So you’ve started your own company – or you are thinking of doing so – that’s brilliant, just remember that with furthering your idea comes responsibilities and many of those are legal responsibilities with serious repercussions if you ignore them. Don’t let that put you off. Every year thousands take the step of setting up their own business without a problem, but as you will soon learn when running your own business it pays to be prepared and educated so do your research.
You may not have even contemplated it before, but the first big question you should confront in business is what form of legal structure your business should take. Why? From day one of setting up your business who you need to notify, what you need to include on your website and how you deal with finances will be determined by the legal structure, so it needs to be sorted out at the very start.
If you are going it alone your choice of business structure is likely to be between operating as a sole trader or a limited company – there are other options but since they are more specialised they are beyond the scope of this article. If you are establishing this new business with another person or group of people then the choice is probably between a partnership and trading as a limited company.
Each option has its own advantages and disadvantages for a small start-up business building online and the below should hopefully help you make an informed decision as to how you will put your business idea into action.
Becoming a sole trader is the easiest, least formal of options and one that is satisfactory to hundreds of thousands of small businesses online and offline across the UK. Don’t think being a sole trader gets rid of all of the red tape however. As soon as you set up a business you are legally obliged to notify HMRC. As a sole trader you must:
- Register as self-employed with HMRC
- Submit a self-assessment tax return each year and pay the relevant tax
- Pay the relevant National Insurance contributions
- Register for VAT if your yearly turnover is more than the threshold (currently £82,000)
All of this applies even if you’re still employed and are running a business in your spare time.
These are formalities you cannot ignore and it also means you have to keep good records of all you financial ins and outs from day one. Once in business you will suddenly realise the value in those small pieces of paper called receipts – keep them safe.
Potential cons of being a sole trader
Although you may operate under a company name – e.g. Pete the Plasterer – in legal terms you are seen as an individual operating as a business i.e. Peter Smith trading as Pete the Plasterer. There’s nothing wrong with that but many setting up their own business do so in the search of a better work-life balance and ironically operating as a sole trader actually leaves no boundaries between work and personal in terms of assets and liability. To many, this can be a burden and a worry, especially if you have been used to all the risks previously being taken by an employer. As a sole trader you may also find that lack of separation is a fear for potential clients, suppliers and banks – who will often have stricter lending criteria for sole traders.
As a sole trader, with no separation of liability, you are liable for any losses your business makes. So if a business deal turns sour and you get left owing a supplier, the fact that you operate under a business name is irrelevant in law. That potentially can put your home, car and any other personal assets on the line. It is often this ‘risk’ that pushes many to look at alternative business structures.
Potential pros of being a sole trader
As a sole trader you can keep all your profits after you have paid tax on them. The simplicity of this is an appeal to many and with organisation and the advice or help of a good bookkeeper or accountant make it a relatively pain free option.
Your choice of business name is also less restricted as a sole trader. Certain rules on decency and trading off another’s reputation may limit your choice but otherwise you are free to call your business almost anything.
You can still employ other people when you operate as a sole trader. However you will need to register with HMRC under the PAYE scheme and deal with employer and employee National Insurance contributions too.
As a sole trader conversion to a limited company status at a later date is a fairly easy step to make once the business is further established.
A limited company has its own legal identity. This means that whilst Peter Smith the Plasterer may be the person behind Peter Smith the Plasterer Ltd, in legal terms they are two separate entities and operate alone – although in practical terms there are further restrictions to avoid people abusing the protection of a limited company.
A limited company is owned by its shareholders. Shareholders appoint directors who run the company according to the articles and memorandum of association – documents which set out the rules for running the business. (These documents are published as a matter of record via Companies House. ) The directors are answerable to the shareholders. In practice, for most small businesses the shareholders and directors are the same people, but this doesn’t have to be the case.
Potential pros of being a limited company
As shareholder any liability for company debts is limited – hence why the term ‘limited by shares’ is used. Other than money invested in shares in the company, a shareholder has no further obligation to meet debts. This is complicated a little if the shareholder is also a director and can be found as a director to have run the company negligently, knowingly building up debts they knew they could not meet.
If your profits are above a certain level there are potential tax benefits of operating as a limited company than as a sole trader. This simple calculator can help you understand the differences:
Any director salaries are still paid via PAYE to HMRC at regular intervals but any additional profits are taxed at a lower taxation rate under a different tax regime than they would be under the PAYE scheme. This often means directors taking a basic salary and topping their income up perhaps once a year via shareholder dividends paid from those additional profits. Such share dividends being taxed at a lower rate under the personal taxation scheme.
There is still a sense of prestige about a limited company, often in the eyes of clients. Although limited status is no indication of a better run business for many it does give a company the edge before placing an order.
A limited company is likely to find it easier to raise finance or investment to help with cashflow as the investment is in a separate legal entity. This can often be achieved by issuing shares to investors or agreeing a charge over company assets.
Potential cons of being a limited company
There is far greater transparency of your success (or failure) as a limited company. Ownership documents are available to anybody via Companies House, as are published accounts which must be submitted by every limited company at least annually. This transparency and the additional administration and small filing costs that go with it are often the barriers to those choosing not to become a limited company.
Whilst taxation benefits can be achieved, National Insurance contributions are often higher for an employed director than they would be under the sole trader regime.
The choice of business name of a limited company is subject to a number of restrictions and no two registered companies can have the same or a too similar sounding name. You also have to have the formal Ltd or Limited at the end of your chosen name. This Companies House document explains more.
A limited company must be registered with Companies House and must have an approvable name, a registered address for documents to be served, at least one director, at least one shareholder and approved company documents setting out the way the company is run. As an online business you have to ensure that your registered name, company number, registered office and place of registration (e.g. England & Wales) are included on your website.
A partnership is more aligned to a sole trader than a limited company in terms of pros and cons (although the option to form Limited Liability Partnerships blurs the lines somewhat). If there is more than one person forming a business then they cannot operate as a sole trader so effectively create a basic partnership. Like a sole trader, there is no separate legal personality, so each partner assumes risk, cost and responsibility for the business. In many cases partners will put in place a formal partnership agreement that defines such risk and responsibility between the partners, especially if there are unequal contributions, but in reality this agreement is really only between themselves and they assume risk for the business as a sole trader would.
Like a sole trader there are less formal administrative tasks to complete than those choosing a limited company structure, but HMRC obligations need to be met – as a partner you technically become self-employed and need to register accordingly. Whilst there are no publically published accounts under a partnership there is more transparency of what is being spent when and where between the partners of the business.
Partnerships are built much on trust. As a partner you could be responsible for actions of your partner that you may not necessary agree with, so you need to ensure sufficient checks and balances are in place so that you each know what the other is doing, without becoming so paranoid it affects your business working.
Choosing your business structure is more important than choosing your business name as it governs how you will deal with customers, suppliers and external agencies. It is worth obtaining expert advice as to the best option for you. Find an accountant with experience in dealing with small businesses and especially those operating in your sector. Remember whatever option you choose can always be changed, but to avoid unnecessary headaches and additional administration it is always best to get it decided and organised from the start.