Richard Curtis considers the pros and cons of business formats for start-ups.
Many people decide to start their own business. That decision – to go ahead with their project – is obviously important, but many will simply start without considering the business format. Commonly, this will come down to a choice between sole trader, partnership or company.
Overview
Subject to any regulatory requirements, a sole trader can simply start to trade under their own or a trading name. Costs will probably be low and they have complete control over the business with no requirement to disclose financial information. However, they are personally responsible for business debts.
At its most basic, a partnership is two or more individuals who are trading together – a formal partnership agreement is recommended to avoid future disputes as to profit-sharing, responsibilities and the like. It has similar advantages to the sole trader format, although individual partners are jointly and severally liable for partnership debts, so those with the most personal assets could find themselves pursued in that eventuality.
A limited company is a formal corporate structure with shareholders and directors, and it must be registered at Companies House. The company may lend gravitas or a perception of permanence but accounts are open to public scrutiny.
Tax considerations
Sole traders are subject to income tax and Class 4 National Insurance contributions (NICs) on the profit made by the business – the amount taken from the business will be irrelevant. There will also be a liability to Class 2 NICs depending on profit level. Similarly, partners are subject to income tax and Class 2 and 4 NICs based on their share of the partnership profits. Again, the amounts of any drawings from the partnership are irrelevant. In both cases, losses might be set against previous earnings giving rise to a tax repayment.
A limited company is a separate entity from its shareholders, directors and employees and it will pay corporation tax on its profits at a rate between 19% and 25%. It will also pay secondary Class 1 NICs at 13.8% on remuneration above a certain level paid to directors or employees. Such remuneration (and the secondary NICs) will be deductible in calculating the company’s profits and will therefore reduce its corporation tax liability.
Directors and shareholders will have more choices as to how they extract money from the company. As well as a salary (subject to income tax and primary Class 1 NICs) if they carry out duties for the company, shareholders may be paid a dividend. This must be paid from profits and is not deductible in calculating corporation tax but is subject to a lower rate of income tax in the shareholder’s hands.
Conclusion
Do not forget factors other than tax and NICs. Potential business risks might point towards the use of a company. Legal and regulatory factors may also bear upon the business format and we should not overlook the expectations of potential customers and suppliers.
The format of the business is not fixed and what is suitable at the outset may not be appropriate later. In its early stages, the flexibility of a sole trader regarding administration and use of losses may be overtaken as the business grows. An expanding workforce and increased trade and associated liabilities, as well as incentivising a workforce and preparing for a future sale, might mean that a limited company is more suitable. This will bring to the fore issues related to incorporation – a subject for another day.
Practical tip
Limited companies are often used by individuals when carrying out work for others or perhaps to avoid being treated as an employee when working through an agency. The ‘IR35’ rules should not be ignored by those using such personal service companies. These seek to counter tax and NIC avoidance if the worker would have been treated and paid as an employee by their client had they not been working through a company.
