Before you start trading, you will need to decide what kind of legal structure you want your business to have. This will determine who makes the management decisions, how much tax you’ll pay, what records you need to keep, who has financial liability for the business and how you raise money. You have three main options:

1. Becoming a sole trader

Becoming a sole trader is the simplest legal structure for your business as it involves little form filling and you do not have to file accounts with Companies House (companieshouse.gov.uk). All you have to do is inform HMRC that you intend to be self-employed and register your business name and you can start trading.

How it works

As a sole trader, your business is owned entirely by you, and you get to keep all the profits after tax that the business makes. The law will not distinguish between yourself and your business, meaning if the business runs into trouble, you will bear all the legal and financial responsibility.

Advantages

• There is little form-filling required.
• Any profit that the business makes after tax is yours to keep
• You have full control over your business
• Accountants generally charge lower rates for sole trader accounts as there is less work for them to do. As a sole trader, all you are required to complete is a profit and loss account.

Disadvantages

• You have unlimited liability for your business. This means you will be personally liable for any debts that your business runs up, so your home or other assets may be at risk if your business runs into trouble.
• As the law sees you and your business as one entity, you will also be personally liable if a customer sues you.
• You may find it harder to sell the business.

The tax situation

You must register for self-assessment with HMRC and complete a tax return every year.  Your profits will be taxed as income, and you must keep records showing your business income and expenses. You must also pay fixed-rate Class 2 National Insurance contributions (NICs) regardless of any profits you make, and Class 4 National Insurance contributions on the profits that you do make.

2. Setting up a limited company

A limited company is a separate legal entity to its directors, which means although you are responsible for the business, you won’t be liable for its debts or other liabilities if it runs into trouble. Setting up a limited company is costlier and requires more administration than registering as a sole trader, but it is less of a risk because it provides limited liability. It could also be more tax-efficient because the profits belong to the company, rather than you, so you are paid as an employee. You may also opt to become a shareholder and take dividends from the company as well.

How it works

Before you can begin trading as a limited company you need to register (or incorporate) with Companies House. Limited companies must have at least one director. They must undergo an annual audit and file accounts with Companies House each year.

Documentation required

To register a limited company you will need to fill in four forms:

• A Memorandum of Association, which explains the company’s name, location and function and includes your objects and liabilities.
• Articles of Association, which describe how it will be run.
• Form 10, or the Statement of the First Directors, Secretary and Registered Office, which say where the company’s registered office is and gives details of directors and their addresses.
• Form 12, or the Declaration of Compliance with the Requirements of the Companies Act, which shows the company meets all the legal requirements.

Advantages

• Owners of limited companies are not legally or financially responsible for the partnership. If something goes wrong, creditors can seize assets from the business but not from its owners, unless you have secured a loan against personal assets.
• Having a limited company can hold greater credibility with customers and suppliers than being a sole trader.
• It can be easier to raise finance as a limited company
• It is easier to sell part of your business than if you were a sole trader

The tax situation

As a director of the company, you will pay income tax on the salary you draw as well as being taxed on any dividends you take. You will also have to pay Class 1 National Insurance contributions (NICs). The company itself will have to pay corporation tax of 19% on the profits it makes. This percentage is reviewed every year.

The practicalities

Company directors must complete a self-assessment tax return each year. You will need to give details of the income from your directorship on the employment pages. If you do not usually fill in a tax return, you must register for self-assessment.

3. Setting up a partnership

Registering as a partnership allows you to share the costs, responsibilities and risks of being in business with one or more other people. A partnership has no legal status, as a limited company would; it is merely a vehicle linking two or more self-employed people in a simple business structure. The profits and gains of the partnership are shared among the partners unless the partnership agreement states otherwise.

Advantages

•  A partnership is a relatively simple and flexible way for two or more people to own and run a business together.
• You will not need to notify Companies House, nor deal with any administrative or accounting requirements which are required of limited companies as all partners remain self-employed.
• You will have the benefit of mutual support and motivation and of sharing responsibilities.

Disadvantages

• All partners are personally responsible – and equally liable – for all debts incurred by the business so you must be confident that your partners are completely trustworthy. If the business runs into trouble, creditors can claim personal assets from you to pay off debts, even if those debts are incurred by another partner – and even if you invested less than another partner.
• If a partner leaves the partnership, the remaining partners may be liable for the entire debt of the partnership.
• Ordinary partnerships are not required to file their accounts at Companies House so other firms may be wary of doing business with them because of the lack of transparency.
• Winding up a partnership can be hard and expensive. Partners need to draw up a comprehensive Partnership Agreement to cover all aspects of the partnership and what action to take if things go wrong.
• If either of the partners withdraws from the business (if they die, resign or go bankrupt), the partnership must be dissolved instantly, since it has no legal status.

The tax situation

Both the partnership and each partner will need to register as self-employed and fill in a self-assessment tax return and return it to HMRC. You will be required to pay taxes on your share of the profits, as well as national insurance contributions. Each partner is personally responsible for paying their own tax and national insurance contributions.

Footnote

It is also possible to set up a limited liability partnership (LLP) that gives partners the benefits of limited liability but allows them the flexibility of organising their internal structure as a traditional partnership. The LLP is a separate legal entity and, while the LLP itself will be liable for the full extent of its assets, the liability of the members will be limited to what they have invested in the business. While in principle any business of two or more people can incorporate as an LLP, in practice it is generally only used by firms of professionals such as solicitors as the limited company structure tends to be more useful for most mainstream businesses.

Top tip

It can be expensive to change the structure of your business once you have set it up so if you are unsure as to what format to choose, speak to a solicitor or accountant. They can also help you with the registration process.

Case study

Gandlake Computer Services, which develops business software in Newbury, Berkshire, started trading as a partnership in 1971. But a few years ago it became a limited company after managing director John Gandley decided this would help to grow the business.

He said: “We were doing well and had strong cash flow. But, because we were a partnership, we were not publishing accounts at Companies House, so that aspect of the business was invisible to our clients. We wanted the market to see that we were very solvent and profitable and had good reserves of working capital so that people could compare us with our competitors.”

As the business took on bigger clients, Gandley was also keen to move from unlimited to limited liability. “All our clients were either limited companies, plcs or big government departments and they didn’t really understand the concept of partnerships. It was always a potential obstacle to doing business that had to be overcome.”

The switch was time-consuming but straightforward, taking six months and a lot of paperwork. Gandley also had to have the business valued by external valuers. He estimated that the whole process cost between £100,000 and £120,000, but expected to recover this through tax savings and business expansion.