Key Factors in Making your Choice
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.