When starting a business, one of the many important decisions you need to make is what legal status you should choose. Many people start out as a sole trader but there may come a time when you decide to register as a limited company, so it is important you know all the facts to ensure you make the right decision for you and your business.
Becoming a sole trader
A sole trader is a self-employed individual who runs their own business and is entitled to keep all business profits after tax has been paid on them.
There is no major issue in starting as a sole trader; you’ll find that it’s often cheaper to do it this way just to see if your business model works. It’s pointless spending money on incorporating a business, setting up business bank accounts, and filing accounts if the business is going to sit dormant.
If you decide to become a sole trader, you must register with HM Revenue & Customs (HMRC) as soon as possible after starting your business. It is important to register quickly because if you leave it later than 5 October in your business’ second tax year, you could be charged a penalty. So, for example, if you start up as a sole trader during the tax year 2012 to 2013, you must register before 5 October 2013.
As a sole trader, some of your tax responsibilities include filing a self-assessment tax return every year, paying income tax on your profits and paying national insurance.
Sole traders must also be aware of when to register for VAT. Once you hit the current VAT threshold of £77,000 turnover, you need to register for VAT. You do not (currently) need to become incorporated.
There is no distinction between business structures for VAT registration purposes, it’s the same for both sole traders and limited companies, currently you need to register if your turnover for the previous 12 months is more than £77,000. Note that it is not by financial or accounting year but actual previous 12 months.
Most businesses can register for VAT online, unless you are registering a business partnership, a business that is part of a group or division, or an international business, in which case you must register by post.
Some businesses may be interested in joining the Flat Rate Scheme. For firms with turnover of less than £150,000, who don’t buy a lot of products, then the flat rate scheme can work quite well. Using this you still collect 20% VAT from your customers but only pay a percentage of your gross sales to the HMRC, keeping the rest as additional profit for your company.
Official guidance states that, under the Flat Rate Scheme, you pay a fixed rate of VAT to HMRC, allowing you to keep the difference between what you charge your customers and what you pay over to HMRC. You can’t reclaim the VAT on your purchases, with an exception for certain capital assets over £2,000. To join the scheme, you must apply to HMRC.
Setting up a limited company
A limited company is legally separate from its shareholders or directors, meaning the company is liable for any debts.
Whilst sole traders are personally responsible for their business debts, the liability in a private company is usually limited to the shareholders.
I would consider starting as a sole trader, but nothing gives you more credibility than having a certificate of incorporation, or even being VAT registered. I have found over the years many customers prefer to see this. If you don’t have that, they won’t do business with you.
It is important to talk to an accountant when setting up as a limited company, and HMRC is a good place to go for advice on corporation tax.
If you do decide to set up a limited company, you must register it with Companies House and inform HMRC when the company starts business activities, an accountant can do all this for you.
Every financial year, the company is required to put together statutory accounts, send Companies House an annual return, and send HMRC a company tax return.
Just like a sole trader, a limited company must also register for VAT if turnover is likely to be over £77,000 a year.
Anyone or any business can be VAT registered, even if you don’t plan to hit the threshold, an accountant would be the best one to advise you on this one.
In terms of charging VAT, if you are below the VAT threshold, you can opt to register for VAT anyway, and then you should charge VAT. If you haven’t registered then you shouldn’t.
Most limited companies are private companies limited by shares. But there are also three other types: private companies limited by guarantee, private unlimited company, and public limited company.
For more information on incorporating a company, visit the Companies House website.
If you are starting a business that is social or environment, you could set up a social enterprise. If you decide to go down this route, you must choose a business structure. This can be either a limited company; charity; co-operative; industrial and provident society; or community interest company.
Each and every person setting up is different in circumstances and it’s at this point you need to chat to an accountant to make sure you are doing what is best for you. Think of the money spent talking to an accountant as a savings account, they are the ones who can advise you and make sure your legal status works for you.