There are advantages and disadvantages to incorporating a business. These should all be carefully considered before making a decision.
Many businesses start off in a small way. There does come a time, however, when thought has to be given to the most appropriate structure through which to operate a business. Should you continue to operate as a sole trader or a partnership, or should it operate through a corporate structure, most typically a limited liability company?
Here are some of the key advantages and disadvantages of incorporating a business.
Advantages of incorporating a business
1. It gives a company a separate legal identity
Probably the key advantage of operating a business through a limited liability company is the separation it gives between an individual’s business and personal lives. Were an uninsured claim to arise against the business, or due to external factors were the business to become insolvent, the owner of an unincorporated business has potentially unlimited personal liability for the liabilities of the business. This means that, for example, his or her home and personal savings are at risk.
With a limited company, in most situations (although there are some exceptions noted later), any liability is limited to the amount the owner has paid for their shares, together with any funds that they may have lent to the company.
2. Improved credibility and perception
Rightly or wrongly, there is the perception among many that you are dealing with a business of more substance when it is operating as a limited company when compared to a sole trader. Becoming incorporated could therefore improve your business’ reputation.
3. Potential tax advantages
While tax benefits should not be the primary driver behind a decision on whether to incorporate a business, there are tax advantages to operating through a limited company when compared to an unincorporated business.
As a guide, based on current tax legislation, a business generating a profit of £25,000 per annum (and assuming the business owner draws out for personal use all profits of the business) would have a reduced tax bill of approximately £400 per annum. With a profit of £50,000 this saving increases to £1,400 per annum. However, against these potential savings you also need to factor in the additional costs of operating a business as a limited company.
4. Low set up costs and simple to incorporate
The UK operates a simple and low cost corporate registry, administered by Companies House. It is important, however, to take appropriate professional advice to make sure the structure put in place is fit for purpose. Decisions need to be made over who will be the directors, the location of the registered office, service addresses of the directors, and the shareholders/share structure for the new company.
5. Protection of a trading name
Because no two companies can have the same name registered at Companies House, incorporation is one way to help protect the trading name of the business. However, for a more comprehensive level of protection, a business should also consider trade mark protection of the name.
6. It could help attract new customers
It is very common for many larger businesses to only contract with limited company suppliers. This has to do with employment status issues. Depending on the terms of any contract or engagement, it could be argued by HMRC that a supplier should, in fact, be treated as an employee, which has potentially significant cost implications for the customer. Currently such risk associated with employment status stays with the supplier if that business is operating through a limited company. Trading as a company should open up more potential customers for a business.
7. It could make it easier to sell the business
Incorporating your business could make it simpler to sell at a later date. Looking to the future, on the eventual sale of a business the transaction is simplified if it takes the form of a sale of an owner’s shares in a limited company, as opposed to the sale of a business by an individual where all individual contracts and assets have to be transferred to the buyer.
Disadvantages of incorporation
1. More information is in the public domain
As information on a company is filed on the public register at Companies House, more financial information about a business is open to public scrutiny. Personal information on a company’s directors and shareholders is also available. While this can be seen as a disadvantage by many, it also has its benefits, particularly in connection with obtaining finance or loans and credit from suppliers.
2. Greater administration and compliance requirements
Operating in a corporate structure requires annual filings at Companies House. An incorporated company also needs to prepare accounts that comply with the Companies Act 2006 and accounting standards.
3. Directors need to comply with relevant legislation
There is a fundamental concept enshrined in the Companies Act that directors need to act in good faith and must promote the success of the company. In addition, there are obligations on directors within the Insolvency Act not to undertake “wrongful trading“. This means trading with the knowledge that a company is insolvent. In such situations, a director could be held personally liable for additional liabilities arising while wrongfully trading.
4. Strict procedures to follow when withdrawing money
One of the concepts that many people fail to appreciate fully is that any money generated by a company belongs to the company, and not to its owners. When withdrawing money from a company, the shareholders need to ensure they follow all relevant tax and Companies Act requirements.
5. Personal guarantees may be required
It is common, particularly with newly incorporated businesses that don’t have a financial track record, for certain suppliers (including landlords) to ask for personal guarantees from directors of a company. Banks also frequently ask for personal guarantees to support any borrowings of a limited company. The giving of personal guarantees is one way that the effectiveness of having a separate legal identity for the business is diminished.
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