Company formation is the term used in the UK for the incorporation of a business. It is also sometimes referred to as company registration.
Company Formation Overview
Starting a small business for the first time can be a scary prospect. Gone is the security of just ‘turning up, doing the 9-5 and then going home’ It’s a delicate and tense process as you try to build and grow, and you may often feel like you’re on your own, but once the hard work and determination starts to pay off you’ll never want to work for someone else again!
There are two main types of business model; Sole Trader or Limited Company.
Every business – no matter how big or small – must have a legal structure, with the bulk choosing to be either a sole trader or a limited company. An estimated 3.4 million operate as sole traders, with around 1.9 million operating as limited companies – so what is the difference between the two? And which could be the best fit for your business?
Definition of a Sole Trader
A sole trader is essentially a self-employed person who is the sole owner of their business.
Definition of a Limited Company
A limited company is a type of business structure where the company has a legal identity of its own, separate from its owners (shareholders) and its managers (directors).
What are the two main business types?
There are two main types of business model; Sole Trader or Limited Company.
Every business – no matter how big or small – must have a legal structure, with the bulk choosing to be either a sole trader or a limited company.
Definition of a Sole Trader
A sole trader is essentially a self-employed person who is the sole owner of their business. It’s the simplest business structure out there – which is probably why it’s the most popular – and you can set up as one via the GOV.UK website (you’ll need to do this for tax purposes).
Definition of a Limited Company
A limited company is a type of business structure where the company has a legal identity of its own, separate from its owners (shareholders) and its managers (directors). Even if a company has only one individual involved with it and that person is the only shareholder and the only director, the company is still a separate legal entity.
That means the company can enter into contracts, and be sued, in its own right. In the event that the company is sued, its directors and shareholders do not have to sell their own assets to pay the debt, unless, in the case of directors, they have been found guilty of wrongdoing or have given personal guarantees.
Sole Trader v’s Limited Company
Now, setting up as either structure will bring its own benefits and drawbacks, so starting with the sole trader option let’s take a closer look…
Becoming a Sole Trader
Registering as a sole trader is the most common way to start a business in the UK. According to the Federation of Small Businesses, 59% of the UK private sector is made up of sole proprietorships. These operate in industries as wide-ranging as marketing, construction, hair and beauty, ecommerce, retail, hospitality, photography and the wedding industry.
The registration process is straightforward and start-up costs are low. Once registered, paperwork and accounting are uncomplicated as there are no other stakeholders to consider. And, you get to be in charge of your own fortunes.
Without doubt the main benefit of starting off as a Sole Trader is It’s easier to change your mind!
Becoming a sole trader lets you dip your toe into the world of self-employment without too much risk. If it doesn’t work out as hoped, you can easily move back into employment by informing HMRC that you’re no longer trading. With a limited company or limited liability partnership, dissolving is a lengthy, more formal process that involves informing bankers, insurers and advisers, as well as dealing with assets and payments to creditors.
The pros and cons of registering as a Sole Trader
You’re in control: As a sole trader, you’re the boss. There are no stakeholders or directors to answer to and how the company moves forward is completely down to you. You make the decisions and you implement them in the way you feel is best.
Low running costs: The cost of setting up as a sole trader is low and only a small amount of capital is needed to get up and running (e.g. money for goods, a website and marketing). Sole traders also tend to operate alone or with only a few employees, which keeps the wage bill low and maximises profit.
Business privacy: Unlike limited companies which are required to make personal and business information public, sole traders get to keep details private so that accounts don’t come under public scrutiny.
Simple set-up process: When compared to the requirements, red tape and paperwork involved in setting up a limited company or limited liability partnership, getting started as a sole trader is a breeze. The only legal requirement for getting started as a sole trader is registering for Self-Assessment. You can register for Self-Assessment with HMRC on the GOV.UK website or by completing an SA1 form.
You’re liable for your business: Sole traders are not seen as a separate entity by law and have unlimited liability as a result. This means that you and your personal assets are liable for business debts.
Finance may be harder to come by: Where limited companies can borrow based on the creditworthiness of the company, sole traders need to make personal guarantees when borrowing. Therefore, you’ll need to maintain a positive credit rating. This can make securing funds more difficult.
Decisions are on you: One of the biggest benefits of being a sole trader can also be one of its biggest drawbacks. The success or failure of your business is on you. If you have employees, there’s added pressure as making the correct decisions affects their future as well as yours. This responsibility can bring unwanted stress.
How to register as a Sole Trader
By registering as a sole trader, you are essentially telling HMRC that you are becoming self-employed. This makes the process relatively straightforward and uncomplicated compared to the other company formation types.
As mentioned above, to set up as a sole trader you need to register for Self-Assessment with HMRC and file a tax return every year. Tax returns can be filed by you or your accountant.
