Sole trader or limited company: Which business structure is best?

You’ve had a great idea and decided to start your own business. You’ve probably looked on the internet and realised that an unexpected choice you have to make is whether to form a limited company or operate as a sole trader.

There are advantages and disadvantages to both. So the question is, should you incorporate your business or remain as a sole trader? Here are the main pros and cons to help you decide:

Advantages

• Incorporation normally provides limited liability. If a shareholder has paid for his or her shares they cannot normally be required to invest any more in the company. However, banks often require personal guarantees from the directors for borrowings and the same is usually true if the company leases premises. The advantage of limited liability will generally apply in respect of liabilities to other creditors;
• A company enjoys legal continuity. It can own property, sue and be sued
• Effective ownership of the business may be readily transferred
• Banks are usually able to take extra security by means of a “floating charge” over the assets of the company which should increase the extent to which the business can borrow
• A company can establish an approved pension scheme which can provide greater benefits than self-employed schemes
• Employees can be offered the opportunity to purchase shares in the company
• The liability of executors acting for deceased shareholders, or of trustees, is clearly defined
• The tax rate is comparatively low. The small companies’ rate of corporation tax means that profits can be kept in the business at comparatively low rates of tax
• It may be possible to dispose of a part interest in the business to a purchaser in the future

Disadvantages

• Costs are incurred on the setting up of a company and there are annual administrative costs
• The costs of preparing annual accounts are greater for a limited company as the accounts have to be in a prescribed format and comply with the Companies Act
• It is unlikely that a small business will be required to have a statutory audit but some industry sectors must have one irrespective of size. This can lead to significant additional costs.
• Directors will be taxed under PAYE with higher NI contributions than for the self-employed
• The company will have to pay employers’ NI contributions
• Dividends do not go towards pensions. Although dividends can be paid and do not attract NI, they do not rank as relevant earnings for pension contributions
• All shareholders are entitled to a dividend. If a dividend is declared, all shareholders are entitled to receive it unless there are different classes of shares or there is a formal dividend waiver procedure
• There are much stricter regulations concerning employee and director benefits, especially in respect of cars.

As you can see, there is no simple answer to the question and one size definitely does not fit all. But when starting out, you need to keep costs to a minimum so there is a case to be made for being a sole trader initially – you can always convert to a limited company later.

The main reason against this approach would be if you are operating in a business that could be classed as being a risk to customers, the public or employees. In this case, incorporation would mean that if a catastrophic accident occurred and damages were awarded in excess of your liability insurance, the excess would fall on the company and not on you.

The other reason to incorporate from the outset is if friends and family want to invest in your business where they would obviously want to have shares.

It is strongly recommended that you talk through the issues with your accountant to make sure that you choose the structure that is most suitable for you.

Tamara Spencer FCA is a fellow of the Institute of Chartered Accountants and the co-founder of small business accountancy firm Network4M. www.network4m.com