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. So which business structure is best for you?
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 limited companies.
There are many differences between the two most popular types of business structure, so it’s important you consider the following points when evaluating with business structure is best for you;
Limited companies and the ‘self employed’ are taxed in different ways.
Limited company tax
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 tax
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). Read more in our guide to Sole Trader taxes.
You must register for Value Added Tax (VAT) if your turnover reaches £85,000 or more per year (2021/22), no matter whether you work as self-employed or through a limited company.
You can register for VAT voluntarily before your turnover reaches the VAT registration threshold if you wish to. This can have benefits. You can find more on VAT in ByteStart’s 60-second guide to Value Added Tax (VAT) for start-ups and small businesses.
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.
Limited company administration
All limited companies are registered with Companies House. You must ensure that you keep the registrar of companies informed of any changes to your company, file a Confirmation Statement and PSC each year, as well as a copy of your company accounts.
You can form a limited company for under £100, so the costs of setting up the business structure itself are not great. Most people now register a limited company online, where it can be done within a few hours. You can do this with our partner, 1st Formations – the UK’s leading company formations service.
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.
Self employed requirements
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.
For an insight into the key benefits of being self employed, read 7 Advantages a Sole Trader (self employed) Has Over a Limited Company
Business structures and credibility
In some industries or professions, you may find it more advantageous to trade via a limited company. Some business owners find that their customers feel more comfortable dealing with a limited company as they can be perceived to be more established and stable than a sole trader.
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.
Limited company liability
A limited company is a separate legal entity, so if something goes wrong, it is the limited company, not its directors which are held liable.
If your company fails and owes money to creditors you will not have to pay the creditors out of your own personal assets (unless fraud or other offences have taken place).
The liability of company directors is therefore limited, and hence the term ‘limited liability company’. This is one of the 10 Advantages running your business as a limited company has over being a sole trader
Sole trader liability
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.
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.