When people are setting up a business, one of the first questions they have to grapple with is what legal structure they are going to trade under – sole trader, limited company or partnership.
If you’re one of our clients, you will already have made this decision but we thought it would be useful to give a quick outline of the differences.
Being a sole trader is the most popular legal structure. Approximately 3.4 million sole proprietorships were created in 2017 and they accounted for 60% of small businesses in the UK.
On the plus side, there are no set up costs and it’s very simple to get up and running. The only requirement is to inform HMRC by 5th Oct of your business’ second tax year. There is very little paperwork and you don’t have to have any dealings with Companies House. None of your information is held on the public record.
As a sole trader, however, you are completely responsible for your business and its finances. You need to be aware that if your business goes bust or you have any business debts, your personal finances and assets could be in danger. Legally, your liability is unlimited.
It’s advisable, therefore, to take out small business insurance policies. This way you can avoid getting sued personally should there be any legal disputes. Remember, the buck stops with you!
You and your business are treated as a single entity, which is also significant for tax purposes. You will have to pay tax on the profits that are above your personal tax allowance (£12,500 for the 2019/20 tax year). This is calculated through the self-assessment system and you will also pay Class 2 and Class 4 NICs.
Being a sole trader is thought to be less tax efficient than being a limited company as there is less opportunity for tax planning via the self-assessment system.
The second most popular legal structure is a limited company of which there were 1.9 million in 2017. There is a certain amount of paperwork required and you need to deal with Companies House but it is relatively straightforward. Note that your company details will be on public record.
The main advantage of having a limited company is that you have limited personal liability should something go wrong. The business is treated as a separate entity from its owners so your own assets are protected.
Despite the higher dividend taxes that were introduced in 2016, a limited company is still considered to be more tax efficient. The company will pay corporation tax and dividend tax and employer’s Class 1 NICs on salaries, while staff pay employees’ Class 1 NICs on salaries. Under the limited company structure, there are more possibilities for tax planning by delaying dividends, for example, until a future tax year to minimise the tax liability.
One of the disadvantages, though, is that you are obliged to prepare annual accounts which need to be filed with Companies House. You also need to file a full set of corporate tax accounts for HMRC. As a limited company, it’s advisable to use an accountant to make sure the accounts are done thoroughly.