'Ltd' or sole trader status?

A question many entrepreneurs face when starting a business is whether to set up as a sole trader or a limited company. This is particularly relevant to franchisees, or those looking to franchise their business, as these are often faced with higher set-up costs. This in turn may require high levels of loan capital, and a longer initial set-up period before the business achieves profitability.  A sole trader can set up in business fairly quickly. Going limited means having to formally incorporate a company with a written constitution in the form of the Memorandum and Articles of Association. This will incur some cost. There are several issues to consider:

The risk factor

A sole trader and his business are viewed legally as the same entity. This means that, should the business fail for any reason, it will have an unlimited liability for its debts. This is why many higher-risk businesses opt to trade as a limited company, so as to limit the shareholders' liability should the venture fail. The banks may in certain circumstances request personal guarantees from the company's director/shareholder in respect of any loans it takes out. Should the company fail, the director/shareholder will then be liable for the outstanding bank loan up to the value of the guarantee.

Credibility
As a limited company is a separate legal entity, it is often seen by other businesses and the public as a more sound organisation. It is for this reason that many franchisors may insist that its franchisees set up as limited companies, so as to achieve the credibility which is essential to the success of its business model.

Raising money
A limited company may have greater borrowing potential because it can attract private investors, business angels and venture capital funding, in addition to borrowing against the assets of the company. This may be particularly relevant to franchisors seeking funding to expand their business network. A sole trader's options are largely limited to borrowing from the bank, family or friends.

Regulations
As a sole trader, your accounts will form the basis of your self-assessment tax return, and this needs to be filed with HM Revenue and Customs (HMRC) by 31 January following the end of the tax year. A private limited company has nine months following its year-end in which to file its statutory accounts with Companies House, where they are available for public viewing. A company must also file a corporation tax return with HMRC within 12 months of its accounting year-end. The accounts of a company will also require an audit when two of the following three conditions are met: the business has turnover in excess of £6.5 million; gross assets exceed £3.26 million; and there are more than 50 employees.

Taxation rules
Profits of a sole trader will be subject to income tax at the following rates: the first £5,435 at 0%; the next £36,000 at 20%; and thereafter at 40%.
Class 2 National Insurance Contributions (NICs) are payable by the self-employed at a flat rate of £2.30 per week. Class 4 NICs are also payable at 8% on profits between £5,435 and £40,040, with a 1% charge on profits in excess of £40,040. The first £300,000 of a company's profits will be subject to corporation tax at 21%. The next £1.2m is taxed at 29.75%, and thereafter at 28%. Profits can be extracted from the company by adopting a tax-efficient mix of salary and dividends. It is possible to extract profits of £37,835 from the company without incurring any income tax liability on the shareholder. Any excess dividend extracted will attract a higher rate tax liability equivalent to 25% of the net dividend received from the company. All the above figures are correct for 2008/09.
The profits you expect to generate from your business, and the level of profits you expect to draw from the company, may render one entity more favourable than another. Your accountant will be able to review your financial forecasts and advise you on your tax position under both options.

Loss relief
Losses generated by a sole trader can be set against other income of the year or carried back to the prior year. Losses incurred in the first four years of trading can be set off against income of the preceding three years on an "earlier years first" basis. Companies incurring losses in respect of a start-up may only carry forward these losses for set-off against future profits.
Due to the above variation in loss relief rules, it may be beneficial to set up initially as a sole trader to take advantage of the loss relief rules and obtain tax refunds for earlier years. Indeed, I have made a number of beneficial claims on behalf of franchise businesses, which have greatly helped with the cash flow of the businesses during this critical start-up period.

So what's it to be?
Depending on your business model, you may decide that risk management is the key factor in deciding whether to go limited or not. Where the risk is perceived to be low, you may be tempted to become a sole trader and take advantage of the favourable tax breaks. The exact tax saving will largely depend upon your personal tax position. It is therefore important that you obtain professional advice tailored to your personal tax position.
Likewise, if you are looking at setting up as a partnership, you will need to consider all of the above points in conjunction with the partners' personal tax position. This is not an easy area but one thing is for sure - it pays to seek professional advice before you take the plunge, so that you do not have to count the cost, quite literally, afterwards.