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Choosing the right business structure: Sole trader, limited company or umbrella

Read on to find out about different business structures, the pros and cons of each structure and key factors you need to evaluate when choosing a business structure.

by Forma on

November 12, 2019

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For small business owners and freelancers who have just started out, staying on top of your business finances and documents can be daunting. Here’s where our article comes in, so you can quickly get a grip on the basics.

What is a balance sheet?

A balance sheet provides a snapshot of the financial condition of a company, showing how much it owns (assets), owes (liabilities) and the amount that is left over for its owners (owners’ equity) at a specific point in time. 

The balance sheet is typically completed at the end of a month or a financial year. It is comprised of three main elements:

  • Assets: These are resources that you own and can be sold. Examples include cash, vehicles, inventory and equipment. 
  • Liabilities: These are your business’ legal debts or financial obligations. Examples include loans, accounts payable and salaries payable. 
  • Owners’ (or shareholders’) equity: This refers to the owner’s share of the assets of a company. It includes the share capital (the amount that a company’s owners or shareholders invest in the business) and retained earnings (funds that are retained in the company’s accounts).

The balance sheet is divided into two sections: the left side shows the assets of the company, while the right side shows the liabilities and shareholders’ equity.


Balance Sheet
Balance Sheet

Assets are listed in order of liquidity. For example, cash or inventory are listed above less liquid assets like property or equipment. 

Liabilities are listed in order of maturity; current liabilities, which will come due within a year are listed above long-term liabilities. The latter refers to liabilities that will remain outstanding for longer than one year. 

The total sum of all assets, less a business’ total liabilities is equivalent to the owners’ equity. This represents the amount that would be available for a business owner to draw out.

Why is a balance sheet important?

The balance sheet lets a business owner and investors see what the company owns and owes, and to understand its net worth. It also indicates the financial health of a business. 

For example, a balance sheet that shows a negative balance in owners’ equity indicates that liabilities exceed assets. This can be a warning sign that the company is in a bad financial situation, and should prompt business owners to dive deeper, and uncover the causes for the negative balance. 

A balance sheet can also be used to calculate important financial ratios. One example would be the working capital ratio, which is obtained by dividing the current assets by current liabilities. This ratio measures a business’ efficiency, and shows how well it is able to meet its short-term obligations. 

And for small business owners seeking external financing, the balance sheet —along with financial statements like your cash flow and P&L—are required documents when you apply for a bank loan. 

Balance sheet templates:

example of a profit and loss statement

What is a profit and loss account?

The profit and loss account (P&L) is a financial report that shows the revenue, expenses and profit or loss of your company over a specific accounting period. 

This period can be a month, a quarter or a year. A P&L is also commonly referred to by other terms, such as the income statement, statement of operations, financial results statement and earnings statement. 

A P&L is comprised of the following key elements:

  • Sales or revenue: The amount that your company earns through the sale of goods or services.
  • Cost of goods sold (COGS): The total amount of all costs involved in selling a product during a specified period of time. 
  • Gross profit: Also known as the gross margin, the gross profit refers to a business’ profit before the operating expenses, taxes and interest payments are taken into account. It is calculated by deducting the COGS from the total sales or revenue. 
  • Operating expenses: This refers to expenditures that a company incurs in performing business operations that aren’t directly related to the productions of goods or services. Some examples include salaries, utility payments, administrative expenses and rent.
  • Net profit or loss: The net profit or loss is obtained by deducting total expenses from gross profit.  

Why is the profit and loss account important?

The P&L is a key financial statement in a business plan, as it quickly shows how much money your business has made or lost. 

What’s important is to compare your P&L across different accounting periods. In doing so, you’ll be able to identify business cycles and trends—such as the peak and trough periods that occur across the year, or aspects of your business that generate the most profit or costs. 

You may also identify changes that are not immediately apparent, such as periods where your expenses are growing at a faster rate compared to your revenue. With these insights, you’ll be better-positioned to make improved business and financial decisions. 

And lastly, information from your P&L can also be used to calculate metrics that are important indicators of your company’s financial health. These include the operating ratio, gross profit margin and net profit margin.

P&L templates:

Introduction

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. 

What are the different types of business structures?

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.

choosing a business structure: sole trader vs limited company vs umbrella company

Weighing out the pros and cons: Sole trader vs limited company vs 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. 

Why not?

  • 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.

Why not? 

  • 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. 

Why not? 

  • 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."



Business structures: Understanding the basics

What is a 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.  

What is a 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. 

What is an 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

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. 

Why not?

  • 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.

Why not? 

  • 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. 

Why not? 

  • 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. 

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 the 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."

