How Should I Set-up my New Business? (Sole Trader / Partnership / Limited Company)

Choosing the Correct Business Structure

New Business?

If you have a business idea or you’re in the early days of starting your business now is the time to start thinking about your business structure.  The legal structure that you set your business up in can be changed, but getting it right from the start can save you a lot of time and money further down the line.  In addition to this if you use the right structure from the start it can save you thousands from your tax bill and may protect your own personal assets should the worse happen with the business.

Tax Differences

Sole Traders & Partnerships

Individuals are subject to PAYE (which is Income Tax) and National Insurance (NI).  If you are currently employed you will notice these deductions coming off your payslip.  It’s no different for Sole Traders and those in a Partnership – these groups of people are also subject to PAYE and NI but they don’t receive payslips, therefore they have to complete an annual Tax Return and pay to the Government based on that.

Every individual is given a Personal Allowance on which they are not taxed – the current rate is £10,000 (but it can differ based on personal circumstances) any income above this level is taxed.  The rate of tax is currently 20% for Basic Rate Taxpayers, 40% for Higher Rate Taxpayers and if your earnings are really high you could be paying 45%.  Those falling into one of the higher bands only pay that percentage on the earnings that fall into that band, they would also pay at the lower earnings rate for the earnings applicable to those bands.

In addition to PAYE, NI must be calculated and paid to the Government for Sole Traders and Partnerships.  There are 2 classes of NI applicable to Sole Traders and Partnerships – Class 2 & Class 4.  Class 2 is a fixed weekly amount, it can be avoided if you earn less than £5,885 however not paying will mean you will lose NI credits which can affect your State Benefit and Pensions entitlement so it is wise to take further advice.  The fixed amount is £2.75 per week.  In addition if you earn over £7,956 you will accrue Class 4 NI at a rate of 9% up to £41,865 earnings, then the percentage drops to 2% for your earnings in excess of £41,865.

In summary you could be paying Tax and NI of up to 49% of your profits (40% PAYE & 9% NI) depending on your earnings level.  This is regardless of whether or not the profits are reinvested back into the business.

Limited Companies

If you set up your business in the form of a Company you could take profits partly by Salary and party by Dividend withdrawal.  Your salary would be subject to the above levels of PAYE and NI however a good Accountant could advise you on the best level to withdraw a salary to minimise your tax liability.  The balance of your required income could then be withdrawn from the Company as a dividend.

After expenses (including your salary payments) the Company profits are subject to Corporation Tax – the current rate for profits under £300,000 is 20% and 21% above £300,000.  Once this tax has been deducted you are able to take a dividend from the remaining profits.

Dividends are taxed at 10% for Basic Rate Tax payers, 32.5% for Higher Rate Tax payers and 37.5% for the highest earners.  However as the Company has already paid Corporation Tax on these profits all Dividends come with a 10% tax credit that can be offset against your personal tax liability.  In short if you are only a Basic Rate tax payer the 10% tax credit offsets the tax due so you have no tax liability on the Dividend.

To summarise the total tax liability through a limited company could reach 45.17% for the highest earners (21% Corporation Tax & an effective 24.17% Dividend Tax after the 10% credit and Corporation Tax deduction).  However if you are using the profits to reinvest into your business and grow for the future then the maximum tax would be 21%.  This is less than half the tax you could be paying as a Sole Trader or Partnership!

Limiting Liability

A large advantage of setting up your business as a Private Company (Ltd) is if the worst happen and the company goes into financial distress you are only liable for the company debts up to the value of your investment in the company.  Therefore if you hold £2,000 worth of company shares you may not receive this back if the company is liquidated or made insolvent – all of the company debts will be repaid prior to you receiving any of your investment.  Your own private assets will however remain safe.

Trading as a Sole Trader or Partnership does not offer this same protection.  If the business goes into financial distress then the creditors can ‘chase’ the owners private assets in settlement of any debts.  If you are in a partnership and only receive a share of the profits you can still be held 100% responsible for the companies debts – this is known as Joint and Several Liability.

There is a special Partnership (a Limited Liability Partnership) that can however be used to limit the liability of some of the Partners within the agreement.  There must, however still be at least one regular partner with no limit of liability.

Paperwork / Admin

Incorporating your business as a Limited Company involves registering with Companies House and providing Annual Returns and Submissions.  There are fees involved with doing this not to mention the time taken for the paperwork and possible Accountants assistance.  In addition if you are taking a salary from the company then you will have to run a payroll which also results in a number of HMRC reporting requirements.

When it comes to Sole Traders and Partnerships you only need to prepare and submit an Annual Self Assessment tax return.  You may still have to run a payroll system if you employ staff but there is no requirement to run one for yourself or your partners.

Access to Experience, Knowledge and Finance

Running a business as a Sole Trader you only have yourself to rely on for experience and knowledge, unless of course you pay a third party for the benefit of their knowledge.  In addition you only have access to finance that you raise or borrow.  If you want to add another person to the business (other than as an employee) you would need to look at either changing to a Partnership or a Limited Company.

Within a Partnership you have the experience and knowledge of all the partners.  It is easy to add more partners or remove partners from the Partnership so the knowledge and experience resource can be changed.  This also applies to access to finance – as more partners come into the Partnership they can inject more funds to the business and provide a broader guarantee which may mean access to loan funds is easier to obtain.

A Limited Company could give the greatest access to finance albeit some lenders may still require personal guarantees for loans despite the Limited Liability benefit.  Additional funding can quickly be raised by offering shares in your company to friends and family.  In return for an investment they would in effect own a percentage of your company and be entitled to a share of the dividends.

Summary

There are benefits and disadvantages to each possible business configuration and you must weigh up the impact on your own personal circumstances.  Talking to an Accountant in the early days of planning your new business could provide you with valuable advice regards the best structure for your situation.

A summary of the main differences follows:

Sole Trader

  • Limited paperwork – relatively informal
  • Can employ staff but don’t have to run a payroll if only themselves
  • Liable for Income Tax (PAYE) and National Insurance (NI) on all taxable earnings
  • Annual HMRC Self Assessment Submissions
  • Can be VAT registered in Traders name
  • No limit on liability for business debts – Private assets at risk
  • As the business grows not very tax efficient
  • Restricted expertise and knowledge
  • Restricted access to finance

Partnership

  • Limited paperwork – relatively informal
  • Can employ staff but don’t have to run a payroll if only Partners
  • Liable for Income Tax (PAYE) and National Insurance (NI) on all taxable earnings
  • Annual HMRC Self Assessment Submissions (individual and partnership)
  • Can be VAT registered in Partnership name
  • Additional support and expertise available from partners
  • Joint and Several liability for all the Partnership debts
  • Earnings can’t be retained in the business in a tax efficient way
  • Increased access to finance compared to Sole Trader

Limited Liability Partnership

  • Hybrid of a Partnership and Company
  • Maintains most features of a regular Partnership
  • Some partners have limited liability
  • Additional paperwork requirements to Companies House

Private Limited Company

  • No personal liability for Company debts
  • Most tax efficient when profits are being reinvested in the business
  • Most tax efficient structure when earnings are at a higher level
  • Very scalable – additional shareholders can easily be added to the business
  • Banks & Creditors may seek personal guarantees despite Limited Liability status
  • Increased Paperwork and Administration requirements
  • Annual HMRC and Companies House Submissions and Returns
  • Can be VAT registered in the Company Name
Disclaimer
The rates and thresholds quoted in this article are correct at the time of writing.  Note rates and thresholds are changed on a regular basis.

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