Sole trader versus limited company: An Approach-Approach Conflict
For commencing a business, the first and foremost step is to decide the form of business entity. In the case of small businesses, the most favorable options seem to be either being a sole trader or form a limited company. Before going further it’s important to understand what do we mean by sole trader and company. A sole trader is a person who is the exclusive owner of a business, entitled to keep all profits after tax has been paid but also liable for all losses. A company is a legal entity distinct from its owner. Everything done in the company is done in its own name. The directors run the company while shareholders fund the company.
Now the question that arises here is whether to go for being Self-employed or forming a Company. It is definitely a tough choice to make. There are a handful of parameters to solve this dilemma. Some of which have been enumerated in this article to help make a choice of entity that caters to one’s business needs.
Beginning with Incorporation formalities, it can be said that setting up as self-employed is the easiest way to kick start a business. All one needs to do is to inform HMRC of ‘self-employed’ status. This can be done online. There aren’t any other fussy formalities to be completed and the business can start working right away. Click here to read about setting up as a sole trader.
On the other hand, incorporating a company is a slightly complex process. The business needs to be registered with Companies House, directors need to be appointed and several other legal formalities and administrative functions need to be carried out before the company starts commencing its business. But, the interesting fact is that its relatively easier to form a company in the UK than in other parts of the world. Click here to read about the formation of a company.
Once a company is registered with a particular name, it becomes its identity, hence choosing the right company name is utterly important. No one else can choose to incorporate another company with the same or similar name as of the registered company since it is protected by law upon incorporation. But no such protection is available to a sole trader. Anyone can choose to carry on business with a name that is the same as or similar to an existing business. This can often entail the migration of customers who are unaware of the original business, damage to the reputation of business, etc.
A sole trader simply needs to carry out a self-assessment and file a self-assessment return each year. A company needs to engage in a number of administrative responsibilities like maintaining various registers, filing of annual accounts with both Companies House and HMRC, filing Confirmation Statement to Companies House, besides filing a corporate tax return to HMRC, etc.
Finance is the lifeblood of any business, especially a new one, and discovering easy sources of funds can be difficult for all new businesses. The limited companies get an edge over sole traders in this area because of the limited liability characteristic attached to them. Also, since most of the information of a company is available in the public domain like annual accounts, details of directors, etc. it becomes easier for financers to fetch information about it and establish its credibility. On the other hand, sole traders would require sufficient time to establish their credibility in the market.
The aforementioned point drives us to another benefit of being a sole trader. Since the sole trader is required to merely file a self-assessment return keeping an accurate record of your expenses, receipts, and invoices from day one would suffice the accounting needs. However, since a company needs to file annual accounts with HMRC and Companies House, the accounting compliance for a company is slightly complex as compared to a sole trader.
A very prominent advantage of the limited company over the sole trader is that it is a more tax-efficient form of business than the latter. This is because the corporation tax rate is 19% which shall further reduce to 17% from 1 st April 2020. On the other hand, the self-assessment basic rate for a sole trader is 20% which goes to a higher rate of 40% and up to an additional rate of 45%. This difference in the tax rates makes the limited company an attractive option.
It’s been a worldwide practice to keep the corporate tax rates lower for purposes of attracting foreign investment. Hence, one can assume that the corporate tax rate might see a further reduction in the future.
Separate legal entity
It’s a limited company’s unique feature which gives it an extra layer of security. A company has a separate identity from its owners. It can hold assets in its own names, can sue and can be sued. Thus, in case of a legal dispute, it is company that is sued. It’s quite difficult under the UK law for anyone to sue a director personally for wrong doings of a company. But, in case of a sole trader, if a legal dispute arises, he/she shall be personally liable for the repercussions of the same.
In the case of a company, the owners (i.e. shareholders) are liable for paying any of the debts of the company, only up to any unpaid amount on their shares in the company.
However, in the case of a sole trader, there is no legal distinction between the owner and the business. If the business fails for any reason, and there are debts outstanding, then he/she shall be held personally liable for this and must ensure the debt is cleared. This situation may at times call for bankruptcy for the sole trader.
Transfer of ownership
In the case of a company, the ownership can be transferred from one person to another by mere transfer of shares. In the case of a sole trader, though the business can be completely sold, the buyer cannot enjoy the credibility and goodwill created by the past owner. Often he’ll have to begin with a scratch to make its qualitative factors strong again.
A Limited Company’s information is easily available in the public domain. It is easier for other businesses to engage with companies since they can always do a background check from its information available before entering into any deal. Companies in a sense are perceived to be transparent and more credible bodies to deal with. This benefit is lost in the case of a sole trader.
One of the most important factors that add to the goodwill of a business is its a number of years of being into existence. In the case of a company, as we know “Men may come, Men may go, but the company fails to die.” Older the company is, better its goodwill is. E.g. Marks & Spencer which proudly states “established since 1884”.
But in case of a sole trader, the goodwill is lost once the person behind running that business dies or leaves that business for any reason.
Deciding the right way...
Each paradigm of the business entity comes with its own pros and cons. Barring a few criteria viz. Incorporation, legal requirements, and complexity of annual accounts, a limited company stands out to be a clear winner with a score of 8 to 3, however, as we know deciding the form of business is a nota wrestling match. The type of business entity chosen primarily depends on the objectives of the person setting it up. As a generalisation, there cannot be any clear cut answer as to which form is better over the other.
We’re all too greedy and most would love to have the best of both worlds (sole trader + limited company). In our opinion, one can start off trading as a sole trader and also set up a dormant limited company at the same time (to save the name and build history). Keep the limited company status as dormant until your business grows to a stage when you can take the plunge and start doing the same business under the company name. This way, you can enjoy the simplicity around being a sole trader and also need not put your hand into the complex filing requirements needed for a trading company. To know how simple the dormant company compliance is, please click here.