if there is any element of legal risk. Try to pin the solicitor down to a fixed price: it will probably be well into the hundreds.

Conclusion

Finally, be aware that running a company is harder than forming one. It imposes its own complex legal and financial obligations both on the company and its directors personally. It may be more important to take advice on whether to trade as a limited company in the first place, rather than on how to set one up.

Useful contacts

Tax issues

Helpline for newly self-employed to register with Inland Revenue and Contributions Agency for tax and National Insurance.

T: 0845 9154515

W: www.hmrc.gov.uk

Companies Registration Offices

Records of limited companies are kept at the Companies Registration Offices. They also offer guidance on how to form a limited company.

Companies Registration Office (England & Wales)

Companies House, Crown Way, Maindy, Cardiff CF14 3UZ

T: 0870 333 3636.

W: www.companieshouse.gov.uk

Companies Registration Office (Scotland)

Companies House, 37 Castle Terrace, Edinburgh EH1 2EB

T: 0870 333 3636. 

Companies Registration Office (Northern Ireland)

1st Floor Waterfront Plaza, 8 Laganbank Road, Belfast BT1 3BS

T:  0845 604 8888.