At the time of commencement of any business there are usually several pressing
issues which have common themes. You will be looking to establish a business
with the minimum of cost and in the minimum period of time.
There are no
formalities at all involved in establishing yourself as a sole trader or
partnership business. If you do so without the benefit of a partnership
agreement, then the business is governed by the terms of an ancient partnership
act passed in 1890 and the business is created effectively automatically from
day one of trading. Although the operation of the business will be surrounded by
statutory requirements, compliance with these is no prerequisite to the business
coming into existence.
Partnerships created in this way are known as
"partnerships at will". They hold many dangers because the relationship between
the partners is not regulated in any way other than by statute. Either partner
can bring the business to an end at any time by giving notice of termination to
the other and unless some other arrangements are agreed with regard to a
continuation of the business upon service of such a notice then business assets
have to be sold and the business dissolved. One of the main purpose of a
partnership agreement is to prevent this sort of scenario developing perhaps
many years after the business commenced trading and when it has established a
substantial value.
Formation of a limited company entails more detailed
preparatory work and the memorandum and articles of association which are the
governing "constitution" of the company have to be formally registered with
Companies House. Directors and a secretary need to be appointed and shares need
to be issued. Administratively, the procedure is more complex and expensive.
There is a very substantial market however in "off the shelf" companies which
have been pre-made by company formation agents and stock piled for immediate
use.
Whichever way the business is established, it is important that the
participators have their roles and responsibilities properly defined either
through a partnership agreement or if trading through a limited company by means
of a shareholders agreement.
The most important distinction between sole
traders/partnerships and limited companies is the whole issue of limited
liability. Once incorporated, a company is a completely independent legal person
and therefore has its own assets and its own liabilities. In normal
circumstances the debts of the business are the debts of the company and not of
the people who formed it. This provides protection to the participators in terms
of their personal assets should the company become insolvent.
This
advantage in the early years of any business is more theoretical than real. In
practical terms if you are starting a new business and seeking credit or
facilities from bankers etc., you will inevitably be asked to provide personal
guarantees in relation to the company's liabilities. If you fail to give such
personal guarantees, then you simply will not get the credit. Limited liability
is far more important in the early years however for those engaged in activities
where there may be claims for professional negligence if something goes wrong.
The limited liability of the company also becomes far more important as the
business grows and the business has its own trading record which can justify a
credit without any personal guarantees. A company can own property, enter into
its own contracts, incur its own debts and sue and be sued in its own name.
Gradually over a period of time the distance between the individuals who run it
and the liabilities which it incurs generally widens.
The other
principal advantage of trading through a limited company in the early years is
the ability to separate ownership of the business from the management of the
business. The shares in the company do not have to be owned by the directors.
There is more flexibility in terms of third party investment and power and
control can be organised in the most appropriate way by means of changes in the
company's share structure. In a sole trading or partnership business this
distinction cannot be made. All of the partners are fully liable for the
business' debts to the full extent of their assets and in general terms they are
both owners and managers.
The story does not stop there however.
Companies are administratively more complex to run and in view of their separate
identity even the founding members, if they work for remuneration, are regarded
as employees of this separate entity. Consequently from day one the company has
to account to the Inland Revenue for PAYE payments and tax is deducted by the
company at source together with employee's National Insurance contributions at a
time when cashflow may be at its worst. This can be avoided in some instances
where for instance the founding members have lent money to the company which
could be repaid as an alternative to remuneration over a period of time.
Generally speaking however, it is a substantial burden. On the other hand
partners in a partnership business can withdraw sums on account of their profit
shares without the need for any PAYE scheme to be established unless or until
the business takes on non-partner salaried staff.