If you're planning to start out on your own, one of the most important decisions you'll need to make is figuring out how you should structure your business.
As a freelancer, contractor or small business owner, there are three main types of legal structures you should consider:
- Sole proprietorship
- Limited company
- Working through an umbrella company
It's a decision that requires careful consideration, and it's important that you seek advice from qualified professionals when you weigh out the pros and cons of each business structure. To begin with, you need to have a good grasp of the basics - and here's where our guide comes into the picture.
Business structures: Understanding the basics
1. Sole trader
As a sole trader, you run and control your company as an individual, and are considered a self-employed person. You are personally responsible for the decisions, as well as profits or losses of the business.
Sole traders can hold a variety of professions - from electricians and plumbers, to graphic designers and software developers.
2. Limited company
A limited company is a type of business structure where the company has its own legal identity. The assets and liabilities of the company are separate from the personal finances of its owner.
As a director and shareholder, you cannot withdraw money out of your business as and when you want to, and profits that are made belong to the company. Even if an individual is the only shareholder and director, the company is still a separate legal entity.
3. Umbrella company
An umbrella company acts as an intermediary between a contractor or freelancer and their agency or client. This means that the agency or end client engages with the umbrella company, rather than directly with the contractor or freelancer.
If you decide to work through an umbrella company, you will be considered an employee. You will not be in charge of managing your payroll, and will instead submit a timesheet and expenses information to the umbrella company on a monthly basis.
The company will also handle your tax, pension and National Insurance contributions, and you will be entitled to statutory employment benefits, such as holiday pay and sick pay.
Weighing out the pros and cons: Sole Trader v Limited Company v Umbrella
Why become a sole trader?
- Simplicity. Setting up as a sole trader is a fairly easy process. Plus, you'll deal with minimal paperwork apart from filing your annual Self Assessment tax return, and abiding by HMRC's record keeping requirements.
- The accounting process is also simpler, as there are typically fewer clients and expenses to account for compared to operating a limited company.
- Privacy advantage over other types of businesses. Sole traders can operate with more privacy, as you're not required to share certain information - such as your company accounts and confirmation statement - with Companies House. This isn't the case for incorporated businesses, which are required to share certain information with the public.
- Unlimited liability. Unlike a limited company, a sole trader business isn't a separate legal entity; the law doesn't distinguish between the individual running the business and the business itself.
- You will be personally liable for the debts that your business incurs, and your personal assets can be seized to pay off these debts.
- It can be tax inefficient. You may benefit from greater tax savings if you run your business as a limited company - particularly if your profits go above a certain threshold. That's because limited companies pay 19% Corporation Tax on their profits, compared to the 20-45% Income Tax that sole traders pay on their profits.
- Obtaining external financing can be a challenge. Banks and investors tend to prefer lending to limited companies, so obtaining external financing can be tricky when you're looking to expand your business.
Why set up as a limited company?
- Limited liability. Your company is a separate legal entity. As such, your personal finances and assets are protected, and can't be seized to pay off debts in the event that your company encounters financial difficulties.
- Tax efficiencies. In general, you'll benefit from greater tax savings if you run your business as a limited company - particularly if your profits go above a certain threshold.
- This is because limited companies pay 19% Corporation Tax on their profits, compared to the 20-45% Income Tax that sole traders pay on their profits.
- You will also be able to claim a wider range of allowances and business expenses compared to a sole trader.
- Increased credibility and commercial acceptance: A limited company tends to appear more credible to businesses, investors, customers and financial institutions, which can lead to increased business opportunities and easier access to finance.
- Increased legal and administrative requirements. Operating as a limited company presents increased legal compliance and administrative requirements.
You need to fulfil your fiduciary duties as a limited company director, and are responsible for ensuring that your company submits the required documents at the financial year-end to Companies House and HMRC.
- The record keeping and administrative requirements can be extensive and time consuming, thereby increasing the general and administrative costs of your business.
- Details of company are publicly available: Limited companies are required to disclose certain information, such as information about its directors and company earnings on the public records.
Why work through an umbrella company?
- Ease of use. Working through an umbrella company relieves you of the administrative burden that self-employed individuals typically deal with, such as managing your business finances, company accounts and bookkeeping.
- You will receive a salary (along with a payslip that shows how it's calculated). No further deduction needs to be made as your income tax deductions and National Insurance contributions are accounted for.
- Flexible. The ease of use that an umbrella company offers makes it a great option for individuals who aren't yet sure if they want to commit to freelancing or contracting for the long term, and want to test the waters by doing short-term contract work.
- Costly way to operate: Working through an umbrella company is generally the most expensive way to operate. You're required to pay PAYE, tax and National Insurance contributions - just like a full-time employee.
- Plus, your umbrella company will impose a fee for using its services. Additionally, you will not be able to take advantage of the tax efficiencies that a limited company structure offers.
- Lack of control: You're not able to enjoy the same level of freedom as you would have operating as a sole trader or through a limited company. You'll have less control over a variety of aspects - from taxation, to when and how much you're paid.
3 Key factors you need to evaluate
When deciding between the different business structures, there are various commercial and tax-related factors you need to consider. Below, we've elaborated on the three key factors you need to evaluate:
1. Legal liability
"To what extent do I need to be protected from legal liability?" is an important question that all business owners need to evaluate.
In an Entrepreneur article, Mark Kalish, co-owner of EnviroTech Coating Systems Inc. further elaborates: "You need to consider whether your business lends itself to potential liability and, if so, if you can personally afford the risk of that liability."
He shares an example: in setting up EnviroTech, Kalish and his co-founder had made a sizable investment in equipment, and had important contracts to fulfil. As such, they decided to incorporate, as they didn't want to take on personal liability in the event that their company incurred losses.
2. Future needs and long-term objectives
The initial stages of setting up your business can feel scary, exciting and all consuming - and leave little time for you to reflect on longer term goals, or to question yourself about what your business might be like in five or ten years.
For instance, what will happen to your company if you're no longer around to run it? A sole proprietorship will be legally dissolved upon the death of its owner, while a limited company will continue its operation as the shares can be distributed to family members or to the remaining shareholders.
Other important questions you need to consider include: What are your funding needs and options for obtaining financing a few years down the road? Do you plan to sell your partnership share, buyout a partner or bring in additional stockholders as you expand?
3. Ongoing administration
In discussing the pros and cons of operating as a limited company above, we've highlighted one of the downsides it presents - which is increased legal and administrative requirements.
Managing these aspects can be challenging, particularly for time-pressed business owners juggling between multiple roles. Before you incorporate your business, it's important that you ensure you have the time, ability and manpower resources to meet the stringent record keeping and reporting requirements imposed by HMRC and Companies House.
Kalish shares a word of advice: "I would always take sole proprietorship as a first option. If you're a sole proprietor and you own 100 percent of the business, and you're not in a business where a good umbrella insurance policy couldn't take care of potential liability problems, I would recommend a sole proprietorship.
"There's no real reason to encumber yourself with all the reporting requirements of a corporation unless you're benefiting from tax implications or protection from liability."
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