How to decide on legal status for your new business

In the current economic climate, starting up a new business might seem like madness. But there are good reasons to think it through – especially if your current employment is less than secure.

First steps

And once you’ve had your free advice from Sheffield Enterprise Agency on your hopeful start-up, you will also have to consider how to structure your company legally.

Sole trader is the most common form of business set-up freelancers and fledgling entrepreneurs choose. But is it always the best? What about limited status and other alternatives?

“Basically, you could go out today and start business immediately as a sole trader. You have a three month window with Her Majesty’s Revenue and Customs to tell them you’ve started trading, and this can easily be done by phone, using their own simple two-sided form or through their website,” says Graham Booth, Senior Accountant with SJD Accountancy, who deals with companies of all types and sizes.

Sole trader is the freelancer’s most favoured option to start with. It particularly suits the ‘one-man-band’ seeking full responsibility for running a business that easily fits their own lifestyle. Sole traders enjoy total freedom to make their own decisions. They also retain any assets they inject into the company.

However, there is a downside. The sole trader remains personally liable for debts accumulated by the business, including awards of court arising from successful claims by disgruntled customers.  Graham Booth cautions, “We would never advise going into any kind of business without professional indemnity insurance cover. There’s probably no real issue if you took wedding pictures and the couple didn’t like the results; but you have to be careful that you don’t include sensitive subjects, like other people’s children, given current concerns.”

Furthermore, failure to repay business overdrafts or loans secured on personal property can mean losing one’s home if lenders apply to court for possession. Business Debtline (0800 197 6026) provides free telephone advice to businesses experiencing debt or a money claim.

Sole traders hoping to work with public sector agencies will also meet problems. This is because their accounts are not a matter of public record, and publicly-funded organisations must be transparent in dealings with private sector companies.

Also, the sole trader model is not the most tax-efficient. HMRC can charge tax right up to a current maximum of 40% of net profits (the amount left after deducting allowable expenses from turnover). But there are still plus points, according to Graham Booth who says, “You should keep proper bookkeeping records for any kind of business, but sole trader is more flexible than, say, a limited company. HMRC is more lenient regards a sole trader’s claims against tax for mixed costs (e.g., using a car or phone for business and pleasure) and calculating a percentage against tax liability accordingly. With a home telephone bill, for example, one can come up with an estimate if having to go scientifically through the bill were impractical. HMRC will likely be ok with that so long as it’s reasonable.

“Through a limited company, however, you would have to register the phone or car in the company name and provide fully detailed records. Otherwise, HMRC will say ‘it’s for personal use’ and be less willing to make allowances.”

Choices!

Limited company

But whilst sole trader is the easiest business to set-up, a limited company is more tax-efficient and remains better protected against liability for things that go wrong. So hiring an accountant is clearly  crucial for those registering a limited company at Companies House (the official register of UK companies). Finding an accountancy service that understands your business and provides ongoing financial planning advice should save money and ease worries in the longer term.

On tax advantages, Graham Booth says, “A major tax efficiency for a limited company is that you can remunerate yourself by way of a salary as well as through holding shares and receiving dividends. After paying tax on company profits, a limited company may put the remainder into a reserve fund from which to pay shareholder dividends. Unlike a salary, dividends don’t carry National Insurance liabilities.

“These reserve funds and dividends will already have been taxed. If the company makes £100,000 profit and you’re left with £79k – £80k, you can, say, draw £30,000 in dividends, so long as that doesn’t take you above your personal tax limit. Dividends are good for business planning. If you don’t use up all your dividends one year, and make a lot less money the next, those reserves sitting there don’t attract further tax. Sole traders don’t have that benefit.

“We always advise that directors should draw a salary, but dividends do allow a way to take a portion of the company’s profits on top. This is deemed an acceptable form of return for taking the risk of running your own business.”

Another benefit of trading as a limited company is that officers’ and shareholders’ personal assets shouldn’t be at risk in the event of business failure – so long as activities are conducted legally and comply with Companies Act requirements. This protection is often foremost in the minds of would-be entrepreneurs.

A further attraction is that there’s no obligation to start trading within set time limits after registering with Companies House. Also add that two limited companies with exactly the same name cannot exist – and each limited company is designated a unique registration number – and it becomes clear why people quickly register their proposed business in the name they want, even before they are ready to start trading.

Partnerships

Another popular business set-up model is the partnership. They are particularly suitable whenever individuals need to preserve some independence whilst spreading running costs and maintaining an equal say in running the business.

“Partnerships are still unprotected in the same way as sole trader,” says Graham Booth. Each partner is taxed on their proportion of overall profits – as with sole traders – and can end up paying the maximum 40% tax rate. Partners are also ‘jointly and severally’ liable for business debts; meaning, if one or more partner incurs business liabilities that can’t be paid, creditors can hold every individual partner fully liable for the entire debt.

However, the Limited Liability Partnership Act of 2000 partly deals with such problems by limiting the liability of each partner so that personal assets stay safely away from business creditors. Limited liability partnerships (LLPs) can be formed by two or more individuals, or different companies, registering appropriately at Companies House. They are almost universally favoured by firms of accountants or solicitors with several partners or more.

Graham Booth says, “Limited partnership doesn’t offer the same tax efficiency as a limited company but you do at least have an element of protection. But a private limited company is less flexible in that if there are, for example, three shareholders with an equal share, distributions to them will need to made in line with this.

“LLPs offer flexibility to apportion share profits based on various factors; e.g.,  where one partner has a higher client load and does more work than a junior partner; or partners with significant seniority being rewarded appropriately over others. Percentages going to each partner can, however, be changed each year.”

Many freelancers sharing workspace tend to maintain flexible, informal arrangements and don’t make formal arrangements. That’s great while it lasts. But creative agencies involving a range of pooled talents – e.g., copywriters, graphic designers, publishers, photographers, etc – working to a common purpose may find the LLP option most attractive.

And the rest

There are other models of company set-up, though they tend to be quite niche. One example is the  “Company Limited by Guarantee”, often adopted by charities.

Sole trader or limited company seems the obvious decision for freelancers. But further research and seeking good advice is most strongly recommended.

(This article provides information based on journalistic research and does not constitute legal or financial business advice. Tailored professional advice should be sought from a suitably qualified professional before starting a business or changing its legal status. All tips are followed at your own risk and the author accepts no liability whatsoever for any decisions made by readers. All text & images ©2009 Russell Cavanagh)

  • Business Link provides great information for smaller businesses
  • Sheffield Enterprise Agency provides useful advice, training and access to business advisers for people setting up in business and living in the Sheffield area.
  • Companies House is the place to register limited companies and limited partnerships
  • Her Majesty’s Revenue & Customs has good resources and will actively help sole traders to register for tax and National Insurance
  • Business Debtline – whose help you will hopefully never need – provides free telephone advice for companies still trading but struggling with debt
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