One of the hardest decisions most business start-ups agonies over is:
How should I trade- what type of business is best for me?
Should I be a Sole Trader, a Partnership, or a Limited company?
Even if you have been trading for a while as a Sole Trader or Partnership and have decided it may be time to change, it can be complicated trying to decide when, and if, you should change structure. Let’s face it, trying to find simple jargon free help and advice on this topic in one place is quite difficult.
One of the first discussions we have with a new client at ZATRS, is about the advantages and disadvantages of the different trading types. Are you sure your structure is the best one for you? And what may have been best 3 years ago may not be the right choice now.
Do you understand why you need to do some things in a certain way! For example, a regular question we get asked by limited company directors is;
‘Why do I have to take my salary separate to any other money I take out of my company – can’t I just take one lump sum each month to cover it all?’ (The answer to this is in the Limited company section of this article or read our How do I take money out of a Limited company? article)
How many of you have started a new business by setting up as a limited company and not really known why – just that ‘your accountant/friend with his own business’ said that was the best thing to do?
What is your understanding of what a limited company is? Have you ever discussed this with your accountant? Asked questions such as ‘Why dividends? and what are they?’’ Who are companies house and what is the relevance to my business?’ Lots of questions anyone with a limited company should be asking.
This is particularly true currently with the recent changes, not least the new Dividend tax which came into effect 1st April 2016 and means now you pay tax personally on your dividends as a shareholder of a limited company as well as through the limited company as corporation tax. And there are also the proposed changes in National insurance for sole traders.
Added to that the changes for how your business information is filed with HMRC will be changing soon with the addition of quarterly filing using software (and possibly by spreadsheet but this is yet to be clarified by HMRC). The first people to have to follow this system will be sole traders whose turnover is over the Vat threshold from April 2018, then in April 2019 by all sole traders, partnerships, and rental property owners (it has recently been put back a year for these smaller traders).
Working for yourself
Just to start up a new business in the first place is difficult. You need to ask yourself some hard questions and be realistic open and honest with your answers;
- Do you have the discipline to switch totally onto work even if working at home?
- Do you have the commitment to see the business through?
- Is your business idea really that good?
- Do you have the skills needed or are you confident you can learn them?
- Have you looked at the market, your competitors, identified your target market etc.?
- Do you have enough capital to last you at least the first 2 years?
- Can you make tough decisions on the spot as and when needed?
If you cannot answer yes to all these, then perhaps a sole trader is not the best business type for you. Think carefully about what you are doing. Perhaps you can still go ahead but bring in someone with the skills you lack, as either a partner or a director. Hopefully in this article we can help you decide on which structure is best for your business by giving you the basics simply and jargon free.
Sole Traders
As a sole trader you are the business. There is no legal separation. You are responsible for everything from business decisions to business debts.
This simplifies things for running your business as you can put money into the business (capital introduced) and take money out of the business (Drawings) as and when you want to- Cash flow not withstanding!
There is no-one else to answer to or to negotiate with if there is a difference of opinion on how things should be run or what direction the business should go in. There are advantages and disadvantages and putting to one side the taxation differences some of these are
Advantages
- You keep all the profits from the business yourself (after tax of course!)
- Your Vision, your ideas, and your decisions
- Choose when you work
Disadvantages
- Any debts are yours personally and your home could be at risk
- It can be lonely – it is all on your shoulders, you have to do everything from sales and marketing to customer service and cleaning.
- There is no cover if you are sick and no sick pay either other than the statutory which must be claimed separately.
Once you have decided and you start trading you must:
Register with HMRC –by the 5th October after the end of your first tax year or penalties may apply.
Class 2 NIC’s – these used to be payable monthly or quarterly however from 2015/16 they were incorporated into the tax return. A much simpler basis for payment where everything is in one place.
UTR – Keep a record of your UTR (unique Tax Reference) – a 10-digit number you receive after registering.
Bookkeeping – Record your businesses income and outgoings. The new digitalisation of Tax means HMRC now want to see your bookkeeping as well as your totals on your tax return.
SA100 – Complete and file a Self-Assessment Tax return (SA100) – having a set of accounts prepared makes this easier. Pay Income Tax – you are taxed on all profits over and above your personal allowance and 9% class 4 NIC on profits over the lower profits limit.
Payments On account (POA) – If you have tax to pay of £1000 or more you will make payments on account (POA) – in effect pay half your tax again towards the following years tax due – on 31st January and 31st July each year.
The tax proportionately is slightly higher as a sole trader, as you are taxed on all profits regardless of how much you have taken personally from the business in that period. The margin is gradually shrinking though as the Government is looking to bring all taxes into alignment.
Partnerships
Basically, a partnership is 2 or more partners with the same idea and vision, who have decided to share income, overheads, expenses, and therefore profit.
