Should I set up a Limited company for my new start-up?

Most business start-ups tend to opt for setting themselves up as a limited company from day one – but is this right?

Answer: It depends.

In many cases, a limited company is the right option but it pays to think through all the options as there can be benefits to thinking a little differently.

You basically have 3 main choices in the UK:

  1. Company
  2. Partnership
  3. Sole trader

The main advantage of a limited company is the limited liability status. This means that the company’s liability to a claim made by say an aggrieved supplier is limited to the share capital of the company. So if the company is set up with £1 share capital – that’s the extent of its liability. Hardly worth pursuing so the shareholders can sleep at night.

Limited liability status is not only important to protect the livelihood of the company owners but it is also useful for protecting valuable assets like trademarks, patents, know-how and other intangible assets.

But a company is not the only business vehicle that can attract limited liability status. Partnerships can also now attract limited liability status as an LLP (Limited Liability Partnership).

Why consider setting up an LLP over a company?

The key issue is flexibility. LLPs are more flexible than companies, particularly in relation to tax planning.

Consider the example of Jane & Freddy. J & F are starting a digital advertising agency. Rather than opting for the typical default option of a limited company, they set up an LLP at Companies House. J & F are partners in the LLP rather than shareholders and directors of a company. J & F pay income tax under Self Assessment rather than PAYE. They don’t pay any income tax until 31 January in the year following the coming 5 April tax year end. So they can diligently set aside this tax and keep it stashed in say a high interest cash ISA or bank account until it is due to be paid to HMRC. This compares with paying tax over monthly under PAYE.

But it gets better. There is no Employer’s National Insurance (currently 12.8% – potentially set to increase to 13.8% from 5 April 2011) on partners’ income from the LLP. Plus partners(and sole traders) are subject to Class 2 and 4 National Insurance which is more favourable than company Class 1 National Insurance. If they have taxable benefits such as company cars then there is also more favourable tax treatment in an LLP than in a company.

And yes…. it gets even better. After 2 or 3 years of successful trading, J & F may decide to incorporate their LLP and turn it into a company. (This might particularly be the case if they feel they have reached the stage where they need external investor funding in return for shares in their company.) The digital advertising agency business and its assets (e.g. computers, cash in the bank etc) would be transferred to the newly formed company at market value. This would crystallise a capital gain based on the market value of the business – however, this tax can be deferred.

The market value of the LLP business would be measured not only on the tangible assets transferred but also more interestingly on the intangible elements of the business, particularly goodwill (which may account for most of the value in the business). Goodwill is made up of the value in the brand, the customer base, its future potential etc built up over the past 2 or 3 years of trading – the factors that would influence a willing hypothetical purchaser to pay over and above the value of the visible tangible assets.

Post transfer, J & F Ltd would be the proud owner of the digital agency business and assets. The goodwill element would attract valuable tax relief in the company. Also, in return for the value transferred in, the company would have a debt owed to J & F as LLP vendors and now shareholders. This creates a highly valuable and flexible tax-free balance that can be drawn down as and when needed by J & F. Combined with a carefully managed remuneration extraction strategy from the company, J & F will have added considerable after tax value to their business which they can enjoy now compared to if they had followed the herd and set up as a company from day one – all by thinking a little bit differently.

The purpose of this short article is to emphasis that there are alternatives to setting up a company for a new business venture. It is oversimplified and the key benefits and principles may change (e.g. in light of the imminent emergency budget!) so, as ever, please take professional advice specific to your circumstances.