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All businesses, no matter the size, must have a legal structure.
There are a few different options however, this article focuses on two types, Limited Company and Sole Trader.
The structure you chose will depend on your individual circumstances and there are advantages and disadvantages to both options.
What is a Sole Trader?
A Sole Trader is a self-employed individual who is the sole proprietor of the business.
All profits are subject to tax on the individual in the tax year that they are earned.
What is a Limited Company?
A Limited Company is a separate legal entity that is separated from the shareholders and directors.
The word “limited” infers that the owners of the business have limited liability for the company’s debts. This is limited to the amount of capital that they have invested in the business.
What are the Advantage of Setting up as a Sole Trader?
One of the main advantages of being a Sole Trader is that it is easy to set up and there is reduced administration and paperwork required.
There are not many filing requirements when compared to other business structures.
Income only needs to be declared on an individual’s Self-Assessment Return. This means that there is more privacy as this is not on public records.
It is easier to change legal structure at a later date, if required, and easier to wind up the business.
What are the Advantages of Setting up a Limited Company?
Limited Liability meaning the shareholders’ personal assets are not exposed in the event of bankruptcy and legal challenges.
There are no payments on account upfront for tax, unlike for Sole Traders, meaning there is reduced cash flow burden.
Generally, a Limited Company is a more tax efficient structure to use as there is scope for tax planning to give the optimum level of income to the shareholders and directors whilst having options to minimise the tax liability.
Corporation Tax is paid at 19% and dividends are paid at 7.5% up to basic rate, whereas Income Tax is paid at 20%, 40% and 45%, depending on the tax band.
There are more allowances and tax-deductible expenses available to Limited Companies over Sole Traders, meaning that this could be a more profitable route.
Setting up a Limited Company also gives name protection, meaning that no one else can use the name. This can become very important if the business has invested time and money developing their own brand and identity.
A Limited Company can be created before a trade even commences.
It is easier to raise finance and gain investment in a Limited Company when comparing to Sole Traders.
What are the Disadvantages of setting up as a Sole Trader?
Unlimited liability, meaning that if the business goes into debt, the individual is liable.
Difficult to raise finance as a Sole Trader.
Higher tax rates as described above and also subject to Class 2 and 4 National Insurance contributions.
Cannot build up reserves in the business as all income is taxed when earned.
Cannot sell the business to investors without changing structure.
What are the Disadvantages of setting up a Limited Company?
There are more responsibilities of running a limited company placed on the directors.
The directors have a fiduciary duty to represent shareholders and to act in the best interest of the company.
There are more filing requirements, annual confirmation statement, Corporation Tax returns, Accounts to Companies House and Accounts to HM Revenue & Customs.
These come with various penalties, fines and interest for non-filing, late filing and late payments.
Accounting fees are generally higher for Limited Companies.
The business, its officers and certain financial information will be searchable on public records such as Companies House.
To register as a Sole Trader, you will need to have a National Insurance number and inform HMRC by registering for self-assessment if you’ve earned more than £1000 in the tax year.
Can I change from a Sole Trader to a Limited Company?
Yes, you can, provided there are no outstanding debts or lawsuits.
The current sole trade will have to cease and HMRC need to be notified. Avar can help with this process.
You can claim incorporation relief when changing business structure in this manner.
