I get this question all the time with start-ups, so I asked Claire to write up a blog - a cracking read for anyone starting out - a great easy to read guide too.
Once you have made the decision to break away from employment and work for yourself, one of the first questions that you should ask is under what legal entity will you trade. Will you be incorporated (Limited Company) or unincorporated (sole trader/partnership). Both have their pros and cons, so here is a brief guide.
We’ve come across a number of business owners who have set up a Limited Company purely because it means that if things go wrong, their house and personal assets are safe. The logic behind this is correct. Having a Limited Company means that you have created something that is separate to yourself so personal and business assets are kept apart.
The problem that we encounter is that often entrepreneurs form a Limited Company to protect their personal assets, but then proceed to treat the Limited Company like it’s a personal asset. That mindset can lead to a lot of trouble in the future and some unexpected tax bills.
Having a Limited Company falls somewhere between having an employer and owning a pet. When you trade as a sole trader you are your business and your business is you. It’s a wonderful and yet scary blurred line. We recommend that you set up a business bank account but other than that things are far more fluid. You will be taxed on all of the profits that you make at the same rate as though you were employed, regardless of how much you actually withdraw from the business. That’s basically because all of the money within the business is yours so you can withdraw however much you want, whenever you want to.
If you set up a Limited Company then you cease being a business owner and become a Director and a Shareholder. The Director is paid a salary through the Limited Company as they are an employee and the shareholders are paid via dividends, assuming there is enough reserves in the company to do so. These formal positions are in place because the money within the Limited Companydoes not belong to you. You cannot extract it at will because it is not yours to take.
Another example of this is your car. If you are a sole trader then the running costs, even the lease can be a deductible expense (not always fully tax deductible however) so the business can pay for it. When you have a Limited Company it cannot pay for any of your motor expenses unless the car is treated as a company car and you receive a P11d benefit. Instead the best way is to keep a mileage log and charge the Limited Company 45p per mile. This may sound confusing but that it because you and your Limited Company are separate so the car is either yours, and you pay for it, or it belongs to the Company and you using it is deemed to be a benefit of your employment as a Director.
The reason we describe having a Limited Company is like owning a pet is because you have to look after it; it cannot look after its self. As the Director you are in charge to make sure that the annual return is filed, a payroll scheme is set up (with auto enrolment), you need to make sure adequate bookkeeping/accounting systems are in place, you need to make sure the accounts that your Accountant prepares are correct and filed on time to both Companies House and HMRC. The Limited Company will also be taxed separately to you, so that needs to be calculated and paid. On top of that, as a Director you will still need to file your own Tax Return so your personal obligations are very similar to the sole trader.
If you are unsure as to what legal entity would suit you and your business, we recommend that you talk to an accountant before you start to trade. This way you can make an informed decision as to what structure is best for you.