Each business structure available to conduct business activities has its own legal and tax implications.
There are four types of business structures (or business media) in the United Kingdom: sole traders, limited companies, partnerships y limited liability partnerships.
This post compares the most common two: sole traders and limited companies.
When a sole trader’s business grows, it becomes necessary to assess whether it would be convenient to set up a limited company due to the tax benefits it offers. It makes sense to set up a private company limited by shares first, as the required starting capital is only £100 (as compared to a public company limited by shares, the minimum starting capital of which is £50,000).
From a legal point of view, however, the implications of a limited company are favorable to a certain extent.
Who is a sole trader?
Sole traders conduct business on their own account (they are ‘self-employed’). In the UK, all sole traders have to register with Her Majesty’s Revenue and Customs (HMRC) and self-assess their performance as soon as they start trading.
A sole trader may hire other workers and must pay income tax, VAT (if the level of income requires it) and National Insurance contributions (NICs) at a percentage that will vary based on gross earnings.
What is a limited company?
A limited company is an organizational unit that must be set up through a process called ‘incorporation’ before Companies House. The liability of the members or shareholders is limited to the sum each of them has agreed (‘subscribed’) to contribute to the share capital. There are limited companies that are prohibited from offering their shares to the public (private companies limited by shares) and others that can do (public companies limited by shares).
SOLE TRADERS AND LIMITED COMPANIES: PROS AND CONS
Incorporation and commencement of operations
One of the advantages of operating as a sole trader instead of a limited company is that sole traders do not need to register with Companies House for incorporation, making them exempt from incorporation and registration fees.
A sole trader may start trading almost immediately, while a limited company has to wait for Companies House to accept its application for registration (to which the memorandum of association and articles of association will be attached) and issue a certificate of incorporation. Public companies limited by shares must also apply for a license to operate (a ‘trading certificate’) and cannot start trading until they demonstrate that they meet the capital requirements (£50,000).
It is possible to start trading before registering with Her Majesty’s Revenue and Customs (HMRC) to pay Corporation Tax, but such registration cannot be delayed more than 3 months from the approval of the application by Companies House.
Separate legal personality and liability
Limited companies have separate legal personality independent from that of their shareholders or members, which means that they can own real estate, sign contracts and sue or be sued as an independent entity (unless the courts decide to overlook the limited liability – pierce the corporate veil – if there is clear evidence of fraud or an attempt to evade an existing legal obligation by using the company as protection).
Shareholders are not personally liable in case of dissolution or debt. Their liability is limited to the amount of share capital they have subscribed.
As for the sole trader, this liability is potentially unlimited. If the product sold is defective, the sole trader is personally sued. Unless they take steps to minimize the risk arising from such liability, for example, by taking out professional liability or product or service liability insurance, they are personally liable, meaning they must pay off their debts using their own personal assets, including their home.
The operations of a sole trader cease if he or she dies or becomes bankrupt.
Since limited companies have their own separate legal personality, their existence is not affected by the death, resignation or bankruptcy of their members, nor by a transfer of shares. They will only cease to exist if dissolution is conducted through the relevant proceedings.
Raising and recovering capital
A limited company (particularly the public company limited by shares) is an excellent means of raising capital. Potential investors are easily attracted by the fact that shareholders have limited liability.
In addition, a shareholder may easily choose to stop being an investor in the company, sell their shares and thus recover their investment.
In addition to share capital, another way to raise capital is through loans. As a result of section 31 of the UK Companies Act 2006 (Companies Act 2006), ‘unless a company’s articles specifically restrict the objects of the company, its objects are unrestricted’. This purports to give companies unlimited power, including the ability to apply for a loan if their constitutional documents do not expressly exclude such power because the relevant company has decided to restrict its object.
The power to request a loan carries an implied power to grant charges as security for any loan, some of which have to be registered with Companies House.
One of these charges, and one of peculiar nature, too, is the floating charge, available to limited companies, but not to the sole trader. Floating charges are created on an indistinct set of present or future assets (for example, stock or book debts), but they do not affect any particular asset until something happens that causes the charge to ‘crystallize’ (for example, if the company becomes insolvent or defaults on the loan agreement). Until then, the company can trade in the assets as it wishes without reference to the creditor.
Floating charges can be created on a group of assets on which, due to practical reasons, it is not convenient to create a fixed charge until the lender needs to execute it. For example, if a company has a number of stock units that it wishes to pledge to a lender, but which it has to sell and replenish daily, with a fixed charge it would have to release the charge for each product it wants to sell.
Another advantage of floating charges is that they do not require that the legal ownership of the asset be transferred to the creditor, hence it is not necessary to register them upon creation. Filing documents proving ownership with Companies House within 21 days from the creation of the charge will suffice.
Given that their are activities are considered high risk, it is more difficult for sole traders to secure a loan than it is for limited companies.
Taxwise, limited companies are treated more favourably than sole traders. Companies pay Corporation Tax on their profits at a rate of 20% for income up to £300,000 and 21% if income exceeds this figure.
Directors are considered employees of the company for tax purposes. It they receive remuneration for their services, they must pay income tax and National Insurance contributions. Shareholders pay taxes on dividends received.
The tax rate for sole traders is 20% if their income does not exceed £40,000. Above this threshold, the rate increases to 40% if income lies between £50,001 and £150,000. Above this sum, 45% is payable. It is at this point when a sole trader should consider incorporating their business into a limited company.
Unlike the sole trader, limited companies are highly regulated (Companies Act 2006, Insolvency Act 1986, Company Directors Qualification Act 1986, and regulations such as the Company Names Adjudicator Rules 2008). Company laws impose numerous requirements on companies (for example, filing annual accounts in accordance with accounting standards). It is the price they have to pay for limited liability.
While it is true that some recent reforms in English company law have reduced this burden, compliance with these rules may be onerous.
Trading disclosure obligations entail a loss of confidentiality for limited companies.
In addition to having to file information about their finances (for example, annual accounts), the Company, Limited Liability Partnership and Business (Names and Trading Disclosures) Regulations 2015 require limited companies to:
- display their name at the registered office and other locations, as well as all business correspondence, official publications, bills of exchange, requests for money and orders for goods and services, invoices, receipts, etc.; and
- include, in their business correspondence, order forms and websites, the company’s registration number with Companies House, registered office and the fact that they are a limited company.
In return for the limited liability enjoyed by their members, as explained above, limited companies are subject to numerous regulations, providing less flexibility (for example, in terms of distribution of capital).
The appointment of directors and the transfer of shares must be made in accordance with the provisions of the articles of association. Laws restrict the choice of company name (for example, the chosen name cannot imply that the company is somehow related to the Government).
Also, amending the articles is not without limitations. The articles of association are a contract between shareholders and between shareholders and the company, and a special resolution must be passed for approving any amendment (ie at least 75 percent of the members voting in favor of the resolution).
Set up as a sole trader: https://www.gov.uk/set-up-sole-trader
Corporation Tax: detailed information: https://www.gov.uk/topic/business-tax/corporation-tax
French D., Mayson, French & Ryan on Company Law, 36th Edition, Oxford