When becoming self-employed and starting their own business, many entrepreneurs spend a lot of time choosing whether they should be sole traders or set up a limited company. Which legal status you choose for your business depends on the type and size of the business.
Let’s find out what options you have when choosing the legal status of your business.
Sole Trader
Most businesses start off as Sole Trader companies. This means you are running your business as an individual. Legally the business is an extension of you, and you are entitled to all the business‘s profits after tax.
Sole traders are the most common type of business in the UK. Most tradesmen, market sellers and freelancers operate as Sole Traders.
The main advantage of Sole Trader status is that there is little paperwork, most of which relates to the owner. The business is an extension of the owner, therefore; the owner pays personal tax.
The main disadvantage of becoming a sole trader is that the owner is responsible for the business’s debts. In most cases, this is fine, but when your business grows and employs people or requires larger premises, it becomes too risky for the owner to be personally liable for all the business debts.
Limited Company
A Limited Company is a company registered as a separate entity from its owner(s).
Directors are responsible for running the company on behalf of the shareholders. Directors often own shares in the business but not always.
The main disadvantage of owning a limited company is the additional paperwork. You will have to report your financial results to the government annually and will pay corporation tax on the business‘s profits.
Many business owners who have switched from Sole Trader to Limited Company are overwhelmed by the extra paperwork and struggle to keep on top of it. It may be required to hire a professional to deal with accounting and/or tax.
If you are planning to change from Sole Trader to a Limited Company, make sure you can afford extra costs for accountants or lawyers to support you in maintaining a Limited Company.
Partnerships
Traditional Partnerships are very similar to Sole Traders in principle. The biggest difference is the business is owned by more than one person. The partners of the business owners share the responsibility of the business. They can share the profits of the business and pay taxes on their portion of the business.
Limited Liability Partnerships
Similar to limited companies, the partners in a limited liability partnership are not personally liable for the debts the business cannot pay. Their liability is limited to the amount of money they invest in the business. This business entity is most commonly found in professional services businesses such as accountants and lawyers.
Not For Profits
There are a few more types of business, these are Association, Charity and Social Enterprise. Let’s look at your options if you want to set up an organisation that is not for profit and for the benefit of the community or specific groups.
Associations
If you are running a club or membership organisation, you can set up an unincorporated association is set between an agreement between a group of people who have come together for a reason other than to make a profit.
This type of organisation is similar to sole traders and traditional partnerships, as the association members are personally liable for the association’s debts.
Charities & Social Enterprises
Charities exist to benefit the public through a charitable purpose. They are run by Trustees who do not personally benefit from the charity. The majority of the profits earned by charities are reinvested into the charitable cause or reinvested into the organisation.
In the past, charities were registered with a governing body for charities; in the UK, the most popular legal classification is a charitable incorporated organisation (CIO) is regulated by the Charities Commission rather than Companies House. Over the last five years, many charities are becoming more commercial and are adopting different operating and legal structures.
Social Enterprises
Social Enterprises are becoming increasingly popular for organisations that help people or communities.
There are many options available to you, social enterprises can be operated as a
- Limited company
- Charity
- Co-operative
- Industrial and provident society,
- Sole trader
- Business Partnership
- Community interest companies (CICs)
The most popular option is a CIC; in the UK, a CIC is a specially limited company that benefits the community rather than shareholders.
- In addition to the traditional method of setting up a limited company, you must submit to Companies House.
- A ‘community interest statement’ explaining what your business plans to do.
create an ‘asset lock’, a legal promise stating that the company‘s profits will be reinvested into its social objectives. - You will also have to limit how much your business can pay shareholders.
- You will also have to get your business approved by the community interest regulator. This is done automatically by Companies House.
Economic uncertainty over the past five years has resulted in a decline in fundraising income for charities. Charities are becoming more commercial, and increasing numbers are evolving into social enterprises.
How you change from a charity to a social enterprise depends on how your business is structured and what you want to achieve as a social enterprise.
Here are your main options:
- Keep the same structure – there is no reason your charity cannot set up a commercial venture within the same legal entity just as long as it is in line with your social mission.
- Set up a social enterprise or limited company owned by your organisation that supports your social mission. Profits from social enterprises can be donated to charity.
- De-list as a charity and set up a social enterprise – this option may not add any value to your actual mission and revenue generation.
Conclusion
Above are the main legal entity options you have when starting your business.
The legal entity of your business does not matter if there is no interest in your product. Make sure there is a big enough market size and validate your business idea with customers before you decide on your legal status.
Starting off as a sole trader is fine. A partnership is fine if you are in a group; make sure everything has been documented.
When your business has got to a stage where you need external funding from an investor or a bank, you should consider registering your business with companies house or the charities commission. The same applies when you need to recruit permanent staff.
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