Establish your business on the right foundations! Sole trader or limited company?
Most people starting a small business tend to start up as sole traders. This is because it’s perceived to be a lot cheaper and easier to go down this route, rather than form a limited company.
All you need to do to be a sole trader is start your business and notify HMRC that you are now self-employed. That’s it – you now have a small business!
Then what normally happens, is that when a business is a couple of years old and is getting to the stage where it needs to take on contractors or employees or it’s signing bigger contracts, the business owner might start to think about trading through a limited company.
However just because this is what most small business owners do, doesn’t mean it’s necessarily the right thing for your business; it’s important to think hard about establishing your business on the right foundations.
So, why might you want to trade through a limited company? There are two main reasons – firstly, if you are turning over at least £30,000 per year then generally it is more tax efficient to trade through a limited company. If you want to use a calculator to check this for your business click here.
Secondly, as the name suggests, a limited liability company gives you limited liability. If you are a sole trader and there is a claim against your business, then you are at risk of losing your personal assets – including your car and your house. If however you trade through a limited company, it is a separate legal entity and unless you have given a personal guarantee or are doing something where directors may have personal liability, your personal assets will be protected. In the worst-case scenario where the company has insufficient assets to pay out, you would wind the company up and the creditor would still have no rights against your personal assets.
So if from day one of your business, you are going to be employing people, entering into high value supply or customer contracts or are likely to have a turnover of more than £30k in your first year, you should think carefully about whether to incorporate as a company.
Moreover, even though you are only a “small business”, you should still have an exit plan – that is, a plan to grow your business and sell it for the best price, giving you a nice return on all of your investment and hard work. If you have read the classic business book “the E-Myth” by Michael Gerber, you will know that in order to really succeed at business, you need to build a business that can operate independently of you – by putting systems and structures in place that allow you to scale the business. It’s almost always better to start putting these systems and structures in place in a limited company sooner rather than later, so that when you come to sell, everything is all neatly owned by the limited company ready for the sale.
Small business owners are sometimes reluctant to incorporate a limited company because of fears about the expense and the administrative obligations. This fear is often misplaced. You can now set up a limited company online very easily from as little as £4.99. The main administrative requirements are to file accounts and to submit an Annual Return (which costs £13 if you file it online). So really the only additional expense (if you can’t do it yourself) is to hire an accountant to prepare your accounts for you, but this can be done for under £100 a year and is something that you should be doing anyway if you are taking your business seriously.
One thing that a lot of small business owners don’t take into account when starting to trade through a limited company is that the company’s money is not their money. You cannot just take money willy-nilly from your company’s bank account. There are only three ways you can legally take money from your company – you can pay yourself a salary, you can take dividends or you can receive repayments on your loans (e.g. if you lent the company money for its business expenses). If you take the money out any other way, you will run into tax problems, so don’t do it!
Another issue that small business owners don’t like is that the accounts are public and anyone can see how well (or not) your business is doing. However not many people (i) know how to obtain the accounts or (ii) would go to the effort of obtaining the accounts, so don’t let that put you off.
Finally, if you form a limited company then you will be a director – and directors have certain legal obligations that if not fulfilled, could result in a hefty fine or, in the very worst case scenario, a prison sentence. But saying that, you have to be doing something pretty naughty to be fined or put in prison. If you want to know more about your responsibilities as a director, you can click here
If you have been trading as a sole trader and decide to transfer the business to a limited company, then depending on the assets that are to be transferred (such as copyright in a logo or other content), you may need an Asset Transfer Agreement and any ongoing contracts that have been entered into, in your name as a sole trader will need to be ‘novated’ (a legal term that means transferred to) to the limited company.
If you have been trading as a partnership (i.e. where you and other people are running the business but you have not yet formed a company) and decide to trade through a limited company, or you have been a sole trader and decide to bring other people into your new company, you should put in place a Shareholders Agreement that will deal with lots of important issues (such as what happens to the business if you fall out). If you are the sole shareholder in your new company, you will not need a Shareholders Agreement.
If you need any help with setting up a limited company, with an Asset Transfer Agreement or with a Shareholders Agreement, email me at email@example.com and I will be delighted to help you.
Copyright Suzanne Dibble, business law expert 2013
Although the concepts in this article have global application, the information contained in the article is based on English law only and is provided for information purposes only and is not intended to amount to advice on which reliance should be placed. Suzanne disclaims all liability and responsibility arising from any reliance placed on such information. Professional advice should be obtained before taking or refraining from taking any action as a result of the above contents.