You’ll need to register by 5 October in the second tax year after you started trading if you:
- Earned more than £1000 from self-employment in the previous tax year
- Want to make voluntary Class 2 National Insurance payments
- Need proof of self-employment for claiming certain benefits or tax-free childcare
There is no charge for registering.
What you’ll need to complete the registration
- Your National Insurance number
- Name, address and contact details
- A name and details for your business (start date of trading, trading activities and business address. If you are working from home, you can use your home address as your business address.
You can trade under your own name or choose another name that represents what you do. Your business name does not need to be registered but if you do choose one, you must include it on all official paperwork.
According to HMRC, sole trader business names must not:
- Include ‘limited’, ‘Ltd’, ‘limited liability partnership’, ‘LLP’, ‘public limited company’ or ‘plc’
- Be offensive
- Be the same as an existing trademark—use HMRCs trademark search tool to confirm
- Include a sensitive word or expression
- Suggest a connection with government or local authority unless you have permission
Your responsibilities as a Sole Trader
Once you have completed the registration for Self-Assessment, you’ll receive a Unique Tax Reference (UTR) number from HMRC (usually around 10 days after registration is completed). This is the only proof you’ll get that you are now self-employed.
As sole trader, you have a set of responsibilities. These are;
- To Keep records of your business’s sales and expenses
- Complete a Self-Assessment tax return every year
- Pay income tax on profits
- Pay Class 2 or Class 4 National Insurance contributions. Class 2 is paid on profits of £6,475 or more a year. Class 4 is paid on profits of £9,501 or more a year. Currently, sole traders have a personal allowance of £11,850 a year.
If you earn less than that, you won’t need to pay tax. If you earn more than that, but less than £45,000 a year, tax is charged at a rate of 20%. If you earn between £45,001 and £150,000 a year, the tax rate is 40%. Anything over £150,000 is taxed at a rate of 45%.
When do I need to file a tax return?
Tax returns can be completed on paper or online. Paper tax returns must be received by HMRC by 31 October following the end of the tax year. Online tax returns must be received by 31 January following the end of the tax year. The tax year runs from 6 April one year to 5 April the next.
Do I need to pay VAT?
You’ll need to register for VAT if your turnover is over £85,000. You can also register for VAT voluntarily if it suits your business. For example, if you offer a service to other VAT registered businesses and want to claim back the VAT.
This question is also so important because business success really depends on leveraging your strengths and addressing your weaknesses.
How much National Insurance do I pay?
Depending on your profits, you’ll pay either Class 2 or Class 4 National Insurance.
Class 2 is paid on profits of £6,475 or more a year. Class 4 is paid on profits of £9,501 or more a year.
Can I employ people as a Sole Trader?
Registering as a sole trader doesn’t mean you’re confined to forever working solo. You’re free to employ as many people as you like, but these employees cannot become partners, shareholders or directors. In other words, you remain 100% the owner.
It is certainly possible to be a sole trader and grow your business into one with multiple staff. A great example of this is Sports Direct owner Mike Ashley.
After registering as a sole trader in 1982, Mike Ashley’s business grew into an empire of over 130 stores and thousands of staff before he turned it into a limited company in 1999.
Is it easy to change to a Limited Company?
There are many reasons why you may want to change your registered business structure as you grow. Limited company status gives you greater borrowing power, and potentially more credibility with clients. It also means you can share the liability for your business.
If you do decide to move forward, it’s a relatively easy process to make the change. You’ll need to notify HMRC that your structure has changed, choose a name for your company, set up a business current account and speak with an accountant to discuss your new responsibilities and options.
Registering a Limited Company
A limited company is a type of business where the company has a legal identity of its own, separate from its owners and directors. The company, rather than the company director(s) enters into contracts and acquires debt etc
Unlike sole trading in which you are your business, a limited company is its own instrument with its own assets. Therefore, if you were to run into financial trouble, you wouldn’t have to sell personal assets to pay the debt.
This also means that any money earned by the company belongs to the company.
For example, let’s say you set up your own catering business and registered it as a limited company called Creative Catering Ltd. In this company, you are the sole director and shareholder.
When your client pays their invoice, this money belongs to the company. Creative Catering Ltd can then pay you a salary as the director or, if you have enough profits, dividends as a shareholder. Creative Catering Ltd can also pay you back for any business costs you’ve paid for personally, such as travel and hotel costs for client meetings, for example.
In essence, you are authorising payments from your company to yourself, adding an extra step between receiving money to your business and transferring it to your personal account for salary earnings.
Apart from those costs, any other money taken from the Creative Catering Ltd bank account may be subject to extra tax.
The pros and cons of registering as a limited company
Registering your business as a limited company gives you limited liability protection, which means personal assets can’t be seized to pay debts unless you’ve given a personal guarantee to a creditor. It also means that the company can survive beyond the ownership of the original directors or shareholders, allowing it to be transferred or sold without disruption to clients or employees.
