One of the first, and most important decisions you make when you set up a new business is to decide what type of legal structure you should work under.
Although there are several less widely used legal structures, such as limited liability partnerships (which are often used by accountancy and other professional firms), the vast majority of small business owners work as self-employed (i.e. as ‘sole traders’ or ‘partnerships’), or via their own a limited company.
There are many differences between the two most popular types of business structure, which we address below:
Limited companies and the ‘self employed’ are taxed in different ways.
A limited company has a separate legal entity from its shareholders and directors, whereas the business and personal affairs of self employed people are treated ‘as one’ for tax purposes.
Limited companies pay Corporation Tax on all annual profits, and company directors are taxed personally on the income they draw down from the company via the annual self assessment process. Dividend tax is levied on any dividends received from the company, and income tax and Class 1 Employees’ NICs are payable on any salaries paid by the company. The company itself must also pay Class 1 Employers’ NICs on salaries it pays to employees.
Self employed people are taxed on all the profits they make each year via the self assessment process. Class 2 and Class 4 National Insurance Contributions are also deducted weekly (Class 2), or annually according to the amount of profits reported (Class 4).
If you are self employed, or run a company, you must also register for Value Added Tax (VAT) if your turnover reaches £77,000 or more per year (2012/13). You can also register voluntarily if you wish to.
Read more in our guide to sole trader taxes.
Administration and Costs
In general, running a limited company requires more of a business owner than being self employed. As a limited company director, you have a number of statutory and financial obligations.
All limited companies are registered with Companies House, and you must ensure that keep the registrar of companies informed of any changes to your company, file an Annual Return each year, as well as a copy of your company accounts.
In reality, the ‘hassle’ involved in being a company director is not significant. Most companies use an accountant to take care of their accounting responsibilities, as well as communications with Companies House and HMRC.
There is less of a legal onus on the self employed, although they must still keep accurate records, and comply with any industry regulations (such as employment laws, health and safety, and discrimination rules). Sole traders will typically employ the services of a bookkeeper or accountant to complete or help with their annual self assessment returns.
You neeed to inform HMRC that you are/are about to become self employed (which doesn’t cost anything), and you can form a limited company for under £100, so the costs of setting up the business structure itself are not great.
Business structure and credibility
In some industries or professions, you may find it more advantageous to trade via a limited company. If you are providing professional services (as a consultant, or surveyor, for example), most clients would expect you to trade via your own company – in fact, it may be a contractual requirement.
Business structures and liability
Your personal liability differs fundamentally according to the business structure you choose. If something goes wrong, it is the limited company not its directors which are held liable (unless fraud or other offences have taken place). As a sole trader, you are held personally liable if things go wrong, such as your business goes into debt, or you face a legal claim from a client or employee.
If your business goes under, creditors can pursue you for your personal assets if you are self employed, whereas the liability of company directors is limited (hence the term ‘limited liability company’).
For these reasons, we always recommend you discuss your business with an accountant before deciding upon the right legal structure to use. You should not rely solely on the information we have provided in this article.
How to set up a limited company
You can form a limited company instantly online with our partner Duport.