Trading Options

Historically, a person starting a business has had to decide between operating as a sole trader, partnership or limited company.  These options are examined in detail below.

Sole Trader

This form of self-employment is perhaps the most common way of being in business and certainly the simplest.  It is in effect the default option because the moment a person actually starts to trade they will be a sole trader unless they have already either set up as limited company, or agreed to start the business with someone else.

Operating as a sole trader is informal.  The individual has no one to answer to other than themselves and there is little by way of regulation governing the way they keep records or the format of their accounts.

Perhaps the biggest disadvantage of being a sole trader is unlimited liability.  Because of the informality of self-employment generally the debts of the business are the personal responsibility of the sole trader and if a creditor cannot be paid the sole trader may be declared bankrupt resulting in the loss of his home and his personal belongings.

Sole traders pay Income Tax on the whole of their profits irrespective of whether or not they have drawn those profits from the business.  They also pay class 2 and class 4 National Insurance.  For the 2008/09 year class 2 National Insurance is £2.30 per week and the class 4 liability is 8% of profits between £5,435 and £40,040, and 1% of profits above £40,040.

Partnership

A partnership exists where two or more persons are trading together with a view to profit.  As with sole tradership it is a form of self-employment.

Operating as a partnership is a little more formal than operating as a sole trader as there is an agreement in place between the partners.  The agreement may be verbal, written or implied and will cover things such as the profit sharing arrangements, capital commitments and management of the partnership.  Partners are answerable to each other but other than that, there is little or no more in regulation that a partnership has to consider.  The position with regulation is similar to that applying to a sole tradership in that the means by which records are kept and the format of accounts is decided by the partners.

Partners can bind the partnership to a debt and all partners are then jointly and severally liable for that debt.  There is, therefore, perhaps a greater risk for a partner in a partnership than there is for a sole trader in that whilst a sole trader is personally liable only for debts that he has created, a partner is also liable for debts created by his partners.

Partners pay Income Tax and National Insurance in the same way as sole traders but only on their own share of profits.

Limited Company

A limited company is a legal entity in its own right.  It is owned by its shareholders and managed by its directors.  Its directors are paid a salary to manage the business, and its shareholders may receive a dividend if the company makes a profit.

Often a business will be set up as a limited company with the same persons being both shareholders and directors.

Unlike sole tradership or partnership, there are formalities involved in operating as a limited company.  Those formalities are set out in the Companies Act 2006.  Shareholders and directors have different rights and responsibilities even if they are the same persons.  Each year the company must file an annual return and submit accounts to Companies House, and the format of the accounts is governed by law.

In return for the formalities that go with incorporation, the shareholders benefit from limited liability and so creditors cannot seize their personal assets if the business fails.  Many see this as a significant advantage as compared to self-employment.

Another advantage is image.  Suppliers and others tend to view a limited company as having more substance than a sole trader or partnership.

Directors of limited companies pay Income Tax and National Insurance on their salaries in the same way as employees.  Additionally the company will pay employer’s National Insurance on the director’s salary.  For the 2008/09 year this liability is 12.8% of the amount by which the total salary exceeds £5,435.

The company will pay Corporation Tax on its profits (after deducting salaries paid to the directors), and those profits are then available to distribute to the shareholders as dividends.  The current rate of Corporation Tax for 2008/09 is 21% for companies with profits below £300,000 per annum.

Shareholders receive their dividends net of a 10% tax credit.  So, for example, a dividend of £900 is treated in the hands of the shareholder as £1,000 gross income from which 10% tax has been deducted.  Basic rate taxpayers are charged 10% tax on their “gross” dividends and may use their tax credit.  This means that they have no personal liability.  Higher rate taxpayers pay 32.5% tax on their “gross” dividends and again can use the tax credit.  In the above example a higher rate taxpayer would pay £225 calculated as follows:
                                               

Put simply, higher rate taxpayers pay tax at a rate equivalent to 25% of the dividends they have received.

Where the directors are also the shareholders they have a lot of freedom to determine how much they should receive as salary for their work and how much should be distributed as dividends.  The total tax liability on dividends is usually lower than the liability on salaries (when National Insurance is brought into the equation) and so very often in small owner managed companies only a low level of salary is paid and the owners are paid principally in the form of dividends. Such arrangements are perfectly acceptable so long as there are available profits from which to pay dividends and the formalities of declaring and paying a dividend have been correctly observed.

There is no “one size fits all solution” to the best trading option.  What is right for one person is wrong for another.  At Warr & Co we can offer tailored advice to meet each client or potential client’s own circumstances.