Set Up
Selecting a Legal Entity For Your Business
1. Introduction The form of entity you choose can have a significant impact on the way you are protected under the law and the way you are taxed and the accounting records you have to keep. There are three basic forms of business organisations. Each has its own benefits and drawbacks and is treated differently for legal and tax purposes. back to top 2. Sole Trader A sole trader is typically a business owned and operated by one individual. A sole proprietorship is not considered to be a legal entity under the law, but rather is an extension of the individual who owns it. The owner has possession of the business assets and is directly responsible for the debts and other liabilities incurred by the business. The income or loss of a sole trader is combined with the other earnings of an individual for income tax purposes. A sole proprietorship is perhaps the easiest form of business to run and operate because it does not require any specific legal organisation, except of course the normal requirements such as licenses and permits. All you need to do is notify the Income Tax, Social Security and (where necessary), VAT authorities that you are working for yourself. A sole proprietorship typically does not have any rule or operating regulations under which it must function. The business decisions are solely the result of the owner's abilities. back to top 3. Partnerships In a partnership, two or more individuals join together to run the business enterprise. Each of the individual partners has ownership of company assets and responsibility for liabilities, as well as authority in running the business. The authority of the partners, and the way in which profits or losses are to be shared, can be modified by the partnership agreement. The responsibility for liabilities can also be modified by agreement among the partners, but partnership creditors typically have the resource to the personal assets of each of the partners for settlement of partnership debts. The requirements in relation to accounting records are similar to those of a sole trader. The rights, responsibilities and obligations of the partners are typically detailed in a partnership agreement. It is a good idea to have such an agreement for any partnership, whether limited or general. A partnership is a legal entity recognised under the law and as such it has rights and responsibilities in and of itself. A partnership can sign contracts, obtain trade credit and borrow money.
A partnership is also required to file a partnership tax return. A partnership typically does not pay income tax; the taxable income is divided between the partners and each partner is responsible for his or her own taxation liability. back to top 4. Limited Company A limited company is a separate legal entity. It has legal rights and obligations quite separate from those of its owners and is responsible for its own debts. It must also file corporation tax returns and pay taxes on profits it derives from its operations. Typically, the owners or shareholders of a limited company are protected from the liabilities of the business. This is because individual shareholder's liability is limited to the amount of their share capital in the company. However, for smaller limited companies, banks and other creditors often require personal guarantees from the shareholders before lending money or extending credit. Even so, the legal protection afforded the owners of a corporation can far outweigh the additional expenses of starting and running a limited company. A limited company is incorporated under the Companies Act. It must also adopt and file memorandum and articles of incorporation, which are the rules that govern its rights and obligations to its shareholders, directors and officers. Limited companies must have annual accounts prepared in accordance with the Companies Acts. Despite recent changes, in some cases these still require to be audited. The accounts and other information must be filed each year with the Registrar of Companies. Limited companies must also file annual corporation tax returns and accounts with the Inland Revenue. There can also be significant taxation advantages in incorporating as a limited company. Please see our article entitled "Should I Incorporate for further details. Incorporating a business allows a number of other advantages such as the ease of bringing in additional capital through the issue of shares, or allowing an individual to sell or transfer their interest in the business. It also provides for business continuity when the original owners choose to retire or sell their interest. back to top 5. Should I incorporate my business, i.e. form a limited company? The main benefit of incorporation for those currently self-employed is to take advantage of the zero rate corporation tax on the first £10,000 of company profits. The self-employed can take advantage of this by incorporating and paying themselves a small salary set at the personal allowance level of £4,615. Directors paying themselves at the personal tax allowance level avoid national insurance contributions altogether. Profits above the personal allowance can be paid as dividends. This tactic is beneficial immediately while the advantages have further improved this year (2003/04) as the national insurance rate increased by 1%. Moreover, the self-employed person is avoiding paying both Class 2 and Class 4 NI contributions by incorporating. It is calculated that a self-employed person with profits of £15,000 may now avoid all tax and national insurance and that an individual earning profits of £30,000 will in the current tax year save £3,831 by incorporation. The figures are marginally smaller for those earning profits over £50,000 because of the impact of higher rate taxation. The gains raise further if a person is able and willing to retain some of the profits - 10% or 20% for example - in the business. This might be a particularly suitable option for a person nearing retiring age. They might then pay themselves a salary and dividends after they cease working full time and perhaps avoid being caught by higher rate taxation. Alternatively they could liquidate the company and pay Capital Gains Tax with the benefit of taper relief. Incorporation may also be specifically beneficial to the self-employed, with offspring going to university. Instead of parents paying the undergraduates a grant from their own money, the children over 18 might be given shares and paid a dividend by the company. There are also the non-financial considerations that the business' accounts will be open for inspection at Companies House, including directors' remuneration. Any person acting as, in effect, a sleeping director should remember that he or she could be held liable for any debts or wrongdoing by the full time director acting in the name of the company. Despite these factors it is likely that the prospect of saving several thousand pounds annually will drive increasing numbers of self-employed to establish companies. Tax is only one of several factors that self-employed people will take into account if considering whether to incorporate," said the Treasury statement. It added: " Any tax saving must be balanced against non-tax factors-in particular the administrative requirements of the Companies Act, which include filing information for the public record. The following booklet issued by the Association of Chartered Certified Accountants is extremely comprehensive and is recommend reading before deciding the best way forward for your business project. back to top |
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