Speak to a mortgage broker

Each lender will have their own lending criteria; some are willing to take into account your retained profits, while others will accept applicants with less than one or two years of self-employment history. A mortgage broker can save you time by pointing you in the right direction, so you know right away which lenders are a good fit with your needs. 

Think twice about switching your business structure prior to your application

Moving between two types of self-employment income just before you apply for a mortgage can complicate matters, and reduce your chances of securing a loan. 

If you’re thinking about going from being a sole trader to a limited company director, it’s best to delay your application until you have one year’s worth of books. If you apply before that, you may be offered a smaller mortgage, or have to choose from a limited selection of lenders. 

Ensure that your credit history is in good shape 

Having a pristine credit history will boost your chances of securing a mortgage and getting access to favourable rates. Your lender may check both your personal and business credit history, so it’s best that you keep a close eye on your credit reports regularly. At a minimum, you should be checking your credit reports once every year. 

If your credit score isn’t yet where you want it to be, there are steps you can take to improve it before your mortgage application. These include:

  • Being timely with your bill payments
  • Keeping your credit utilisation low
  • Monitoring your credit reports regularly, and reporting any mistakes immediately
  • Avoiding unnecessary credit applications (these can trigger a credit check, which can affect your credit score) 

Keep tax deductions to a minimum

Nikki Merkerson, Community Reinvestment and Community Partnership Officer at JPMorgan Chase advises that self-employed workers should “write off fewer expenses for at least two years before applying for a mortgage”. 

Lenders look at your net business income—so individuals who deduct a lot of expenses show an income that appears much lower than it actually is. This works against you when you apply for a mortgage, as you “need to show more money to afford more house”, states Merkerson. 

Obtain an agreement in principle

Having an agreement in principle can help speed up your home-buying process. It’s an indicator that your credit is in good shape, and conveys to your seller and estate agent that you’re a serious buyer. 

Understand your finances

Make sure you understand your business finances, and are able to provide further details when asked to by your lender. 

If you’ve experienced a dip in your income or cash flow, make sure you’re able to explain these fluctuations—such as why and how it happened, and what are the measures you’ll implement should you experience cash flow issues or a fall in income in the future. 

Showing that you have a plausible reason, and that you’re well-prepared to deal with similar circumstances down the road will increase your chances of securing a mortgage. 

Keep up-to-date records and accounts

Don’t underestimate the importance of keeping good records. Dominik Lipnicki, director of brokerage Your Mortgage Decisions explains that it can make all the difference, as even applicants with stable earnings and a good credit history are rejected due to poor records. 

“It really pays to have up-to-date accounts prepared by a qualified accountant,” he adds. “If you scrape through with the bare minimum of paperwork, your options will be very limited and you’ll probably end up paying a higher rate.”

Additional points to note

1. Dividends can’t be paid out if a company is losing money

Dividends can only be paid on profits that a company has earned during the year, or from accumulated profits from previous years. On the other hand, salaries can be paid out even when a company has made a loss. 

2. Paying a dividend doesn’t reduce your company’s corporation tax bill

Companies pay Corporation Tax on its profits before dividends are distributed, so paying a dividend doesn’t affect your company’s corporation tax bill. On the other hand, salaries are considered as business expenses. These reduce your profit, and subsequently your Corporation Tax.

3. Creating different classes of shares can be an option worth exploring

Does your company have working and non-working partners? Creating different classes of shares may be an option you might want to explore, so that both types of partners don’t wind up receiving the same dividend rate. 

4. Timing is key 

In general, companies distribute dividends every quarter or half year. There aren’t any hard and fast rules when it comes to how often dividends are paid out—and this is something your need to consider carefully. That’s because: 

  • It can have an impact on the amount of tax you pay: Dividends can be a way for you to balance out your profits from one year to another, so you can avoid being put into a higher tax bracket. If your profits are £55,000 in the first year and £10,000 in the second year, you can declare a lower dividend for the first year so that you pay the basic rate for both years—rather than paying the higher rate for the first year.
  • It can have an impact on your HMRC deadlines: Income tax on dividends are due in January after the tax year (running 6th April - 5th April) in which the dividend was distributed. This means that tax on a dividend received in February 2019 will be due in January 2020. If the dividend was paid out on May 2019, the tax will be due in January 2021. 

5. Your personal pension can be affected

Receiving income as dividends (rather than a salary) can help reduce your tax load. Yet, it’s important to keep in mind that your personal pension will be affected, as getting a salary increases contributions that can be paid into your personal pension. 

We recommend checking in with your accountant about minimum salary requirements that may be imposed if you want to make contributions to a personal or executive pension plan. You may also want to discuss whether setting up a company pension scheme is an option you should consider. 

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