One of the most commonly asked questions that I hear time and time again from people who are thinking about starting a business, is whether they should operate as a sole trader or whether they should set up a limited company.
While there are other legal forms that businesses can take such a as partnerships and LLPs, sole traders and limited companies are by far the most common options, so I’ll be focusing primarily on these two business types in this article.
The important thing to remember here is that there is no specific right or wrong answer to which legal form you should take; it really depends on a number of factors. To explain why, let’s go through the ins and outs of each option.
Operating as a sole trader is the simplest option, and comes with the least regulatory and accounting responsibility. All of the profits from the business belong to you (after tax of course), you simply need to complete a self-assessment tax return once a year to declare your earnings to HMRC.
Working out your tax liability is pretty simple. You only pay income tax on your profits (i.e. your total sales minus all of your business expenses). You don’t really need to hire an accountant, though you may wish to in order to be sure that you’re being as tax efficient as possible, and that you aren’t accidentally claiming for things you aren’t allowed to.
If you’re running a sole trader business full time, you are what is referred to as self-employed. Assuming that you aren’t continuing to be employed elsewhere at the same time, you should contact HMRC to let them know that you are becoming self-employed. You can register as a sole trader in a couple of minutes on the HMRC website.
A very important thing to consider when operating as a sole trader is that you essentially are the business. This means that you are personally liable for any trade credit or debts incurred, and any contracts that are entered into as part of the business are actually with yourself as an individual. So if things go wrong, and you go out of business owing lots of money to suppliers, you’re the one who is left holding the bag as the saying goes.
In certain cases this could mean that personal assets such as your home are left exposed. This is probably the biggest consideration to think about when deciding what legal form to operate under, and is the key reason why I would only recommend operating as a sole trader in very small turnover businesses.
Setting up and operating as a limited company is more complicated than operating as a sole trader, and comes with a number of additional responsibilities.
Limited companies are required by law to submit a set of statutory accounts every single year, and must also report to Companies House when certain key changes are made to the business.
Unless you have an accounting background yourself, realistically you will need to pay an accountant to take care of these areas for you. Basic accounting costs for limited companies can range anywhere from a few hundred pounds per year up to several thousand pounds depending on the size and complexity of the business.
Unlike in a sole trader situation where you are the business, Limited companies are a separate legal entity in their own right, which are owned by shareholders and run by directors. Legally speaking, any profits generated by a limited company are owned by the company, not you.
Assuming that you are both director and shareholder of your business, there are two ways in which you can withdraw money for yourself. As a salary, paid as remuneration for your services as a director or as a dividend paid out of profits to you as a shareholder. It’s also worth noting that as a director of a limited company, you are technically an employee of the business rather than a self-employed person (though this can still be a bit of a grey area depending on how you pay yourself).
Despite the additional complexity and costs involved, there are some very big benefits to operating as a limited company. Firstly, it’s normally much more tax efficient to operate as a limited company. For example, if done correctly you could potentially save yourself thousands of pounds in income tax when compared to being self-employed.
The biggest benefit however is that a limited company has “limited liability”. This is an absolutely critical point which revolves around a company being its own legal entity. When a limited company enters into a contract or incurs debt, the legal liability lies with the company, not with you as an individual. So if the business fails, any outstanding debts stop with the company; you as an individual are completely shielded (unless you’ve signed a specific agreement with a creditor stating that you will personally guarantee their debt, which isn’t advisable in my opinion).
If you decide that going limited is the right option for you, before you can start trading you will need to register your company name at Companies House. You can either do this directly using the forms available on their website, or via a formation agent like UKPLC. Unless you know exactly what you are doing, I would normally recommend using an agent. There are plenty of cheap web based services out there that will take care of everything for you for under £20.
The other options that you may well be aware of are partnerships and limited liability partnerships (LLPs), which I will outline briefly below:
Partnership - A partnership simply a sole trader business being run by more than one owner. Personally I would tread very carefully with partnerships, as in a lot of ways you are trusting your partner(s) with you own personal financial security. A partnership holds the same personal risks as sole trader business, so your partner could potentially incur debts that you would end up personally liable for in the case of the business failing (I’ve seen this happen to people before). If you do decide to take this route, make sure that you put in place a rock solid partnership agreement drawn up by a solicitor.
Limited Liability Partnership (LLP) - This is a bit like a hybrid between a partnership and a limited company, and is most frequently used by professional service people like accountants and lawyers. LLPs offer the same simple tax set-up as a sole trader or partnership, but at the same time offers limited liability to the partners. The drawback is that you don’t get the same tax efficiencies that you would be operating as a limited company.
Overall the choice really comes down to how much personal risk you are willing to shoulder, and whether or not you are prepared to take on the fixed costs and administration involved with running a limited company. Though my two cents is this; if you’re having trouble making up your mind, I’d suggest testing the water as a sole trader, and then registering as a limited company as soon as you start to generate enough sales to justify the costs involved.