Trading Status

Operating your own business can be a rewarding and fulfilling venture, but, at times, it can also feel like sailing against a tide of rules and regulations.

Knowing the laws that apply to your business and how to comply with them can help to make life easier. Breaking the law through ignorance is no defense and may result in financial penalties or even imprisonment – it is vital to be well informed!

Setting up a new venture

When setting up a new business, one of the first things to decide is what trading status will suit best. The main options available are sole trader, partnership or limited company.

Hem Gujadhur explains some of the things to be aware of when deciding which status is best for your business.

Sole trader:

According to the government, three-quarters of all British businesses are sole traders, which amounts to about 3.6m businesses (out of some 4.8m firms). Why is it the most popular choice? You benefit from the relative simplicity of the structure, as there is less paperwork than alternative structures. You also retain complete control.

A sole trader is a self-employed, exclusive owner of a business. When you are a sole trader you keep all your business's profits after you've paid tax on them. You're also personally responsible for any losses your business makes and any debts it may have.

As a sole trader, you will need to inform HMRC that you are self-employed. This is relatively easy. If you do not register, you risk a £100 fine. There is little point in delaying, it’s quick and easy.

Hem says “You have to pay to set up a limited company and running it requires slightly more administrative effort when it comes to tax. Registering as a sole-trader costs nothing, while accounting costs and tax liabilities are likely to be cheaper than if you started a limited company.”

Sole traders must pay tax (of course)

You pay income tax based on your business profits. You (or your accountant) must fill in a self-assessment tax return each year, detailing your income and expenses. You must also keep detailed financial records, including details and proof of all sales and expenses (such as invoices and receipts).

It is advisable to put some money into a ‘tax fund’ bank account each month. When it comes to paying HMRC, you'll be glad you put this away each month. Being faced with a large tax bill you haven't saved for is a nightmare. Many people aim to save 25% of their earnings in this way. Failing to pay your tax bill on time results in penalty charges.

Sole traders can still employ staff

Contrary to the implication of the name, you may employ people as a sole trader. If you do, you must collect income tax and National Insurance contributions from them and pay these to HMRC and you will therefore need to operate a PAYE payroll scheme.

Partnership:

A partnership is similar to a sole trader business but, of course, a partnership must involve two or more people to own the business and share the responsibility. If two (or more) people start a business, you share the workload, the initial investing capital and the financial risk of failure.

There is another crucial risk to consider, the risk of falling out! Partnership agreements are not required by law but we strongly advise you to have one.

Partnership agreements

If you go into business without a partnership agreement, you will be bound by the terms set out in the Partnership Act 1980 which allows a partner to withdraw without giving notice and to insist on the immediate return of their capital contribution.

Hem says “This can be a minefield and a complex area of law, so, if you can, take professional advice from the outset. Setting out expectations in an agreement can often prevent the breakdown of the business relationship later.”

Advantages of a Partnership

• Tax efficiency - with a partnership, you draw earnings, as opposed to receiving a salary through PAYE. You also don’t need to make National Insurance contributions.
• There’s no need to register at Companies House or file annual returns. However, as above, it is highly recommended that a partnership agreement is made, which would also explain the business structure, legalities and each partner’s responsibilities.

Disadvantages of a Partnership

• Joint and several liability. This is quite a big disadvantage, often overlooked at the beginning (because nobody wants to think about what would happen if their business fails). Each partner is liable to the entire debt of the business.
• Regardless of each partner’s financial status, if one cannot afford to pay any debt back and goes bankrupt, the entire debt will be left to the remaining partner(s). Worst-case scenario, a partner may have to sell the family home to pay the partnership’s debt
• If a partner leaves a partnership business (eg retires, changes job/career), they may still be liable if the business becomes insolvent later on. Some partners who leave a partnership choose to continue investing, because they often get a good return over the years. However, they could be brought back into legal dispute and liability clauses if the business becomes insolvent.
• Shared responsibility, which can lead to disputes and falling-outs.

Limited company

A limited company is owned by its shareholders (usually the directors) and all profits generated belong to the company. The company debt remains separate from individuals. This must be registered by sending the necessary forms to Companies House.

Advantages of a limited company

In terms of personal risk, this is the safest way to operate in business and the structure is by far the most versatile, but it comes at the price of increased red tape and greater tax considerations.

The distinct main advantage is that the Directors of a limited company are not personally responsible for the company’s debt. If the company goes downhill, the directors and shareholders will undoubtedly be upset and worried for the business, however, their own personal circumstances will not be affected (eg their mortgages, savings and other personal investments are safe).

However, if there has been any wrongful trading, this will not apply. If the authorities can prove the directors have been fraudulent, they will be held personally liable.

Disadvantages of a limited company

• Setting up - a limited company must register and file annual returns at Companies House.
• Companies must pay corporation tax (higher than income tax).
• There are more director duties and legal responsibilities.
• Higher accountancy fees.

Which is the right choice?

It’s impossible to tell how well a company may do in the future. If the business is a success, a partnership can be highly beneficial. However, if the business were to fail, would you be prepared to pay off the entire debt and put your own personal finances at stake?

Regardless of the kind of business you want to set up or how many people you want to involve, you must consider all the risks (as well as benefits).

There are also other less common structures to consider. A legal adviser will be able to help you make the right choices for your business and your own circumstances.

There are lots of other things to consider… You may also need premises, be careful when signing lease agreements – if you move your business and sell the lease on you could find you are liable for the debt if the next person defaults.

Always seek professional advice

This article provides only a basic introduction. Hem concludes “These are just a few of the areas that need to be considered very carefully, there are many more – employing staff, agreements and contracts, intellectual property. Whatever your motivation for making this brave leap, it won’t always be straightforward. At Frettens, our team of lawyers are passionate about helping you to make your new project a success and would be happy to meet you to discuss your business venture.”

At Frettens, all of our solicitors offer a free initial meeting or chat on the phone to answer your questions. If this article raises issues for you or your business, please call us on 01202 499255 Hem or a member of the team will be happy to discuss it with you.