The most important decision when you become your own boss is choosing your legal structure. The second most important decision is making sure that structure is right for your business and you.
There are many structures available: the main ones are sole trader, limited company, partnership and limited liability partnership.
I’m going to focus on the two structures chosen by most solo women entrepreneurs: sole trader or limited company.
This is a practical guide to the importance of risk when you choose your business legal structure.
The 4 Crucial Factors
There are 4 crucial factors to consider when making your decision between trading as a sole trader or a limited company.
- Your Clients
- Your Risk
- Your Circumstances and Preferences
Yes, tax is number 4, no matter how much we like to legally reduce our tax bills. It’s not a good decision to be a limited company for tax reasons if the other factors are against it. It’s easy to do, it’s not easy to undo!
Let’s look at the risk in our 4 factors when deciding which structure is right for you.
1. Your Clients
Do clients in your industry require you to be a limited company?
My tech clients have contracts with companies like Apple. Apple won’t hire them as a sole trader so the decision is made for them.
Ask around your industry so you know what the position is. Is the norm to be sole trader, limited company or does it not matter?
If you’re new, consider the first few years of your business and whom you’d like to work with beyond the initial start up period.
Action: What’s the risk of limiting the clients you want with each structure?
2. Your Risk
What size contracts do you have or will have?
Your risk is higher if the value of your contracts or your income / turnover is higher.
I have a client who makes hair accessories. A £75,000 contract with Selfridges makes her business risk higher than a crafter making hair bands at weekends. There is more that can go wrong with a bigger contract for goods, and insurance cover often only goes so far.
You may be a consultant charging £25,000 per contract with only 6 clients. The risk per client may be low. Even so, your turnover is £150,000. Higher turnover businesses are usually limited companies but if you prefer the minimal paperwork of being a sole trader, consider risk as part of your decision. If you have a full-time employed role, sometimes the paperwork and legal obligations that is part of a limited company may not be worth the tax saved.
Do you have assets to lose? As a sole trader legally you are the business so personal assets may be at risk if there is a problem. If you rent, don’t have assets and have a low risk business, this is usually not a problem. Of course make sure you have insurance.
When you have a higher risk business, a higher turnover or substantial assets, it is a good idea to trade through a limited company.
Action: What is your turnover? What are the risks you can’t control in your contracts? What are your personal assets? Is your business low risk? Look at insurance options
3. Your Circumstances and Preferences
Risk assessment is more than just about your business if you’re a solo entrepreneur. You also need to consider your personal and household income and circumstances.
One freelancer client trades through a limited company because it enables her to protect her National Insurance contribution record and make tax-efficient pension payments. She earns the second income for the family and investing income for the future is her first priority.
You may want to be a sole trader because you work full or part-time. You can sometimes get a tax refund which you wouldn’t be able to do as a limited company. This works especially well in your first year or two in business.
What are your preferences? It is easy to do the required paperwork for a sole trader compared to a limited company. A limited company has many more legal requirements, deadlines and ‘boxes to tick’ complete with penalties if they aren’t done right or on time.
A sole trader needs to do accounts and file a self-assessment tax return. Most sole traders can do this themselves after some coaching. Even the coaching is a tax deduction expense!
Some people aren’t suited to keeping up the paperwork required of a limited company. Be honest if this is you and talk to an accountant to look at your options.
Action: If you’re feeling overwhelmed by the obligations of a limited company but feel it may be right for you, again ask an accountant to support you with the learning curve so you feel confident and understand
Are your profits over £35,000?
Limited companies are taxed differently to sole traders. If your profits or non-business income is £35,000 or over, explore being a limited company for the tax benefits. The usual arrangement is paying yourself a basic salary and taking the remainder in dividends (making sure you do the legal paperwork and stick to HMRC’s rules).
You pay less tax than if you are a sole trader.
However, there are downsides. It is easy to incorporate, it is not easy to revert to becoming a sole trader. It isn’t too difficult to do your own accounts with some help if you’re a sole trader. As a limited company you need an accountant and a budget of £700 – £2,500 per year to cover the additional costs. If you have a high or more complicated transaction level, this will be more.
Other tax reasons to be a limited company are inheritance tax and wanting to share profits with someone not involved in the business. Contact an accountant if you’re interested in either of these.
Action: If you are a sole trader earning profits of £35,000 contact an accountant to discuss your options
Take it one step at a time if you’re feeling overwhelmed and get help if you need it. Time spent on this decision now pays dividends later and that’s a good risk assessment.
How did you assess the risks when you chose your business structure?