Deciding whether to operate as a sole-trader, partnership, limited liability partnership or limited company is hard. The issue involves many factors, including your tax position, who else is involved and the kind of business you are in. Here are twelve points to consider when deciding.

Ease of starting up

To start a business as a sole trader, just get going. Tell the Inland Revenue and Contributions Agency that you are self-employed. If you are going to trade under a name other than your own, you must put your own name on your headed paper. You must inform the national Insurance office within three months of becoming self-employed, or you could be fined.

Starting as a partnership is almost as easy, though it is wise to draw up a proper agreement first. If you don't, you will be bound by the terms set out in the Partnership Act 1890. This has drawbacks. For instance, under the Act a partner can withdraw without giving notice.

On the other hand, a new business status entity - a limited liability partnership (LLP) - gives greater protection. This is a cross between a partnership and a company and gives you the personal protection of a limited company with the tax advantages of a partnership. LLPs must be registered at Companies House.

Alternatively, you can create a limited company. This has a life of its own so continues to exist regardless of the resignation, death or even personal bankruptcy of its managers or shareholders. What's more, shareholders enjoy limited liability for debts incurred in the course of business.

You can create one from scratch or buy one 'off the peg'. This costs around £150 (excluding agent's fees) plus £10 if you want to change the name. You also have to register your company with Companies House, which costs £20 and involves a lot of paperwork. Ideally, get a solicitor to help you.

Credibility

Sole traders often feel at a disadvantage when negotiating with big corporations. Many people feel that trading as a limited company gives them extra credibility.

Yet today's business climate is coming to favour small businesses because they offer a truly personal service. Indeed, many organisations happily work with sole traders if they provide strong evidence of competence and skilled backup.

Raising money

All types of business can raise money through loans and overdrafts. A partnership also has the option of introducing a new partner to the business, who would bring extra capital. On the other hand, a limited company can raise money by selling equity to, say, a business angel.

Limiting your exposure

A sole trader has unlimited liability for all the money the business owes. The same goes for a partnership, with the added drawback that you're also liable for all your partners' business expenses, even if they ran them up without your knowledge. However, the creation of the new trading status, the LLP, may resolve some of these issues.

By definition, in a company, shareholders' liability is limited to a certain figure. So provided you haven't traded fraudulently, your personal assets like your home are safe. However, most banks will ask for personal guarantees anyway, often with your house as security.

Professional indemnity

If you sell knowledge or skills, you could face enormous claims should something, however unlikely, arise later because your work was bad, negligent or mistaken.

It may be hard to imagine a situation where you might be liable for millions of pounds. However, if you are one link in a chain, the overall effects of a small mistake on a large project could be out of all proportion to your contribution.

So you will need adequate professional indemnity insurance. Sole traders need to take out a range of insurance policies as much as any limited company. However, one drawback of being a sole trader or partnership is that, even having taken out professional indemnity insurance to cover you for a certain amount, you could still be liable for more. As a limited company, shareholders' liabilities are fixed.

Also problems, and hence claims, can often take many years to emerge and, unusually for insurance, you have to be covered at the time of the claims, not when the work was done. So a sole trader has to keep paying premiums for years, possibly even into retirement, whereas a company can simply cease trading.

Your accounts

While your accounts as a sole trader or partnership must be accurate, you don't need to get them audited, though you will need to satisfy the tax inspector. Self-employed people turning over relatively little only have to supply 3-line accounts to the taxman: income - expenses = profit/loss.

As a limited company you don't need to have your accounts audited if your turnover is below a certain threshold, though you must still file your accounts at Companies House. As a small company, you can file a shortened balance sheet and special accountant's report if you choose.

Click here for the current small and medium company thresholds and audit exemption thresholds.

National Insurance Contributions (NIC)

As a sole trader or partner, you pay flat rate Class 2 NIC. You also pay Class 4 NIC on a portion of your taxable profits.

For the current rates, and the upper and lower limits for Class 4 NIC, visit For details visit current tax rates.

If you form a limited company, you will become an 'employee' of your own company. As an employee, you will pay Class 1 NIC. Plus, as an employer, you will pay Employer's NIC.

Tax and profits

Sole traders pay income tax on profits (which includes any 'salary' you pay yourself). Partners are taxed on their share of the profits (and 'salary') as if they were a sole trader. Both partners and sole traders must fill in a self-assessment tax return and pay the Inland Revenue in instalments in January and July.

As a director of a limited company, you pay income tax on your salary and corporation tax on the profits you leave in your business. The current tax regime is highly advantageous to limited companies.

Shareholders can be paid dividends. Directors can only take money out of the company in the form of a salary, or dividends if they are also shareholders. Both attract personal tax, though dividends do not attract NIC.

The current tax regime is highly advantageous to limited companies so look very carefully at this option, although it does not suit all circumstances.

Selling assets

If you sell an asset for a profit, as an individual, sole trader or partner, you become liable for capital gains tax after a certain level.

In a limited company, if you sell an asset and make a capital gain, it is charged against corporation tax. There is no annual exemption, though indexation still applies.

Directors would be wise to consult with shareholders before selling major assets.

Losses

If you are starting a business and are likely to make a loss in your first year(s), you will be better off starting as a sole trader or partnership if you have another source of income. This is because you can offset losses against your future profits in the same business, or against other income in the previous three years if your losses occur in the first four years of business. You can also offset losses against capital gains in the year of the loss and the year before, or in the year of the loss and the year after, depending on when you started your business. This includes personal income.

As a limited company, you can only offset losses against company profits of the previous year, against future profits or against any capital gains the company makes.

As a limited company, there are reliefs available to set trading losses against all profits (including capital gains) of the same accounting period, and the previous 12 months. If these reliefs are not used, losses may be carried forward to set against future trading profits.

Pensions

While you may contribute what you want towards a pension, contributions made on your behalf by your company attract tax relief at your highest tax rate. Many people opt not to take the relief but to add this back into the pension, so increasing the total amount saved.

Sole traders and partners, meanwhile, have maximum contribution levels on which they get tax relief.

Selling

Because it is a legal entity in its own right, a limited company is easy to sell.

Sole traders and partnerships can find a new partner. However, this has other implications, such was whether the other partners can work with the new person. For this reason, many sole traders and partnerships incorporate when they are thinking of selling.

Summary

The main benefit of trading as a limited company is protection is anything goes wrong. However, it involves more paperwork and legal responsibilities, and the tax situation can be complex and specific to your circumstances. You would be wise to consult an accountant before you make your choice.

This information is meant as a starting point only. Whilst all reasonable efforts have been made, the publisher makes no warranties that the information is accurate and up-to-date and will not be responsible for any errors or omissions in the information nor any consequences of any errors or omissions. Professional advice should be sought where appropriate.

© 2008 Published by Cobweb Information Ltd