Choosing the right one is one of the most important early decisions the self-employed can make. It determines how an operation looks to clients and influences whether, and how, the business grows.
Anyone who works for themselves is, by default, a sole trader - or if they are working with others, a partner, unless they form a company. In the UK, there are no legal formalities for sole traders or sole proprietors, although anyone who trades in their own right is obliged to tell the Inland Revenue and the Contributions Agency.
As a sole trader the business is yours and yours alone, as are the profits. But if there are losses they are yours too.
The banks' literature for small businesses suggests that people setting up on their own start as sole traders. This status has advantages, especially for freelances who sell their skills: it is easy to run, with no time- consuming and costly record-filing requirements. "Sole trader status is the simplest way of running a business, and is preferable for a lot of people," says David Williams, head of tax at Wingrave Yeats, the London accountants .
The other choices are a partnership or a limited company. In some professions, such as law and accountancy, partnerships are compulsory. But for most self-employed people, they offer little more than sole trader status, with the disadvantage that a partner is liable for any debts other partners run up.
The "limited" in limited company means limited liability, and one of the most convincing arguments for incorporation is the protection it offers should the worst happen. A company is an independent body in law; a sole trader's business and personal affairs are legally (and in the eyes of a creditor or litigation-happy customer) one and the same.
For businesses with some risk, from builders to computer consultants, limited liability makes sense. "As a sole trader, if anything goes wrong you will be sued in your own name, and any assets you have could be available to a creditor," says Helen Lusby, a partner at George Davies and Co, a Manchester law firm .
"People go down the limited company route because they believe it offers them a degree of protection. Any action is against the company, rather than you."
Forming a limited company is easy. There is no need to use an accountant or lawyer, most of the paperwork can be done in a few hours at Companies House, and buying a ready-made company costs less than pounds 200. The law now allows companies with one sole director.
Companies have to submit accounts to Companies House every year, but firms with a turnover of less than pounds 90,000 need not have an accountant prepare the books.
Limited companies have some tax advantages, but professional advice is vital to exploit them. In a good year, directors can leave money in a company and draw it - and pay less tax - when times are harder. You might be able to reduce your tax bill by putting a lower-taxed spouse on the payroll.
Directors can save on National Insurance by taking part of their pay as dividends, and companies can make better pension deals. But the administrative burden includes PAYE and employers' NI contributions; the paperwork might outweigh the advantages. In some sectors forming a company is standard practice. Freelances working for agencies will need a limited company to avoid being taxed at source.
There is a certain cachet to limited status. "If you are a limited company with just one or two people, you can present a corporate identity. Commercially, it can help to swing things," suggests Mr Williams.
People who start companies often say they do so because they want their business to be more than the sum of its directors. Sole traders say they do not want to dilute the personal link between them and their work (see the case study above). The deciding factor may be whether a business wants to hire staff to share the work.
q Next week: Do you need a special business bank account? The pros and cons of VAT registration will be covered with tax in a later piece.
The mark of independence
Eddie Semaine runs The Brand IT Co from his home in Burnley, Lancashire. The business, which he set up two years ago, marks high-value equipment such as computers with the owner's postcode. The marks are almost impossible to remove, making the goods worth far less to a thief.
Mr Semaine considered a limited company, but opted to stay a sole trader. The reasons are partly personal. Mr Semaine suffered a number of heart attacks before moving to the North. By keeping the business small, he feels he can work without endangering his health.
"A limited company would have meant a lot of work from my point of view," Mr Semaine says. "I would have needed somebody to handle that side. As we are at the moment, we do our jobs, enter it into a book and our book- keeper takes it to the accountant."
It is flexible, too. "If you want to go ahead with something, you have to discuss it in a company. Here, it is my own responsibility."
If Mr Semaine did want to expand the business, he would do so by franchising. A limited company, he concedes, would protect the name of the business, but he has no desire to employ staff. "At the end of the day, you are as good as your worst man," he says.Reuse content