A partner can be;
- an individual – in which case they are classed as self-employed, and they are taxed in the same way as a Sole Trader
- Or they can be a limited company – which has different rules for taxation
Partners can put money in and take it out as they wish, it is not a separate entity (as with a ltd company), and because of that partners are usually personally liable for any business debts and losses. This means your personal assets such as your home could be at risk.
So, you need to think carefully before starting a partnership, e.g. ask yourself the following questions;
- Who is going to put what into the business in terms of money and assets?
- What are the individual roles going to be? Who has what skills and what is each partner’s area of responsibility e.g. sales, customers?
- What will the partnership ratio split be?
- Can all the partners work comfortably together? What are personalities like?
- Who will be the nominated partner responsible for keeping the accounting records in order and making sure tax returns are filed?
A good way to find out if this will work is to sit down as partners and discuss your vision for the business and future goals – do you all have the same ones in mind? Where do you each see the business in 2 years, 5 years, 10 years etc?
Once you have decided you must:
Register with HMRC – A partnership needs to be registered in its own right (HMRC/directgov.uk are good places to go to for this) and by October 5th after the end of the first tax year. If you pass this deadline, you may be issued a penalty once you do register or file a return.
Keep hold of your Partnership UTR as well as your personal UTR – HMRC then issue a 10-digit unique tax reference (UTR) specifically for the partnership. You will be asked who the ‘nominated’ partner is; that is the partner responsible for keeping records and filing tax returns for the partnership. Each partner must be registered with HMRC for self-assessment also. You do not need to register at Companies house.
Decide on Record Keeping – Record your businesses income and outgoings as with the sole trader above. Also record separately how much each partner has put into the business and how much they have taken out in the tax year. This becomes extremely useful when deciding what to take out of the business or if a partner wants to leave.
How do I get paid? – A Partner is self-employed therefore doesn’t get ‘wages’ Instead each partner takes money out as and when they have agreed or need. This is called drawings – the same as for a sole trader. It is important this is recorded for the partner’s capital accounts. You do not pay tax on drawings. You pay tax on your profit share.
File a Self-Assessment Tax Return – The Partnership has its own tax return to complete – an SA800. Filing deadlines are January 31st for tax year ending the April 5th before this. However, the partnership does not pay tax.
Tax – Instead the SA800 partnership tax return has ‘partnership pages’ at the back where the business accounts are split according to the ratio, and then added to the partners’ individual tax returns. Tax is then paid by each partner through their own tax returns.
Split Profit /Losses – In a partnership this is shared, but not always 50-50. It’s up to the partners to decide. Often this is according to initial money invested into the business, or work roles taken. It’s better to have a written partnership agreement, rather than relying on always agreeing on everything. This applies to losses and to business debts, which are also split between partners according to this ratio.
In effect a Partnership is basically 2 or more ‘Sole Traders’ working together from a taxation point of view. However, the income in theory should be more and costs and profit split between partners for tax. This means you pay less tax but you also take less profit.
Limited Company
A Limited company is a separate legal entity in its own right. This means it has its own Unique Tax Reference (UTR – ten-digit number), can own assets, and must complete its own tax return.
The main reason for setting up as a limited company instead of as a sole trader or partnership tends to be liability. In a limited company your liability is generally limited to the amount you have invested in it, usually the face value of the shares. This limits the risk to yourself of losing your assets such as your family home etc. This can be very useful if you are in a trade with a high-risk factor. Obviously, you want your business to do well and will do everything you can to make sure it succeeds but it’s good to have peace of mind.
There are different types of limited company, but a private limited company is the most common and the one you are most likely to set up. This means the company cannot offer its shares for sale to the public unlike a public limited company (plc).
You also need to understand the different hats you’ll wear when running your own limited company; Shareholders and Directors. Shareholders own the business and Directors run the business. Since 1st October 2008 you no longer need to have a company secretary either – there can be just a sole director.
The tax breaks for a company are greater, such as not having to pay National Insurance contributions on profit or making payments on account to HMRC. However, the payoff for that is the paperwork and red tape is greater. Instead of just filing accounts at HMRC you must file accounts as well as an annual return at Companies House also.
There are numbers of advantages and disadvantages to choosing to trade as a Limited instead of a sole trader or partnership.
Advantages
- Limited Liability –your liability is generally limited to the amount you have invested in it. So if the company got into difficulty and couldn’t pay its debts – those debts belong to the company and not you. Your personal assets such as your home etc. are not at risk.
- Your name is protected – your company name is registered at companies’ house and this means no-one else can legally use it for another Ltd. Once incorporated a private limited company must have ‘Limited’ or ‘Ltd’ at the end of its name.
- Taxation – a limited company pays corporation tax only (currently 20% at small companies’ rate-up to profits of £150k, reducing to 19% from April 2017) and not national Insurance contributions. It does this through a CT600 – corporation tax return.
- Credit Terms – A limited company is relatively easy to credit check so this often means suppliers are happier to offer credit terms as they can see the history of the business.
- Credibility – having a limited company can give the business more perceived credibility.
