Whether you’re just starting out in business, or have been at it for a while, there are three main types of ‘trading vehicle’ to consider if you want to make sure you’re on the right track. They are:
1. Sole Trader
More detail on each is provided below:
A Sole Trader is an individual who is self-employed.
The advantages of operating as a Sole Trader are:
It is the simplest and cheapest way to start up in business.
A Sole Trader gets beneficial tax treatment when it comes to trading losses (compared to the owner of a Company). This can be an important factor in the early years when losses are more likely and a tax refund would be a welcome boost to finances - for more information see https://suttonstax.co.uk/blog/post/relief-trading-losses-unincorporated-businesses
There is no need to operate PAYE or produce dividend documentation for the money you take from a sole trade business to pay yourself, so there is less paperwork.
Annual accountancy fees and the administration burden will usually be lower as a sole trader than if you trade via a Company.
On the downside:
It is essential to realise that a ‘sole trade’ and the ‘individual’ who runs it are one and the same ‘legal entity’, and that this fact has important implications. Specifically, if you are a sole trader you will be personally liable for all the debts of the business if it goes wrong. Creditors will have a claim on your personal assets (including your home), and, if you have insufficient assets to pay, you could ultimately be made bankrupt.
Furthermore, you will be taxed on all profits the business makes regardless of whether you actually draw the money out of the business for personal use. This can be disadvantageous if you want to reinvest profits in your business in order to try and grow.
Nick is a businessman from Kendal. He starts a new business as a sole trader selling bathrooms and makes £40,000 profit in his first year. He doesn’t need to draw the profits and would prefer to reinvest them in additional showroom stock, hoping to attract more customers and make more profits in future years.
Unfortunately, by the time he’s paid Income Tax and National Insurance on his profits he only has c. £21,000 left to reinvest. If the profits had been made in a limited company, he could have reinvested £32,400 in his new business.
Finally, sole traders are sometime seen as ‘less credible’ than those individuals who operate through a limited company. There is no obvious reason why that should be the case, but nevertheless Company status can help you win and retain business; it depends on who your market is.
If you’re going into business with others, a Partnership is one option.
A Partnership is defined as a business relationship between two or more persons engaged in business with a view to making a profit (and in this case ‘person’ means individual, company or trust).
The most common form of partnership is the ‘general partnership’, in which each full equity partner is jointly and severally liable for ALL partnership debt and obligations. Partners in a general partnership are therefore subject to similar risks to those faced by sole traders. (NB. the tax on partnership profits is not a ‘partnership debt’, so each partner is only personally liable on their own share).
A Limited Liability Partnership (LLP) is another form of partnership, best described as a hybrid of company and partnership. An LLP allows partners to be taxed on their profit share as individuals whilst also limiting their exposure to partnership liabilities. However, LLPs can be expensive to form, and also carry a more onerous administrative burden. Accounts must be filed at Companies House so are therefore available for inspection by the general public (this is not the case for a general partnership).
There are many issues you will need to be aware of if considering a partnership as your trading vehicle, not least because of the complications that arise when you are in business with other people.
Whilst there is no legal requirement to have a written partnership agreement drawn up, the best of friends often end up arguing over business, so I would strongly recommend that you do. A written partnership agreement should clearly define the partnership’s purpose, the rights and obligations of partners, and all the main aspects of the governance of the partnership.
The legal fees for advice on this document can be expensive, as can subsequent amendments.
Where there is more than one person in business, a partnership is sometimes the best choice; for example if partner profit shares are in excess of £150,000 and minimising tax is the priority, or where early years losses are expected, but in the majority of cases I would generally recommend a Company.
A Company can be used by one individual as their own trading vehicle or by many individuals as a shared trading vehicle.
The Company’s owners are called ‘shareholders’, and the Company is managed by its ‘directors’. In many ‘private’ companies (as opposed to the ‘public’ companies you will see listed on stock markets) , the shareholders and directors are the same people.
The Company’s purpose, the rights and obligations of shareholders and directors, and its internal governance are determined by the Memorandum and Articles of Association – the company equivalent of a partnership agreement. A proforma Memorandum of Association and Model Articles can be downloaded at Companies House, see https://www.gov.uk/government/publications/give-notice-of-subscribers-company-with-share-capital and https://www.gov.uk/government/publications/model-articles-for-private-companies-limited-by-shares/model-articles-for-private-companies-limited-by-shares respectively, and adopted/adapted by your Company.
These model documents have been developed over years so will incorporate almost all the procedures and rules you will ever need for running the company. Nevertheless, it is a relatively simple process to amend any article if it doesn’t meet with your specific requirements. It is also possible to draft and agree a supplementary ‘Shareholders Agreement if there are important additional issues that need addressing which aren’t easily dealt with by the Model Articles.
A significant advantage of Company v Sole Trade or Partnership is that trading through a company limits the company’s owners liability for the company’s trading debts. There are different types of Company, and therefore as to the form of the liability limitation, but most commonly companies are formed with ‘share capital’, and the owners’ liability is restricted to the amount of any share capital that has not been paid for. As most companies only have a nominal amount of share capital - eg, 100 £1 shares, which would cost the shareholder(s) just £100 – there is often no unpaid share capital and no potential shareholder liability.
The overall tax burden for limited company owners is generally lower than for sole traders and partners even if all profits are drawn – for more information see https://suttonstax.co.uk/blog/post/incorporate-save-tax. Furthermore, a Company’s owners are only taxed when the company ‘distributes’ its profits, leaving more post tax profits for reinvestment in the business should the owners choose to do so.
The disadvantages of a company
Accountancy and administration fees are generally more expensive for a Company than a Sole Trader, but about the same as the costs for a Partnership.
Accounts and other documentation must be filed on a regular basis with Companies House and those documents are a matter of public record (but see note below).
The fact that your accounts are a matter of public record may not be as alarming as it first sounds. ‘Small companies’ can opt to file ‘filleted accounts’ with Companies House. ‘Filleting’ means you can remove the Profit & Loss Account, notes to the Profit & Loss Accounts, and/or The Directors report (so nobody getting accounts from Companies House can determine what your turnover, margins or overhead are!)
A small company is one which meets 2 out of 3 of the following criteria:
a) Turnover of no more than £10.2million
b) A Balance Sheet value of no more than £5.1 million
c) No more than 50 employees
If you are on your own in business and only expect modest profits, or even losses, at the outset, and your business is low risk, operating as Sole Trader may be the way to go.
If you are in business with others, and/or make good profits, and/or there is some risk attached to your business, a Company is probably the better option. Once profits are c.£20,000+ p.a the increased costs should be outweighed by the tax savings afforded by a Company.
To get detailed advice on what would be best for your business please call me on 0145394 32540 or 07881 286903, or email firstname.lastname@example.org.