A company name has to be unique. No two companies in the UK can have the same name or names that are very similar, and no other business can register the name you’ve chosen. As a sole trader, unless you’ve registered your company name, you won’t be afforded this same level of protection.
As a company, it’s possible to raise funds by selling shares in your business to new investors, and there is no limit on the number of shareholders you can have. This can give you access to capital to grow your business that sole traders can never have.
Registering as a limited company gives your business professional status and paints a picture of credibility that can be attractive to clients. What’s more, some clients – large corporations and companies in the financial sector in particular – prefer to work with limited companies. Due to the level of risk in the contracts that they award, the fact that limited companies are subject to more rigorous reporting and monitoring in their business means that some clients will only work with other incorporated businesses.
As a limited company, you’ll pay 19% corporation tax, as opposed to the 20-45% tax paid on profits as a sole trader. You’ll also have more flexibility in how you can manage finances for tax purposes.
Rather than withdrawing all of your profits and paying more personal tax on top of Corporation tax each year, you can leave surplus income in the company for running costs. This will allow you to pay less tax while having money available when the business needs capital.
The withdrawal of profits can be deferred to a later tax year. This strategy can work well if taking out all profits would mean paying a higher rate of income or dividend tax.
As a company, you’re able to pay yourself in a combination of salary and dividends. If your salary is below the lower profits limit, your income tax will be lower and Class 4 National Insurance can be avoided. If the dividends that make up the rest of your income are paid from post-corporation tax profits, you won’t have to pay personal tax on the first £2,000 in a single tax year. If they’re above that, the dividend tax to be paid is still likely to be lower than income tax rates.
Where sole traders are only required to complete an annual Self-Assessment tax return, limited companies must file their accounts, an annual return and a corporation tax return. On top of that, as the director, you’ll also need to complete a personal tax return. If you’re not using an accountant, the time it takes to prepare and file paperwork can be a drain on your business.
Tax and accounting can also be more complicated as limited companies must file accounts with Companies House within nine months of the company’s year-end.
These accounts include some or all of:
- Profit and loss
- Director and auditor reports
- Balance sheets
- Notes to the account giving further details on profits, cash flow, sales, assets and liabilities.
Filing these accounts may (if you’re using an accountant) mean paying admin costs and accounting fees.
When you register as a limited company your company accounts and confirmation statement are made public. Your office address will also be in the public domain. However, it is possible to use your accountant’s office or a token address if you work from home.
How to register a business as a Limited Company
There are several different kinds of limited companies that can be set up in the UK, but the most common two are;
Private limited company – limited by shares (Ltd.): This the most popular kind of limited company. With this kind of company, the public isn’t able to buy shares in the business and shareholders are only responsible for their percentage of investment. So, if a shareholder invests 40% of the cost of the business, they are responsible for 40% of the company.
membership organisations and sports clubs whose owners want to benefit from Public limited company (PLC): This is similar to a private limited company, except that shares are offered to members of the public. Taking a company public requires at least two directors and shareholders, a company secretary and a minimum of £50,000 of issued share capital.
To register your business as a limited company, you need to set up with Companies House. This can be done online on the GOV.UK website or via post by completing an INO1 form.
A limited company can be formed by one or more people by signing their name on a memorandum of association. This is their agreement to form the company. A ‘person’ includes individuals and companies.
To set up as a limited company with Companies House, you’ll also need:
- A company name and address)
- At least one director (including their name, address and date of birth)
- A least one shareholder (the shareholder and director can be the same person)
Choosing a name for your company
Your company name must end in ‘Limited’ or ‘Ltd’.
It needs to be original too. If your name is the same or too similar to another name, you may have to change it.
Companies House also states that names cannot contain any sensitive words or expressions, cannot be offensive, and cannot suggest a connection to government or a local authority without permission.
Something to keep in mind is that you don’t have to trade under your company name. You can choose one name as your registered name and another to trade under. For example, Asda Stores Ltd trades in the UK as Asda.
As with a sole trading business name, a trade name cannot:
- Include ‘limited’, ‘Ltd’, ‘limited liability partnership, ‘LLP’, ‘public limited company’ or ‘plc’
- Contain a ‘sensitive’ word or expression unless you get permission
- Once you’ve chosen a business name and completed the application, make sure to check all details carefully before submitting it. Any information that needs to be changed at a later date may incur a charge.
It’s also important to note that not everyone can be a Company Director. Anyone who is under the age of 16, has been disqualified from acting as a company director, or is an undischarged bankrupt cannot be appointed as a director. These, however, are the only restrictions.
Finally, If your turnover reaches £85,000 or you expect sales to be greater than that total in a year, you’ll also need to register for VAT with HMRC
Find the Best Company Formation
Starting a new business what type of company formation do you need?
Exciting Futures was created as an all-in-one solution by bringing together the tools or services you may need to run your business! When you map out your business model, your company formation will be one of the overall parts your business needs to review.
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