Monthly Archives: March 2011

How To Set Up Your Business – Part Three – Limited Company

In this, the third and final article in a series of three, we will look at the option of setting your new business up as a Private Limited Company.

Many people are under the impression (wrongly), that in order to start their own business, they must first set up a limited company. This can put people off before they even start. As can be seen from the previous articles in this series, it is not necessary to form a limited company if you prefer not to. However, there are numerous reasons as to why someone might prefer to run a business as a ltd company and some of these reasons are detailed below.

HOW DO I SET UP A LIMITED COMPANY?
Out of the three options of sole trader, partnership and ltd company, setting up a limited company requires the most ‘work’ – mostly paperwork. However, don’t be put off – it isn’t as hard or complicated as people often believe.

To form a ltd company from scratch, you can use a solicitor, however there are numerous firms in the UK that specialise in setting up ltd companies or that will sell you an existing company ‘off the shelf’. To find a firm that provides this service, just do a quick Google search for ‘company formations’ or similar.

Most people will opt to set up a private limited company. The company must have at least one director and a secretary. If there is only one director, he/she cannot act as the company secretary as well. The director and secretary will normally also become shareholders – the people that actually own the company.

Your next choice is to decide between an ‘off the shelf’ company and a new company. An off the shelf company is already set up and you simply transfer the shares and directorships to yourself. This is probably the quickest way of obtaining a ltd company, but you are limited to the choice of names of already formed and available companies. Once you have obtained your off the shelf company, you can change the name if you wish.

With a new company, you start from the beginning and form a brand new company, with your choice of name (subject to availability).

Fortunately, whether you decide to set up or purchase your new company using a solicitor, a ltd company transfer service or by dealing with Companies House yourself, you will always have someone to help you with the process and to ensure that you have filled in the various forms correctly.

FINANCIAL LIABILITY
A limited company is a separate legal entity in itself and this means that ‘it’ – the company, is responsible for its own debts. When a company is formed, the ‘shareholders’ purchase shares in the company and this payment is normally the starting capital that the company uses to establish itself. The shareholders maximum liability is the value of their initial investment for their shares. Regardless of what happens later on with the company, they cannot be called upon to come up with more money to pay off company debts. In addition, the company director’s personal assets cannot be touched to pay off company debts, unless the company has been trading fraudulently.  This is known as ‘limited liability’, since the liability of the owners is limited, unlike a partnership or sole trader whose liability for the company debts is unlimited.

Now, before you get excited about the prospect of setting up a company and running up huge debts that you might never have to pay off, read on…..

As I said above, a company is its own entity and as such, it can be valued ‘on its own’. Usually, as a company grows, the directors will retain some of the profits each year to add value to the company balance sheet. This is a bit like the companies savings account – each year that goes by, it saves a little bit more of its profit and so the business value grows. The value of a ltd company is sometimes referred to as its ‘Net Worth’. The net worth of a company is basically the amount of money that would be left if all the company assets were sold and all the company debts were repaid. In the beginning or if every year the directors withdraw all of the profit for themselves, the company may have a very low net worth and as such, minimal value.

Note that the net worth is a snapshot value – it is not necessarily equal to the price that a company would fetch if it were to be sold. The net worth is the value that would be left if the company stopped trading at a point and everything was sold and all debts repaid. When a company is sold, other factors come into play such as the future profitability of the company and the perceived value of any goodwill that has been built up over the time the business has been trading.

If a company has a low net worth, then a prospective lender may, quite rightly, feel uncomfortable about lending the business any money. After all, if you went to the bank for a loan and your only asset was £100 worth of shares, then the amount the bank will lend you would be minimal. For this reason, it is perfectly normal for a lender, especially banks, to ask for company directors to guarantee the debts of the business. Therefore, if the company defaults on a loan, the creditor can require the guarantor to repay the debt instead and may resort to seizing their personal assets if necessary.

Many directors do not like giving guarantees for their companies – when I worked in finance it was something that I often asked for and which regularly caused directors to get a bit upset. My answer was always the same:

‘If you as a director do not have enough confidence to support your own business by way of a guarantee, then why should we support it and lend you any money?’

A bit harsh? Maybe but perfectly true. After all, if you have doubts about risking your own money on your own business, why should anyone else be prepared to risk their money on it?

The good news is that once a business has become more established and has a reasonable net worth, then there is a good chance that you will be able to ask the lender to cancel your personal guarantee and let the company stand on its own two feet.

TAX/NATIONAL INSURANCE
Tax and NI is a little bit more complicated for ltd companies but don’t worry, once you get your head around it, it is really quite easy to understand the basic principles.
As I said before, the ltd company is a separate legal entity, so even though it is your company, technically you are not classed as being self-employed. As a director of the company, you are in fact an employee of the company – that’s right; you’ve just got yourself another job!

