Time to Decide Whether to be a Limited Company or Sole Trader
Having decided to start a new business, one now has to decide whether to trade through a “limited company” formed for the purpose or as a “sole trader”.
In order to assist you in making that decision, let’s consider the following points.
If a limited company becomes insolvent, all its assets will be sold and used to pay its creditors, etc.
If there are more liabilities then assets, it is unlikely that there would be any distribution to the shareholders.
Normally, the shareholders would lose the consideration they paid for their shares and if the shares were fully paid up, there would be no further liability on the shareholders.
In a newly formed company, normally the issued share capital would be low and therefore a foreseeable loss would be small.
In similar circumstances, if a business carried on by a sole trader or a partnership becomes insolvent, the personal assets of the sole trader or partners would, if necessary, have to be realised to pay the creditors.
It may result in personal bankruptcy for the individuals involved.
An exception to limited liability would be where large creditors (e.g. Banks) may insist on personal guarantees from Directors/Shareholders.
If yours is the sort of business which buys materials or services from other businesses, needs a small overdraft or has to operate from rented premises, forming yourself as a limited company has the edge.
You may be able to get away without guaranteeing all of these debts; it is certainly worth negotiating to avoid doing so.
In a private family company, if the profits fluctuate from year to year, it is possible to spread the director’s remuneration over a number of years to insure that personal allowances and lower rates of tax are utilised in each year.
In a sole trader or partnership situation, if large profits are made in one year and a loss in another, profits may be liable to higher rates of tax whilst in the year of loss, personal allowances would be lost.
The valuation of the net assets of a limited company, when so required, may be based upon what is termed as a “minority basis”.
This can be achieved by making sure that no one person has an overall control of the company with each shareholder owning 50% or less of the issued share capital.
For example, if a company has net assets of £100,000 and has one shareholder with 100% equity, the valuation for inheritance tax purposes would be £100,000.
If three shareholders held the equity equally, then the valuation would be considerably less then £100,000.
It is thought that a limited company may give your business more credibility than a partnership or sole trader; but this may not work if a customer researches your company and finds, for example, that it has a paid-up capital of £100, which is the typical situation of a very small business.
On balance, if you are going to be dealing with large companies, becoming a limited company will probably have the edge on credibility.
It is very easy to start up as a sole trader or partnership.
Normally we would inform your Inspector of Taxes and DSS.
In partnership, although there is no legal requirement for formal agreement between the partners, It is highly recommended that a solicitor draw up a formal written agreement.
You can start a formation of a limited company from scratch or purchase one “off-the-peg” and change its name.
The formalities involved in setting up a company can take some time.
You cannot commence trading until the company has been registered with the Registrar of Companies and all the formalities completed.
A limited company needs to comply with the disclosure requirements set out in the Companies Acts.
Setting up as a sole trader involves the least work and fewer formalities.
There can be some advantages in the formation of a limited company in that set rules are laid down for certain aspects of the running of the company and these rules are not so easily variable as are the terms of a partnership agreement or sole activities.
Employees and/or children can be given shares without being given any management control or substantial liabilities.
In case of sole trading or partnership activities, if employees and/or children were made partners, they would have some degree of control over the business and an appropriate partnership agreement would need to be drawn out.
They would in most situations take on the unlimited liability as regards business debts.
If a relationship changes between the partners, there may have to be variation to a partnership agreement by way of a Deed of Variation.
In case of a sole trader and a partnership, the law does not set down any formal requirement as to the presentation of accounts.
The accounts need to show a true and fair picture.
The form of accounts for a limited company is laid down by law in the Companies Acts.
The full or modified accounts would also need to be filed at the Companies Registration office.
Public would have access to all company information filed with the Registrar of Companies.
In contrast, public has no right of access to sole trader or partnership accounts.
The rules relating to Limited Company accounts are more onerous.
There is no legal requirement for sole trader, partnership or small companies to have their accounts audited.
The partners may require their accounts to be audited if it is one of the terms of the partnership agreement.
Partnership accounts are not normally audited.
Depending upon the size of the limited company (e.g. Turnover > £1m), the accounts may need to be audited.
In a start up situation, it is unlikely that a company would require a full audit.
Small companies are very similar in audit and accounts preparation requirements to sole traders.
As a sole trader or a partner you would be liable to Class 2 and Class 4 National Insurance contributions whilst as an employee of a limited company you would be liable to Class 1 Contribution.
Class 2 contribution is a weekly flat rate payment and is payable by all self employed.
There are a few exceptions e.g. Low earnings.
Class 4 is computed as a percentage of your taxable profits.
DSS benefits are restricted in case of both of these contributions and in particular unemployment benefit is not available.
National Insurance contributions will cost you more as a limited company, although you are entitled to more benefits.
If you need to raise funds for your business, the form of your business can dictate your choice.
As a sole trader or a partnership, your options are limited and depend upon your own resources and the bank manager.
Depending upon what security is offered, the banks may offer money either as an overdraft facility or a loan.
The terms of the loan are always negotiable and it is advisable to discuss with the lender with the view to tailoring the terms to suit the circumstances.
The choice with a limited company is wider.
Depending on the company and its financial stability, future prospects, etc., it is possible to raise venture capital from a fund, banks may be prepared to lend using, what is known as a floating charge on your assets, as a security.
In conclusion, each case would need to be considered on its own merit.
A limited company has several advantages: limited liability, greater credibility, more avenues for raising finance and easier to dispose part of your business.
Sole trader and partnerships have less onerous rules about accounts, lower National Insurance payments and better tax treatment of losses.