Deciding on Self Employment or Limited Company

As you plan to start a new business, you probably would be faced with the choice of operating as a sole trader (self employment) or as a limited company. In some cases, this decision can be clear cut while in others you will need to weigh a number of factors. In this article, we will examine the main considerations to help you make that choice.

Legal Position

In legal terms, a sole trader and the business are one and the same. This means that the sole trader takes all the rewards but is responsible for all the risks of the business. Therefore, if the business runs into trouble, the sole trader will be liable for any financial, legal or other consequences.

A limited company, by contrast, enjoys a separate legal personality from its owners. All transactions are conducted in the company's name. The liability of the owners is limited to the value of their shareholding although this protection does not extend to personal guarantees or when the company is used as a front for illegal activities. Setting up a limited company, therefore, amounts to creating an interest in an entity.

Paperwork and Responsibilities

A sole trader is the simplest business form and does not require complex records and accounts to be kept; a simple income and expenditure statement with relevant receipts will suffice. However, a sole trader has to register with Her Majesty's Revenue and Customs (HMRC) for annual Self Assessment and VAT purposes.

More responsibilities and paperwork come with a limited company. In the first instance, the company must be registered with Companies House, and given a Certificate of Incorporation. It must have as a minimum: one director who must be at least 16 years of age; Memorandum and Article of Association to define and guide its operational scope; an acceptable name; and a registered office. A limited company must keep proper records for a number of years. It must prepare and file annual reports and accounts, even when not trading, and there is a tiered penalty for non-compliance. HMRC must also be informed of the existence of the company.

Taxation

The profits of a sole trader are taxed in much the same way as any employment source, which is that, apart from statutory allowances, there is very little scope to minimise the tax burden. In addition, a sole trader pays a fixed rate class 2 National Insurance Contributions (NICs) and class 4 NICs on annual profits.

With a limited company, tax savings can be made by controlling what proportion of profits is taken as salary, dividends and retention in the business for future growth. Certain expenses, such as the company's share of pension contributions, are treated as allowable business expenses which provide further tax advantages. Some of these tax benefits may be eroded with adverse corporation tax rules or where the limited company operates through a Managed Services Company, for example.

Property, Finance and Administration

There is no formal difference between what is owned by the sole trader and what belongs to the business. Finance for business needs would come from personal resources or loans. In any case, being self employed is not necessarily a hindrance to sources of capital since the evaluation of any business proposal by potential lenders would be based purely on merit.

A limited company will have a bank account in its name, maintain proper books for its assets and liabilities and build up its own credit rating. Therefore, there is a clear distinction between the property of the owners and that of the company. Apart from loans from banks and other lenders, a limited company may seek to secure additional funding through the issue of shares and debentures but such arrangements will be severely impacted by the generally poor marketability of a private limited company's shares.

Administration for a sole trader is a simpler exercise since there is no formal structure. For a limited company, the cost of administration is relatively high as a result of implementing measures necessary for compliance to legal requirements.