One of the first decisions you will need to make is the legal form of
your business. For most people this will boil down to being either a
sole trader (or a partnership if there are other people involved) or a
limited company. There are advantages and disadvantages to both.
A sole trader or partnership is indistinguishable from the people
running it. The profits of the business are your income, but so are the
debts. If your business cannot pay its bills, the creditors will look to
you for payment instead.
A limited company confers a degree of protection from outstanding
debts as the shareholders are only liable for the amount of capital they
invest in shares. This can be as little as £1. In some ways the benefits
of limited liability are a chimera because any serious lender will expect
you to guarantee the debts of the company and even put up your own
home as security. There is also such a thing as fraudulent trading
whereby directors can be made liable for debts of the company if they
knew at the time they were incurred that there was little or no prospect
of them ever being paid. That apart, limited liability is a big advantage.
One of the disadvantages is the additional financial disclosure
required of limited companies. Statutory accounts must be filed at
Companies House each year and will be available for inspection by
the public. However, most small companies only have to file
abbreviated accounts consisting of a balance sheet and a few notes.
No profit and loss account is required so you can still maintain a
certain amount of privacy over your financial affairs. Only the Revenue
will require a full set of accounts, plus an analysis of your expenses.
A limited company is a separate legal entity from its shareholders or
directors so its income and assets do not actually belong to you. If you
want to take money out of the company, you must declare it as salary,
dividends or expenses. Alternatively you could take it as a loan but
you would need to pay the company a certain rate of interest or it
would be treated as a taxable benefit. The company would also have
to pay extra corporation tax until such time as it was re-paid.
Furthermore, if the company was unable to pay its bills as a result
then the creditors could appoint a liquidator who would seek to recover
the loan from you.
The other main advantage of trading as a limited company is the opportunity to reduce tax and NI contributions by taking profits as dividend rather than salary. This is the so-called tax-motivated incorporation so despised by the present Government. See our information sheet on Dividends for details of how this works. A husband and wife reach owning 50% of the shares in a company could save tax and NI of over £15,000 per year with the correct mix of salaries and dividends.
The above tax savings may appear too good to ignore but there may be some advantage to staying as a sole trader or partnership for the first few years and then incorporating as a limited company later. Profits in the early years may be too low to produce much of a tax saving by trading as a limited company, but it also gives you the opportunity to create some goodwill in the business, being its overall value in excess of the tangible net assets. You could then incorporate the business as a company, sell the assets to the company including the goodwill, treat it as a capital gain qualifying for entrepreneurs relief and take the cash tax free from the company until the debt is re-paid. However, it must be said that the goodwill must attach to the business itself rather than its owners otherwise the Revenue would disallow it (were they ever to prove that this was actually the case!). See our information sheet on Incorporation for further details.
Finally, some advice about partnerships. When you go into partnership
with other people you do not just agree to split the profits between you
in a certain way. You also become responsible for any debts they may
incur on behalf of the partnership. All partners are jointly and severally
responsible for the debts of the partnership, so you need to trust your
partners implicitly. Often people go into business together as partners
when it is really just one or two of them who run the show and earn
most of the fees. The other partners may play their part, often an
important part, but you should consider whether they should really be
partners or whether it would be more appropriate for them to be
employees or external consultants. As employees you can still reward
them with a stake in the business if you trade as a limited company as
there are some good staff share schemes with tax advantages, but
you should try to avoid a situation where the tail starts wagging the
dog and the whole business falls apart because the partners no longer
agree. The same thing goes for directors and shareholders in a limited
company. Be careful who you go into business with!