In your employed status, you pay income tax in exactly the same way as if you had a normal job – usually through the PAYE (pay as you earn) system on a monthly basis. In addition, the ltd company has to pay corporation tax on its profits. Don’t worry if that sounds as though you pay tax twice on the same money – you don’t. Your salary will already have been deducted from the profit of the company as an expense; therefore it will not be taxed twice. Take a look at the following, very simplistic example. Note that the following does not take account of tax allowances or any relief that may be available, it is purely to illustrate the above point.

ABC Ltd
INCOME £50,000
EXPENSES £20,000
DIRECTORS SALARY£20,000
PROFIT £10,000

The company will pay corporation tax on the profit of £10,000. In addition, the company director will pay tax on his salary of £20,000.

National Insurance is also slightly different for a ltd company. The employee (company director) makes a contribution and the company also makes a contribution on the employees’ behalf. Clearly if you are the only director and it is your company, then both contributions are indirectly coming out of your pocket.

FINANCIAL RECORDS

Yep, you’ve guessed it already – the financial recording keeping rules for ltd companies are a bit more complicated as well!

Limited companies must file a copy of their annual accounts with Companies House, within a set timescale after their year end. Failure to do so can result in penalty fees being incurred. Smaller companies are able to file abbreviated accounts and are not required to have the accounts audited (this means being checked by an accountant to confirm that they give a true and fair view). Larger companies have to file full accounts and are required to have the accounts audited.

In fairness, a larger company is more likely to have several directors and shareholders and it is likely that these shareholders will expect the company to produce audited accounts so that they can see how their investment (their initial input of cash to purchase the shares)is doing.

Unless you are qualified or have some experience in accountancy or book-keeping, I would recommend that you employ a professional to prepare company accounts. At least this way you can be sure that they have been completed correctly and they will be ready before the Companies House deadline. Many small company director’s leave the accounts until the last minute and then either rush to do a whole years worth of figures in one go or just don’t bother and end up being fined. As the old saying goes, a good accountant will earn his fee in saved tax and penalties.

CREDIBILITY
Despite the fact that it is very easy to set up a new ltd company and the fact that it can be done for next to nothing, larger companies often prefer to deal with ltd companies rather than sole traders or partnerships. Personally, I don’t think that credibility alone is a good reason to set up a limited company, unless you absolutely have to in order to deal with other businesses. There are far more important things to take into account, such as accounting requirements and potential tax liability etc.

How to set up your business – Part Two – Partnership

In the second of a series of three articles about how to set up your new business, we will be looking at the Partnership option…

In many ways, the partnership route to setting up a new business is very similar to setting up as a sole trader – with the obvious difference that more than one personis involved. A partnership can be formed by any number of partners – it doesn’t have to be just two people. It is common practice for some professions to be operated as partnerships regardless of size – for example accountancy firms.

HOW DO I SET UP A PARTNERSHIP?
Setting up a partnership is very similar to setting up as a sole trader. You can choose a ‘trading as’ name and simply become ‘Bob Smith and John Green trading as ‘County Plumbers’. In the same way as with a sole trader business, if you are trading under a different name to the partner’s names, you need to list the partners name and a business address on any stationery.

Again, it is not necessary to register the partnership name with anyone, but each partner must advise their tax office of their new self-employed status.

In addition, whilst it is not a legal requirement, it is absolutely vital that the new partners draw up and sign a ‘Partnership Agreement’. This agreement should normally be prepared by a solicitor and will outline such points as:

The names of the partners
The name of the business and its purpose/activity
Date the partnership begins (and time it will last if appropriate)
Details of initial investment by the partners and details of interest to be paid to partners in respect of their investment (if any)
The profits split – not all partnerships split profit 50/50. If you put 90% of the capital up and your partner only worked part-time for the business, would you want to share the profit down the middle?
Details of how the business will be managed and who will have control over different aspects
What will happen if a partner dies, retires or wants to leave or sell his/her share of the business

When a new business is being set up, especially if it is being set up by friends, it is very easy to forget about or just not bother with a partnership agreement. I cannot stress strongly enough –

YOU ABSOLUTELY MUST HAVE A PARTNERSHIP AGREEMENT!

I have seen numerous businesses run into difficulty because the partners have fallen out over a particular issue and some have even ended up taking each other to court. If they had of had a partnership agreement, this may have been avoided.

It is worth mentioning at this point that there area couple of different types of partner (actually there are a few more, but these are the main two types):

FULL PARTNER A full partner will be involved in the day to day running of the business and will share in the profit/loss of the business as agreed in the partnership agreement.

SLEEPING PARTNER A sleeping partner will not normally be involved in the day to day running of the business. This type of partner normally makes a financial investment into the business and in return will benefit from an agreed share of future profits or an agreed return on his/her investment.

FINANCIAL LIABILITY
Again, in the same way as with a sole proprietorship, the partners are personally liable for any debts of the partnership, with one very important difference. Each partner is jointly and severally liable – this means that each partner is liable for any debt of the business, including the share of the other partners.

