Money Q & A: How do I ensure that two really is company?

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I am hoping to set up a small website business with a friend. I live in London and he lives in Scotland. Should we set up as a partnership or a limited company?

BT, LONDON

The short answer is that you should get advice from a bank or accountant. Your decision will depend on a variety of factors. If you opt to become a partnership, the tax position is akin to being a sole trader, although you will have to fill in one partnership tax return as well as your own individual tax returns. Although the legal position of a partnership is different from being a sole trader, in practice you may not notice much difference. For example, partnerships and sole traders have the same unlimited liability, whereas if a limited company gets into financial trouble only the assets of the company are at risk, not your personal assets.

The key factor could be whether you expect to generate a lot of profits. If you set up a limited company, you will become employees of that company. You can then decide your own salary and any dividends to be paid out on your shares.

Any profits you make that you keep within the company will be subject to corporation tax, currently 21 per cent and falling to 20 per cent next April on companies making profits of pounds 300,000 or less.

This could mean less tax to pay than if you paid out all the money in the form of salaries or dividends.

On the other hand, National Insurance contributions will be higher because you will have to pay both employer's and employees' contributions. But you will get better benefits than from being a sole trader or partner. You will become entitled to unemployment benefit and, perhaps more importantly, you will build up entitlement to Serps - the state earnings-related pension. And, as a limited company, you will be able to establish an employer's pension scheme, which will effectively allow you to pay in more by way of pension contributions than if you were a partnership.

However, if you are unlikely to have enough spare cash to pay even the maximum limits for a personal pension, this may be only a theoretical benefit.

You will have to take account of the extra costs of a limited company, for example the legal setting up of the company and meeting the various requirements such as an annual audit of the accounts.

This really is only a flavour of some of the issues. Do get advice. A useful introduction is found in NatWest Bank's The Business Start-up Guide, free from NatWest branches.

EAR today

I have seen an advertisement for a current account that quotes a monthly interest rate on authorised overdrafts and then expresses the monthly rate as an "EAR". The EAR, presumably an annualised rate, is inevitably higher than the monthly rate multiplied by 12. But how does this EAR differ from the APR?

ML, LIVERPOOL

Are you familiar with the concept of CAR, "the compound annual rate" of interest on savings accounts? If the account pays 8 per cent a year and interest is added to the account just once a year, the annual rate you receive is 8 per cent. But if interest is paid every six months, you get 4 per cent twice a year. The second payment will include some interest on the interest paid after the first six months. This pushes up the overall amount of interest you receive; in this case the CAR would be 8.16 per cent.

An EAR works along the same lines and is used to show the interest rate on borrowing. If interest is debited monthly and you don't pay off an overdraft you'll be charged interest on interest. The cost of borrowing is expressed as an EAR - effective annual rate. The EAR is commonly used to express the rate of interest on current account overdrafts.

By contrast, an APR - annual percentage rate - takes account of all the unavoidable costs of borrowing. It is only a very rough guide and has received much criticism.

However, the EAR is potentially even more misleading. Current accounts often carry monthly fees. If these are factored in to produce an APR the APR can be considerably higher than the EAR, especially on small overdrafts. Treat both the APR and the EAR with some caution.

Write to the personal finance editor, Independent on Sunday, 1 Canada Square, Canary Wharf, London E14 5DL, and include a phone number; or fax 0171-293 2096; or e-mail i.berwick@independent.co.uk

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