Choosing the right legal structure for your business is arguably one of the first things you should consider. However this decision is often rushed and not fully considered.

Whether you are a one-man band or have a number of employees, you need to choose the right legal structure to protect you and maximize the amount of money you can take from your business. The decision is a bit like a maze, but there are a few things that may point you in the right direction.

What is a sole trader?

If you are a sole trader you run your own business as an individual and are self-employed. There is no legal separation between you as the owner and the business itself. You can keep all your business's profits after you've paid tax on them and you are personally responsible for any losses your business makes.

What is a limited company?

A limited company is a separate legal entity from the business owners (shareholders) and its managers (directors). It can be formed whether you are a one-person business or have a number of employees. When you form a limited company you represent the business as its director. As director, you are responsible for the business decision you make although critically your business assets and liabilities remain totally separated from your own personal finances.

What are the main differences?

Liability

As a sole trader there is no distinction between your business decisions and your personal wealth. If your business was to fail you may lose personal assets and money. As a limited company, there is clear separation between your personal finances and those of your company. As director of your limited company you are responsible for the legal and financial decisions your business makes, however there is clear separation between your personal finances and those of your company. If your company was to run up large debts or ultimately fail, then your personal assets would generally be protected.

Raising finance

If you are looking to expand your business you may need to raise finance to buy new equipment or to invest in the marketing of your business. As a sole trader the options available are limited to personal bank loans. However as a limited company you will be able to raise funding in a variety of ways including the issuing of shares to investors. This opens up the opportunity of participating in some very tax efficient schemes such as SEIS and EIS. SEIS is a Seed Enterprise Investment Scheme and allows investment to be raised at a much lower cost than the size of the investment. Imaging raising £50,000 at a cost of only £25,000 to the investor. This is possible with the SEIS scheme and this scheme is only open to limited companies.

Tax

As a sole trader HMRC considers your profit to be the same as your income. You will pay National Insurance and tax and on your profits as part of submitting your self-assessment annual tax return. When you operate as a limited company your ability to take money out of the company is different. There are two types of income which are taxed. The business is taxed by a corporation tax on the profit of the business. Your personal income is taxed by income tax, national insurance, and dividend tax. For many shareholding directors, the majority of their pay is made up from dividend payments. Generally lower levels of personal tax are paid when taking money out of a limited company when compared to the tax paid by a sole trader.

As a sole trader all of your income is taxed at up to 45%. There is not an option to defer some of the tax because you wish to invest in your business at a point in the future. With a limited company, after you have paid corporation tax of 19% on your profits, you can leave the remainder in the business without paying any further tax. This gives you the option to reinvest in the business at a later point in time using profits that have been taxed at a lower rate. This is particularly relevant if you are looking to grow and expand the business.

Annual Accounts

As a sole trader your accounting is generally straightforward. There is no obligation for you to file any of your accounts and you will probably be able to manage the majority of your accounts by yourself. As a limited company you have to prepare formal annual accounts which have to be filed with Companies House every year and also submit a corporation tax return to HMRC. It is very likely that you will need to pay for the services of an accountant to ensure that your accounts are accurate and complying with current legislation.

Perception

Your reputation as either a sole trader or a limited company will be the most important factor in helping your business succeed. However when approaching a new customer for work you will need to demonstrate credibility. Research has shown that both commercial businesses and residential customers have more confidence when buying a service from a limited company than from a sole trader. Limited companies are generally regarded as being more credible.

So what is the right legal structure for your business?

Unfortunately the answer is “it depends”. We have outlined some of the high level factors worth considering, but there are others. All of these factors should be considered in depth to arrive at the right answer for you and your business.

The popularity of operating as a sole trader is largely due to the simplicity of this structure which makes it easy to set up and inexpensive to run. This is why it is the most popular option accounting for over 60% of all small businesses. If you plan to keep your company quite small, work as a one-man band, work largely on private/residential jobs then it is likely that you will benefit from the simplicity of being a sole trader.

If your company has plans to expand, needs to raise investment, is involved in large projects or works in the commercial sector then we would suggest that you may benefit from becoming a limited company.

Before making this decision, it is important for you to consider all the factors involved. We would strongly advise you ask an accountant to assess your position and future plans to ensure that your structure is appropriate for you and your business