What trading style should I use in my business?
You can use various trading styles to trade under in your business. The different styles are, in essence, different sorts of legal entities. The main differences between them arise from:
- The relationship between the the owners of the business, and
- The legal relationship between the owners and their their creditors.
I will explain these differences below.
Main trading styles
The main trading styles used by businesses are the following:
- Sole trader
Advantages and disadvantages
From a legal, regulatory and practical point of view each trading style has its advantages and disadvantages.
The trading style you chose to trade under will, probably, depend on:
- Your circumstances, and
- The size of business you intend to establish and maintain.
The legal requirements and taxation implications of these various trading styles are largely similar in all western countries, but they have some differences.
(Please note what follows is not legal advice and you should seek professional advice before you proceed.)
If you trade as a sole trader, the first thing to recognise is that you and the business are the same legal entity. You are, effectively, the business. In essence this means you are personally responsible for all the debts of the business. Probably, this is the biggest disadvantage of trading as a sole trader.
The next disadvantage is one of perception. Sole trader businesses are seen by the business world as being small ventures. Consequently. they are not taken very seriously. This could have an impact when they try to secure external funding, or do business with bigger companies. If you are a business where this perception doesn’t matter then being a sole trader could suit you.
Also, if you plan always to be a small enterprise and are comfortable with this then being a sole trader is OK. However, note that as a sole trader it is only the ownership that is sole, as you can employ as many people as you like to work with you in the business.
A big plus for sole trading is that easier to set up and cheaper to run than a company. This is because it has less regulatory formalities and accounting requirements.
To set up as a sole trader in the UK , all you need to do is to advise HM Revenue & Customs that you are starting a business in your own name.
Taxation in the UK
As a sole trader in the UK your business income is included with all your other personal income for income tax purposes. You make only have to submit one tax return. Whereas, with a company, you have to lodge a company income tax return as well as your own personal tax return.
Taxation in the US
In the US, sole proprietorship works in the same way as in the UK. The owner “is the business”. He or she only has to file only one tax return covering personal and business income. The tax liability is said to “pass through” the business to the owner.
Where there is more than one owner of a business they can usually operate as a company or as a partnership.
A partnership does not have limited liability. This means partners have personal liability for the partnership debts. Importantly, each individual partner is liable for all the business debts. The result of this is that where any partner cannot pay his or her share, the other partner (or partners) will be liable for the total debt. This is known as “joint and several liability”.
However, this liability can be avoided by setting up a limited liability partnership. If you are interested in a trading as a limited liability partnership you should get expert advice.
[Note in some countries, including the UK, you must trade as a partnership and not a company if you are a legal or accounting firm.]
Taxation of partnerships
For tax purposes, partnerships are like a sole trader business. This means the liability for taxation rests on the partners. In US parlance a partnership is a “pass through” entity, meaning the profits and losses pass though to the tax filings of the owners.
Partners should clarify the rights and responsibilities of the respective partners in a written partnership agreement. This helps avoid misunderstandings and potential problems in their future relationships.
See also John’s blog on business partners at: https://www.freeforumofideas.com/blog/business-partners/
Company or LLC
A company is a separate legal entity from its owners and/or its directors. The shareholders are the company’s owners, while the directors manage the company. A company by law must also have a Company Secretary. In smaller private companies shareholders and directors are often the same people. However, they need not be.
A Public Company has limited liability and has several advantages over a private LLC. These advantages include the ability to issue its own shares to raise capital from the public.
If you trade as a company it is the company (as a separate legal entity) that is liable for the business debts and not its owners (or shareholders). Shareholders have what is known as “limited liability”.
Limited liability is an important protection where a company fails owing money to its creditors. If this happens with a sole trader, they have to pay the business debts out of their own pocket and their personal assets are at risk. With a company the creditors are paid from the business assets and the shareholders’ liability is limited to the money paid into the company to purchase their shares.
This where the term “limited liability company” or LLC comes from. If there are insufficient assets to pay the creditors then the creditors have no recourse to the shareholders or directors for their losses.
In practice, however, shareholders and or directors often do end up being liable for company debts. This is because lenders and suppliers to the company insist on getting shareholders’ or directors’ guarantees for the money lent, or debts arising from the supply of goods and services to the company.
Setting up a company in the UK
Setting up a small private company is relatively easy and cheap because a company can be “bought off the shelf” online from a company formation firm.
In the UK, a company has to deal with more regulations and costs than a sole trader.
- First, a company should have its own bank account besides the owner’s bank account.
- Second, a company needs to lodge a tax return and the owners also need to lodge their personal tax returns.
- Third, a company needs to make an annual return to Companies House confirming various things such as shareholders’ and directors’ names. This information is available to the public.
Tax advantages of a company
There are, however, some tax advantages in having a company. One cannot generalise about these advantages however, because tax rules change every year. Expert advice needs to be taken on this issue.
Corporations in the USA
In the US the situation with companies is a bit more complicated. There are three types of companies, namely:
- The standard LLC
- The S Corporation
- and the C Corporation.
US LLCs like UK LLCs provide a large degree of liability protection to business owners. However, the taxation treatment of the standard LLC is different from the UK LLC.
A US LLC is a “pass through” entity, meaning the business does not pay tax on profits, rather profits and losses pass though to the tax filings of the owners.
The S Corporation is a half way house between the LLC and the full C Corporstion. Only US citizens and permanent residents can form S Corporations. However, S Corporations are permitted to to raise funds through the issue of stock (shares). S Corporations are also “pass through” entities for the purpose of tax filings.
The C Corporation is a full corporation equivalent to a public company in the UK. The C Corporation is not a pass though entity: It must lodge its own tax return and any dividends to shareholders (or owners) must appear on their personal tax returns. This of course can result in double taxation.
Many businesses will progress through various types of incorporation as they grow, acquire new owners and need to raise capital with the ambition of being fully incorporated C Corporations or Public Companies.
A franchisee who buys a franchise from an established trader (a franchisor) usually trades as a sole trader. A franchisee is buying the rights to trade under the umbrella and support of the franchisor. This, the franchisee is taking advantage of the tried and tested business model of the franchisor, as well as its brand name, the goodwill and its marketing activities.
The franchisor also provides detailed guidance on how to run the business. Usually, this is provided in the franchise manuals.
The rights and obligations between franchisee and franchisor are laid down in a franchise agreement.
There is lots of information about franchise opportunities online and franchise fairs are held regularly in most countries.
So, what trading style should you choose?
The answer to this will, in the end, depend on various issues, including:
- Your personal circumstances
- The availability of suitable business partners
- The intended size of your business
- Your appetite for legal risk
- The availability of suitable franchises and your ability to buy one
- The capital you have available to buy an existing business
- The regulations in your industry