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If you have started trading by yourself, unless you have taken steps to incorporate your business into a company, odds are you are doing business as a sole trader. A sole trader is one of the four main business structures commonly used in England and Wales. This article will explain how the law recognises a sole trader and what the essential legal considerations are for you as a business owner.
Creating a Sole Trader Business
At any point where you start to do business of any sort on your own, such as babysitting, selling art, or running a plumbing operation, the law will imply the structure of a sole trader onto your business. You do not need to file any application with any government body to begin trading as a sole trader.
It is always possible to convert your sole trader business into another business structure.
You will be personally liable to the government for all taxes made by your business. These can include Value Added Tax (VAT). In practice, you will assess your business profits as income tax.
Distinguishing Features
It is obvious when someone is operating as a sole trader in many cases. However, if there is any doubt, you are likely working as a sole trader if your company has:
- no separate legal personality. If you have not incorporated a company, it is likely that your business does not have a distinct legal personality;
- unlimited liability of the business owner;
- only one owner — if there is more than one person with an interest in the business who is not simply an employee, the business is not operating as a sole trader;
- ownership and management consolidated in a single person;
- a lack of any filing requirements or administrative formalities; and
- no constitutional documents.
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Unlimited Liability
There is no legal distinction between what you do in your personal capacity and what your business does. This is because your business does not have its own legal personality. Consequently, it cannot own any assets, nor can it be responsible for its own debts.
We will consider two examples of how carrying unlimited liability for your business can pose a problem:
- if your business begins to struggle to make money; and
- if your business causes injury or loss to another person.
Example A – Financial Difficulty
Many businesses borrow money and receive certain goods on the supply of credit. These are collectively known as liabilities. So long as your business brings enough money in, there is no problem.
Where this is the case, if you cannot come to an agreement or arrangement with your creditors, they can initiate proceedings against your business.
Example B – Loss or Injury to Another
It is of course possible to manage your business so that you never run the risk of not paying a supplier or repaying a loan. For instance, if your liabilities never exceed less than half of your cash on hand, you are unlikely to run into any cash flow problems.
However, if you injure another person or cause them economic loss, provided there is an actionable claim against you, the calculated damages could far exceed the assets your business has available to pay the damages.
Mitigating the Effects of Unlimited Liability
Operating as a sole trader can be dangerous. For example, if something unforeseen happens, your business and your personal assets would be at significant risk.
However, where the risk of liability increases, you will want to know how to protect yourself.
Using a combination of the following can help you mitigate the effects of unlimited liability.
Contracts
When negotiating contracts with your customers and suppliers, it is possible to negotiate specific terms that cap the total amount your business will be liable for. These are often called specified damage clauses or exclusion clauses.
The difficulty is that contract terms must be precisely worded; if they are too broad or too narrow, they may not have any legal effect.
Insurance
All prudent business owners should obtain insurance, even if it is not strictly a legal requirement (although it often is). If you are operating as a sole trader, this is doubly true given the operation of unlimited liability.
You will need different policies depending on what kind of business you operate, but generally, you should look into:
- professional indemnity insurance;
- occupiers liability insurance; and
- employers’ insurance (if applicable).
Incorporating Your Business
You can incorporate your business so that it obtains its own legal personality. This effectively creates a legal barrier between your assets and liabilities and those of your business.
The downside with incorporation is that company directors are subject to numerous administrative burdens. These include filing certain documents with Companies House (the public body in charge of regulating companies) like accounts and keeping them up to date with any changes, such as issuing new shares. As a result, this can impose additional costs on your business.
For many business owners, there comes the point where the benefits of incorporation outweigh the disadvantages.
Key Takeaways
Operating your business through a sole trader structure (also called self-employed) is a great way to start your business because you do not have to do anything other than start trading. This is why it is a typical business structure for small businesses. However, because your business does not have a separate legal personality, you are personally liable for all of its obligations, no matter how much. There are specific ways to mitigate this, including negotiating favourable contracts, obtaining insurance, and incorporating your business.
If you need help navigating the legal implications of operating as a sole trader, our experienced business lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
Frequently Asked Questions
A sole trader, also referred to as self-employed, is anyone operating a business where they are the sole owner of the business and have not incorporated the business into its own legal personality. As such, they have unlimited liability for all of the business’s debts and obligations.
Because a business operating as a sole trader does not have a separate legal personality, it cannot own property or enter into its own contracts. Therefore, the business owner must assume responsibility for the business’s liabilities. The ultimate effect is that if the business does not have enough assets to pay its debts, the court can order the business owner to sell their personal assets to meet the liabilities.
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