Business and organisational characteristics - Sole trader

Learning Outcomes

After reading this article, you should be able to:

• Identify the defining characteristics of a sole trader business structure.
• Explain the concept of unlimited personal liability and its implications for the owner.
• Outline the key formation, administrative, and taxation requirements for sole traders.
• Compare the advantages and disadvantages of operating as a sole trader compared to other business forms.

SQE1 Syllabus

For SQE1, you are required to understand the nature of different business mediums, including their setup, regulation, and key legal implications. This article focuses specifically on the following aspects relevant to sole traders:

• Business and organisational characteristics (sole trader)
• Legal personality and limited liability (specifically, the lack thereof for sole traders)
• Procedures and documentation required to form a business (specifically, the minimal requirements for sole traders)
• Taxation implications for the business owner (Income Tax and National Insurance for sole traders)

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following statements regarding the liability of a sole trader is correct?
   1. The sole trader's liability is limited to the capital invested in the business.
   2. The sole trader benefits from separate legal personality, protecting personal assets.
   3. The sole trader has unlimited personal liability for all business debts.
   4. Business creditors can only claim against the business assets, not personal assets.
2. What registration is mandatory for an individual starting a business as a sole trader in the UK?
   1. Registration at Companies House.
   2. Registration for Corporation Tax with HMRC.
   3. Registration for Self Assessment with HMRC.
   4. Registration with the local council only.

3. True or False: A sole trader business continues to exist legally after the owner's death.

Introduction

A sole trader represents the simplest form of business organisation available in England and Wales. It involves an individual carrying on business on their own account, without the need to create a separate legal structure like a company or a partnership. This structure is prevalent among small businesses, freelancers, and professionals operating independently.

Key Characteristics

The defining feature of a sole trader is the absence of legal distinction between the business and the individual owner.

Key Term: Unincorporated business
A business structure that does not have a legal identity separate from its owner(s). The owner(s) and the business are treated as one entity in law.

This means the individual is the business. All business assets are owned personally by the individual, and all business contracts are entered into by the individual in their personal capacity.

Key Term: Sole trader
An individual who owns and runs an unincorporated business by themselves. They are personally responsible for the business's debts and keep all the profits after tax.

Liability

The most significant legal consequence of the sole trader structure is the owner's liability exposure.

Key Term: Unlimited liability
The owner is personally responsible for all business debts and obligations without limit. Personal assets are at risk if the business cannot meet its liabilities.

Unlike shareholders in a limited company, a sole trader's personal assets (e.g., house, car, personal savings) can be claimed by business creditors to satisfy outstanding business debts. If the business fails and incurs significant debt, the owner could face personal bankruptcy.

Worked Example 1.1

Sarah runs a small bakery as a sole trader. The business struggles and accumulates £20,000 in unpaid supplier invoices. The bakery's assets are only worth £5,000. Can the suppliers pursue Sarah personally for the shortfall?

Answer: Yes. As a sole trader, Sarah has unlimited liability. The suppliers can legally pursue her personal assets, such as her savings or potentially her home (subject to certain protections), to recover the remaining £15,000 owed.

Formation and Administration

Setting up as a sole trader is straightforward, with minimal legal formalities.

Registration Requirements

No registration is required at Companies House. The primary administrative step is registration with HM Revenue & Customs (HMRC).

Key Term: HMRC
His Majesty's Revenue and Customs is the UK's tax, payments, and customs authority.

Sole traders must register with HMRC as self-employed for Income Tax and National Insurance purposes, typically shortly after commencing trade. Depending on turnover, registration for Value Added Tax (VAT) may also be necessary.

Business Names

A sole trader can operate under their own name or choose a trading name. If using a trading name, certain restrictions apply (e.g., avoiding sensitive words or suggesting connection to official bodies without permission). The owner's name and an address for service of documents must be displayed at business premises and on business stationery.

Record Keeping

Sole traders must maintain accurate records of all business income and expenditure for tax purposes. These records are required for completing the annual Self Assessment tax return.

Financial Aspects

Taxation

Sole traders pay Income Tax on their business profits via the Self Assessment system. They are also liable for Class 2 and Class 4 National Insurance contributions. The calculation of trading profits involves deducting allowable expenses and capital allowances from chargeable receipts.

Raising Finance

Accessing finance can be challenging for sole traders. They cannot issue shares like companies. Funding typically comes from personal savings or loans. Banks often perceive lending to sole traders as higher risk due to unlimited liability and may require personal guarantees or security over personal assets (e.g., the owner's home). This limitation can restrict business growth potential compared to incorporated structures.

Revision Tip

When advising a client on choosing a business structure, always balance the simplicity and privacy of the sole trader model against the significant risk posed by unlimited personal liability. Consider the nature of the business, its potential liabilities, and the client's attitude to risk.

Advantages and Disadvantages

Key Point Checklist

This article has covered the following key knowledge points:

• A sole trader is an individual running a business without creating a separate legal entity.
• The owner and the business are legally the same, resulting in unlimited personal liability for business debts.
• Formation is simple, requiring primarily registration with HMRC for tax purposes, not Companies House.
• Sole traders pay Income Tax and National Insurance on profits via Self Assessment.
• Raising finance can be difficult compared to incorporated entities due to the inability to issue shares and perceived lender risk.
• The structure offers complete control and privacy but lacks continuity beyond the owner's involvement.

Key Terms and Concepts

• Unincorporated business
• Sole trader
• Unlimited liability
• HMRC