Disadvantages
- Paperwork & Record keeping – this must be much organised, and there are more filing requirements with the addition of Companies House as well as HMRC.
- Your Money – as a sole trader you can take money out as and when you want, called ‘Drawings’, however with a Company you have two roles and money taken out must be documented as being for one of these roles. As a Director you earn a salary and as a shareholder you own shares in the company on which you take dividends as long as there is a profit. So, every penny must be accounted for either as Salary or Dividend.
- Credit and finance – Although you have limited liability, in reality whenever the company needs financing such as loans, leases etc you will usually be asked to provide a personal guarantee (often referred to as a ‘PG’). This means if it does not get paid you are responsible for the debt.
- Filing requirements – the limited company must file with HMRC a full set of accounts and a Corporation tax return (CT600) for every financial period. In addition, it must file with Companies house a set of accounts (abbreviated for smaller companies) and an annual return every 12 months
We have already talked briefly about the advantages and disadvantages and what a limited company is. So, let’s say you’ve decided this is the best structure for you.
What other things do you need to think about?
- Company Name –there are strict rules for what it can and cannot include.
- It cannot be a duplicate of or too similar to another company name (unless you get permission)
- It cannot contain ‘sensitive’ or offensive words (see companies house for a list of these)
- It can’t suggest your part of a local authority or the Government.
- Address. You can have different addresses e.g.
- Registered office address – where the company records are held and official communications delivered to e.g. HMRC and Companies House. Available to public. Must be an actual address.
- Trading address – where the business actually works/trades from.
- Officials – there are mainly 2 types of officials involved in running a Limited company and in some business where it is 1 person they will have both roles (wear 2 hats!)
- Director – must be at least 1 director who is an individual over the age of 16.
- Shareholder – must be at least 1 shareholder in a company limited by shares. Their address is public unless a service address is used such as the registered office.
- Secretary – no longer needed but optional.
- The new Register of PSC’s (People with Significant Control) – this came into operation from April 2016.
- You need to start gathering information and compiling a register of anyone with significant influence on the business.
- As of June 2016 this needs to be filed as part of the new ‘Confirmation Statement’ which replaces the Annual Return.
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- Shares –how many shares do you want to issue initially and at what value? E.g.
- if you issue 100 shares at £1 each the share capital of the company is £100. Who is going to own these shares? Who will have control e.g. 51% or more?
- What about ‘Alphabet shares? these are other classes of share such as ‘A’ shares which you can prescribe different rights such as non-voting to. They can and are often used as a reward share for employees so you can vote a dividend out of extra profit but without giving control of the business. Also, if you have different classes of shares then a different amount of dividend can be taken without affecting ownership.
- Company rules – most people tend to use an incorporation service to set up their company. They usually supply a standard template ‘Memorandum and articles of association’.
- Memorandum of association – a legal document which each initial shareholder must sign confirming they are all agreeing to form the company. You cannot change the wording on this as it is a legal statement.
- Articles of Association – These are the rules on how the company should be run. They can be changed and often should e.g.
- Are there specific items which involve how decisions are made in the company and who can make those decisions?
- What about what happens to shares if shareholder wants to leave? What should happen to their shares i.e. should they be first offered to the other shareholders?
- What about if a shareholder dies – who runs the business and do the same rules apply to share sales as above
- CT41G – Usually Companies house will inform HMRC who then send you a letter including your company unique tax reference. This is very important as its often the only official record you will get initially with the Company UTR on it. You need to reply to confirm whether you are trading or dormant. They will want to know details such as type of business, addresses date of accounts etc.
Company Director: what does that mean?
Because there can be quite severe penalties for failing to carry out your responsibilities as a Director, you need to know what they are. For example, you could be fined, disqualified as a director or in worst case scenario; prosecuted. You could also end up being personally liable for your company’s business liabilities.
The Companies Act 2006 set out these responsibilities of directors for the first time and these are as follows:
- Use your skills, judgment and experience in a way which will be most likely to make the Company a success. Take into consideration the impact of your decisions on
- any employees
- relationships with suppliers and creditors
- the reputation of the company and
- the long term success of the company
- Follow the company’s rules, as laid down in its Articles of Association
- Think for yourself as a director, and although it’s acceptable to rely on advice from third parties, make your own decisions for the benefit of the company as to whether or not you follow that advice.
- You must exercise reasonable care skill and diligence, for example;
- keep company records up to date including everything from book keeping to meeting minutes and dividend vouchers,
- file all returns on time and report any changes to HMRC and/or Companies House.
- make sure the company’s accounts are a ‘true and fair view’ of the business’ finances
- Avoid conflicts of interest and make sure you inform any other shareholders if you might personally benefit from a transaction the company makes, such as if the company is planning to trade with another company in which one of the directors or their spouse is a shareholder, as an example.
- You must not accept benefits from third parties, for example, which are being given to you as a possible way of influencing decisions. Normal corporate hospitality etc is fine.
You also have a duty to declare any interest in a proposed transaction or arrangement to all parties concerned.
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