Choosing the structure of your business and identifying the accompanying legal requirements is absolutely essential; as this will affect how you run your business, how you do business in the future and, perhaps most importantly, the tax you pay.
It doesn't matter what home-based business you are planning, it could be a nail salon, pet grooming service, language tutor, physiotherapist, landscape gardener, affiliate marketer or eBay seller. Before you take another step, you need to decide what kind of legal structure will be most suitable for your venture.
The 3 Most Common Types Of Business Structure
While there are a number of different types of business structure, there only three main types that you need to explore when operating a home-based business: Sole Trader, Partnership or Private Limited Company.* Below is a breakdown of each type of business structure, together with their advantages and disadvantages, what you have to do to set them up and finally what the costs are likely to be.
*There are others such as Public Limited Companies, Private Unlimited Companies and Right-to-Manage Companies, but there's no need to worry about them. If your business takes off and your empire expands, just get your lawyers to sort it out.
1. Sole Trader
Setting up as a sole trade is by far the simplest and most straightforward way of starting a business. You can start up at any time simply by registering your business and there is no fee! The good news is that, after tax, any profits go straight into your pocket. The bad news is that if your business fails you are personally liable for any debts, which means that your house and any other assets can be seized.
The Advantages:
Fast start-up with no registration fee
Minimal records and accounting
Greater flexibility as you can control when and where you work
Greater privacy as you don't have to answer to anyone else
Any profit after taxes is yours and yours alone
The Disadvantages:
You are personally liable for any debts
You are solely responsible for all the legal requirements and paperwork that come with submitting your yearly tax bill and paying your own National Insurance Contributions (NICs)
Premiums for insurances such as life, home and car are generally higher
How To Become A Sole Trader
All you need to do is register with HM Revenue & Customs (HMRC), which you can do online by going to HMRC.You will be asked some basic information about yourself and your business, HMRC will gladly set up tax records for you and you are ready to go! Once registered, you'll receive a self-assessment tax return that you have to complete every tax year (6th April to 5th April) and the kind people at HMRC will calculate how much you owe. NB: Even if you already fill in an annual tax return, you need to inform HMRC as soon as possible or you may be fined!
The Records You Have To Keep
General bookkeeping of expenditure and income of all business-related costs
If you are employing people you need to either contract them as a supplier and keep a note of costs or, if you employ them full-time, calculate their monthly Income Tax and NICs with Pay As You Earn (PAYE)
What It Will Cost You
Income tax on any profit
Class 2 National Insurance at the fixed rate
Class 4 National Insurance on any profits
PAYE if you are employing people
2. Partnership
If you don't want to go it alone, a business partnership is the next natural progression. In essence, a partnership is two or more self-employed people working together and sharing the workload and any resultant profits. While it's not a legal requirement to have a formal agreement in place, I strongly advise it! Like any relationship it all starts out with good intentions and a shared vision, but things go wrong, circumstances change and it can all too easily end up in tears. I once set up a partnership with two of my best friends and it all went swimmingly for nearly three years until the cracks started to appear. The result was a long drawn-out court battle to 'divorce' our partnership, resulting in two fewer names on my Christmas card list.
The Advantages:
Fast start-up with no registration fee
No formal agreement required (although recommended)
Minimal records and accounting
Someone to bounce ideas off and share the workload
Shared cost and risk
Any profit after taxes is shared between the partners
The Disadvantages:
With a simple partnership you are not only liable for the overall partnership's debts but also any debts incurred by other partners regardless of whether you agreed to the expenditure or not.
Profits are generally shared in equal proportions regardless of the actual working contribution made
You are jointly responsible for all the legal requirements and paperwork that come with submitting your yearly tax bill and paying your own National Insurance
Premiums for insurances such as life, home and car are generally higher.
How To Form A Partnership
Each partner must register individually with HM Revenue & Customs (HMRC) (even if any of the partners already fills in an annual tax return, you all must inform them as soon as possible or you may be fined!) Optional: a deed of partnership outlining how the business will be run and duties and responsibilities of each partner. You don't have to go to a lawyer to draw up a partnership, simply draw up and sign a mutually agreeable division of profits and, most importantly, what happens in the event of the partnership breaking down.
The Records You Have To Keep
One partner should be appointed the nominated officer, responsible for submitting the annual partnership tax return
General bookkeeping of expenditure and income of all business-related costs accrued by each partner
A partnership statement showing how profits (or losses) have been divided amongst the partners
In the majority of cases, each partner is responsible for paying their individual Income Tax or National Insurance Contributions based on the above
If you are employing people you need to either contract them as a supplier and keep a note of costs or if, you employ them full-time, calculate PAYE
What It Will Cost Each Partner
Income tax on any apportioned profit
Class 2 National Insurance at the fixed rate
Class 4 National Insurance on any apportioned profits
PAYE if the partnership is employing people
2b. Limited Liability Partnership
The main difference between an LLP and a standard partnership is that the business is liable for the business' debts and not the individual partners. This protects partners from personal bankruptcy and debts incurred by other partners, but offers exactly the same tax advantages as a normal partnership. All the other details for forming and running an LLP partnership are as above, except that accounts will most likely have to be audited and filed at Companies House.
3. Private Limited Liability Company
If you really want to protect yourself from any potential business failure, then it may be wise to choose a Private Limited Liability Company. The company is owned by its shareholders, yet it is an entirely separate legal entity and the structure of the company limits the shareholders' liability to the value of the shares issued. Which basically means that if the business goes bust, your personal assets can't be touched (unless you have been acting illegally... ). There is no minimum share capital requirement, but shares cannot be offered to the public and any profit is paid to shareholders in the form of a dividend.
The Advantages:
Keeps business and personal finances completely separate
If the business goes bankrupt, you don't
Generally regarded as a safer business trading partner than a sole trader or partnership
The Disadvantages:
Lots of paperwork and lots more rules
Before you can start trading you need a certificate of incorporation issued by the Registrar of Companies. While Companies House will automatically pass on your details HMRC, you also need to contact your local HMRC office to advise them of your company's existence.
The Records You Have To Keep
Your company's name, place of registration, registered number and registered office address must be displayed clearly on everything from your letterheads to invoices, websites to emails
Detailed bookkeeping of all business-related expenditure
All payments to salaried directors, employees and contracted services
Self-assessment of the level of corporation tax to be paid
What It Will Cost
Corporation tax on all profits
PAYE to collect monthly Income Tax and National Insurance Contributions from all employees and directors
Value Added Tax (VAT)
Finally, regardless of the business structure you choose, by law you must register for VAT if your business is going to turn over more than the current figure of £77,000 per year. If you genuinely don't believe that your business will exceed this figure then you can wait, but keep a careful eye on your monthly figures! HM Customs and Excise has more power than the police and can enter your home at any time, without a warrant, and seize anything they believe is related to their enquiry. I remember getting two hours' notice about a visit from an inappropriately named Mr Pratt from the VAT office, who proceeded to audit my returns with uncanny insight. As a result, by the time he had left my office, he or rather HMRC was several thousand pounds richer.