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Sole trader, partnership or limited company? The decision about which legal corporate structure to adopt means addressing key issues of risk, tax and profit sharing

This article was first published in the January 2013 UK edition of Accounting and Business magazine.

When individuals set up a business, the decision on which corporate structure to adopt is one item on the agenda that must be settled decisively. For many it will probably be one of their earliest encounters with compliance and how an accountant in practice who is asked for assistance responds can go a long way towards defining the relationship.

For this kind of task presents an opportunity to do more than just set out and explain the liability, filing and tax issues. It also gives an accountant who is on the ball the chance to start probing the unwritten business plan along with an opportunity to start adding value early on.

Mark Gold, partner with Silver Levene and chairman of ACCA’s Global Forum for SMEs, says: ‘For accountants, the key to helping people make the right decision is asking questions and finding out their expectations and intentions.’

For many, the choice between becoming a sole trader, a limited company or a partnership will be fairly straightforward. The right choice will depend on what kind of issues matter most to them. For many, minimising the tax liability will be key. For some, privacy on performance and revenue will be more important.

‘I have seen a client turning over £1m choosing to stay as a sole trader, undoubtedly paying more tax than he needed to, but keeping things that way because he didn’t want to reveal too much detail to competitors,’ says Gold.

Norman Younger FCCA, managing director of Formations Direct, says he has seen no fall-off in company formations. However, he adds that he would hesitate to read into that any sort of recovery story. ‘A lot of people become self-employed or set up in business as a necessity,’ he points out. ‘They set up a limited company as a way of contracting to a former employer, for instance. The fact that figures are holding up is not necessarily indicative of an economic pick-up.’

Changes to corporation tax rates and top-rate income tax aside, there is probably little in the current climate that will force radical changes in the decision on structure. A key point, says Gold, is that in the UK all the options offer reasonable flexibility as long as the business owner or sole trader understands the main advantages and limitations of their chosen structure.

For the sole trader whose business grows in a meaningful way, incorporating as a limited company further down the line is a good option. It also acts as a useful way of building in more protection. ‘A limited company will suit them if there is a real danger that personal assets are at risk as the company grows,’ says Gold.

Sole traders

In the UK, 3.6 million individuals operate as sole traders. The economic climate has prompted many, either through choice or the loss of employment, to set up on their own.

It remains quick and easy to set up as a sole trader, with no requirement to register with Companies House.

The main downside is risk. There is no legal protection of personal assets if the business incurs debts or attracts a lawsuit. Yet even this need not prove an insurmountable barrier. A lawyer or accountant can protect themselves with liability insurance while a photographer or consultant is more likely to suffer reputational damage than far-reaching financial harm.

But although the top rate of personal taxation is coming down from 50% to 45%, the sole trader arrangement is not the most tax-efficient option for high earners.

Partnerships

Partnerships remain a popular option for groups of professionals who trade on their expertise. A partnership is still a good way of acknowledging mutual commitment in sharing costs, decisions and other responsibilities – provided, that is, you have set up a formal partnership agreement that specifies how you will share profits or losses and settle disputes.

This can be an important issue for the accountant to probe at the outset, Gold says. ‘In a 50:50 partnership, you need to know who’s going to make the final decision. This can be very simple, but it needs to be decided at the outset.’

Other than that, filing arrangements are straightforward; there is no need for a balance sheet and another key advantage is flexibility in profit sharing.
Liability can be a sticking point. Partners are personally liable for debts. Creditors can put in a claim against their personal assets, even if debts are incurred by another partner.

Limited liability partnerships

Limited liability partnerships have been around for over a decade. They provide greater security for partners because they limit liability to the amount invested. If debts are incurred, creditors may seize business assets but not personal assets.

‘You get the protection of a limited company, but you are taxed as if you were a partnership,’ says Gold.

Limited liability partnerships must file company documents with the registrar of companies, as well as accounts and an annual return.

Limited company

Limited companies are the most popular choice for small businesses. Figures from the Department of Business Innovation and Skills for 2011 show that 1.3 million limited companies are active in the UK, compared with 447,000 partnerships.

The ability for directors who are also shareholders to draw both a salary and dividends makes it an attractive option for growing companies, particularly with corporation tax coming down.
Keep talking

The key to it all is to keep the dialogue with clients going. ‘A good accountant has to understand clients’ needs now and in the future to advise what structure best meets their business and personal requirements,’ says Gold.

Liz Loxton, journalist

Last updated: 19 Mar 2014