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Choosing a Legal Entity for Your Business

Written by: Timur Sultanov

Article Overview: There are three types of legal entity that can be used for running your business: • Sole trader • Partnership • Limited company

Choosing a Legal Entity for Your Business

In the following paragraphs you will find a brief description of the three alternatives.

For the sake of completeness, mention should be made at this point of two specialised legal entities - companies limited by guarantee and limited partnerships.

The references to 'debts' in the following paragraphs do not just mean loans, but cover all business liabilities - loans, overdrafts, trade credit, tax, VAT, etc.

Sole trader

As the name implies, this business format can only be used if you are trading as a single owner in your own name. In legal terms, the business does not exist as a separate entity - you and the business are one and the same. In financial terms, you are fully responsible for all business debts as it is you personally who has incurred the liability.

The bank account will be called something like John Smith trading as Pilem High Gadgets.

To comply with law, all important business documents, such as headed notepaper and invoices, must give details of the business owner if a trading name is used. In the above example it would not be sufficient to simply state 'Pilem High Gadgets' and the address. It would have to be made clear, usually as a footer, that it is John Smith trading under that name.

If you are leaving paid employment to go into business there are often tax advantages in the early years to being a sole trader, particularly if you expect not to make an immediate profit (you may be able to claim back some of the tax that had been deducted by your former employer from your pay). However check with your accountant, and read about limited companies below before making your final decision, as tax is not the only consideration.

Partnership

A partnership is a legally defined term. Partnerships are governed by the various Partnership Acts and by some aspects of the Companies Acts. These Acts do not affect you on a day-to-day basis, so they are nothing to worry about, but they will affect how your solicitor writes the partnership agreement, and how your accountant prepares the annual accounts.

If there are two or more of you, you need to decide whether to be a partnership or a limited company.

All partners are fully liable for the debts of the partnership, in the same way as a sole trader. In normal circumstances, you cannot get out of liability by claiming that the other partner was not authorised to incur the debt.

As with a sole trader, all important documents such as invoices must give details of ownership if a trading name is used - i.e. any name that does not include all the partners' full names. Some partnerships, such as large firms of solicitors for example, have many partners, and putting all the names on the stationery would be impractical. Therefore, the law states that either all the partners' names must be shown or a statement as to where their details can be seen must be included.

If you could trade as a sole trader, the alternative of forming a partnership with your spouse/partner might be suggested by your accountant, as he may feel it would be advantageous to split the income for tax purposes. The problem with this is that, as a partner, the spouse/partner then becomes liable for the business debts. A better solution might be to take the spouse/partner on as an employee and pay a salary. That would certainly provide better protection for the family home (unless it has been offered to a lender as security, of course).

You will need to have a partnership agreement drawn up.

Limited company

A limited company is a separate legal entity in its own right. The term 'limited' in this context means that the shareholders' liability is limited to the share capital they invested. In other words, if you bought some shares in Wall Mart and they went bust (some chance!), you lose your investment, but you cannot be asked to contribute any more to pay off Wall Mart's creditors.

A limited company is owned by its shareholders and run by its directors. There must be at least two shareholders, but there can be a single director. The company is registered at the appropriate Companies House, has a registered number, and has an official address which is called the 'Registered Office'. All formal documents served on the company must be served at the- Registered Office to be validly served.

All important documents must state the company name in full, where (country) the company is registered, the registered number and the address of the Registered Office.

Forming a limited company is the only way that you can limit in any way your personal liability for business debts. It sounds ideal, but there are other considerations, both pluses and minuses:

• A new company has no track record on which to base credit decisions. Therefore financial institutions will almost invariably insist on personal guarantees from the shareholders. Creditors, such as trade creditors, who are not able to take guarantees may not initially be prepared to sell on credit.

• A limited company is not a licence to act irresponsibly. Directors can be made personally liable if they do not run the company's business in a financially responsible manner.

• Anyone who has a strong influence over the way the company is run will be regarded as a director, even if he is not

formally appointed as one (this is called being a 'shadow director'), and as such he could become personally liable for company debts in the event of financial irresponsibility in the company's affairs.

• The above provisions are clearly designed to stop reckless people hiding behind a limited company. That said, we have all seen examples on the television where people get away with it, and it does happen all the time with small businesses.

• The limited company gives your accountant more options on how you are paid - by salary or by dividend - which may help your tax and National Insurance situation. There are also more options for pension arrangements.

• The other important consideration is when stock is to be used as security for a bank debt. In order to have effective security over stock, a bank needs to take what is called a 'floating charge'.

A legal 'charge' is a term to describe taking security over something. For example, if you have taken a mortgage to buy your house, the mortgage is a legal charge over the house. In the case of your house, it is called a fixed charge because the house doesn't change. You are not allowed to sell it without accounting to the mortgage lender.

If a charge is taken over stock in a business, the individual stock items come and go on a daily basis and, unless you are given permission to buy and sell in the ordinary course of trading, you clearly could not run the business. The bank takes a 'floating' charge whereby it is secured by whatever items of stock are there at any given time, and you are allowed to buy and sell as long as it is in the normal course of trading.

A limited company is the only business entity that can give such security so, if you are acquiring a business where the value of stock is substantial and will need to be used to secure finance, a limited company could be your only option.

A limited company is easily formed. Your accountant/solicitor can arrange it for you, or you can go directly to one of the specialist company formation agents (why not do the latter - it is simple and may save you money on accountants'/solicitors' charges?). Formation agents are usually based in offices near the registry ( Cardiff , for example, for companies to be formed in England and Wales ) or in other major cities. They advertise in Yellow Pages, as well as the business-to-business sections of national and regional newspapers. Fees are fairly standard, and it should not cost you much more than £100 or so to form a company.

Forming a limited company can be a good way to go into business with a partner, since the limited liability aspect might protect you and your personal assets if your partner does something financially rash. Although it is not a partnership as such, if you are forming a limited company with a business partner it is a good idea to draw up an agreement similar to a partnership agreement. In this case you would call it a shareholders' agreement, but you would cover the same general headings as described already for a partnership agreement.

What if the business is already trading as a limited company?

If the vendor is already trading as a limited company he may suggest you take the company over. This is very easy to do because all you need to do is execute a deed of transfer in respect of the shares. Since the business is owned by the company, and you now own the company, you now own the business. However, this is not generally a good idea because, however careful your investigation, you can never be certain that some unexpected creditors 'might not turn up with financial claims on the company at a later date. It is far better to start with a brand-new company with no history.

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