To illustrate, if a business runs into financial trouble and Partner A has no personal assets and Partner B has considerable personal wealth, then the creditors of the partnership (the people that are owed money), may decide to pursue Partner B for everything owed, as it is more likely that they will get the money back than from Partner A.

The above applies regardless of which partner committed the partnership to the debt in the first place or whether the partner is a full or sleeping partner.

Because of this ‘joint and several’ liability, it is vital that you fully trust your partner – it is perfectly possible that his/her actions could cause you to be made bankrupt. An extreme point maybe, but nonetheless possible and it does happen.

TAX/NATIONAL INSURANCE
As with a sole proprietorship, partners pay tax as per the normal rates, based on their share of the profits generated by the business.

National Insurance is the same – each partner pays the fixed level of Class 2 contributions and then may have to pay Class 4 contributions based on their share of the businesses profits.

FINANCIAL RECORDS
In the same way as a sole proprietor is not legally obliged to prepare audited accounts, neither is a partnership. It may however be even more advisable for a partnership to employ a qualified accountant or book-keeper, as the fact that the profits of the business are being shared between two or more partners may complicate the individual partners’ tax position slightly and it is best to make sure that everyone pays what they should.

CREDIBILITY
There isn’t really any difference between the credibility of a partnership and the credibility of a sole proprietor. A partnership may be seen as being a slightly larger concern, but as stated above, some larger companies will still prefer to deal with a limited company rather than a partnership.

There are some exceptions to this – as already mentioned, some professions, such as accountants or solicitors, will trade as partnerships and this is seen as being perfectly acceptable and indeed, the ‘norm’.

How to set up your business – Part One – Sole Trader

Over the next few days, we will be publishing a series of three articles which will help you to decide upon the best way to set your new business up – sole trader, Limited Company or Partnership.
rticle we will look at the Sole Trader option…

Becoming a sole trader is the most common route for individuals when starting a new business. The reason for this is because it is usually the easiest option, with fewest legal requirements. In addition, if you wish to start your business on a part-time basis, this option is ideal.

There are several elements to look at when deciding which legal format your new business should take and it is important to have an understanding of how your choice of format will affect each of these elements.

How do I set up as a sole trader?
Setting up as a sole trader is extremely easy. You simply decide upon a name for your business, such as ABC Plumbing and your legal business name becomes Bob Smith trading as ABC Plumbing (obviously replace Bob Smith with your own name!!).
You don’t even have to trade under a ‘trading as’ name, if you want to go about business using just your own name, then that’s fine. Note that if you do trade using a trading name, you must put your own name and business address on your headed paper and other stationery.

It is not necessary to formally register your business name with anyone, but you do need to advise the Inland Revenue about your new self-employed status so that they can update their records in respect of your income tax and National Insurance contributions. It is a legal requirement that you do this within 3 months from the end of the month in which you became self-employed. If you don’t do this, you are liable to a fine.

If you plan to start your business on a part-time basis, whilst still employed in another job, you should also let your tax office know. It is likely that they will merely make a note on their records and then ask you to fill in a self-assessment form at the end of the tax year so that you can declare the additional income earned from your own business.

FINANCIAL LIABILITY
Sole traders are personally responsible for all debts accumulated on behalf of the business. This liability is unlimited and an individual’s personal assets, such as their house or car, may be seized and sold in order to pay off business debts (subject to the necessary court orders of course). Ultimately, if a business fails and the sole proprietor is unable to repay the business debts, even after the sale of his/her assets, then he/she may be made bankrupt. Be under no illusion – if you are a sole trader and you incur business debts, you are the one that is liable to pay them back.

TAX/NATIONAL INSURANCE
As a sole trader, you will pay income tax at the normal rates – the same as if you were employed – based on the profit of your business.

National Insurance is paid in two ways when you are a sole trader. Firstly, you pay ‘flat-rate’ Class 2 contributions and secondly you may have to pay Class 4 contributions. Class 4 contributions are based on your profits and are paid as a percentage of your profits.

FINANCIAL RECORDS
If you choose to operate as a sole trader, there is no legal requirement for you to have your accounts professionally prepared or audited. You are quite free to do all the book-keeping yourself. However, you may find that employing an accountant or qualified book-keeper is beneficial when preparing your tax return or if you need to prove your income at any point, for example in order to obtain a mortgage.

In my experience, the majority of business owners are not accountancy experts anyway, so as well as getting rid of a, quite frankly, boring job, employing a professional can cost less than doing the work yourself, especially if they manage to save you some tax.

CREDIBILITY
In terms of business credibility, many would consider a sole trader to be at the bottom of the pile. A business trading as a sole trader implies a small concern, rather than a substantial company. This is often completely incorrect – I know several sole traders that make profits of over £100,000 a year – well in excess of many limited companies. Sometimes a sole trader simply doesn’t want the additional ‘hassle’ of setting up a ltd company. Unfortunately however, it is a fact that if you intend to sell or deal with large companies, you may find that you have more credibility (rightly or wrongly) if you are using a ltd company to trade from rather than as a sole proprietor.