1. Key factors to consider

1.1. Consider the level of personal risk you are prepared to take on.

If you set up as a sole trader or as a partnership you will be personally liable for the debts of the business (see section 2 and section 3).

A limited company or limited liability partnership offers some protection against liability for business debts (see section 4 and section 5).

1.2. Consider how much record-keeping you want to do.

The administrative burden is far greater for a limited company than for a sole trader or partnership. The government is currently considering simplifying these rules, but no change has been made as yet.

1.3. Think carefully about the tax implications of the business form you choose.

If you set up a limited company you will be taxed as an employee, whereas as a sole trader or partnership you will typically be treated as self-employed.

The right choice will depend on your circumstances. For many people total tax and National Insurance may be lower if they are self-employed. But high-earners might get tax advantages from retaining profits in a limited company or making pension payments.

Consult your accountant or tax adviser.

It's generally not a good idea to choose your form of business for tax reasons alone.

1.4. Think about how you want your business to be perceived.

Potential clients, suppliers or investors may see a limited company as more credible. Sole traders - although they can employ people - tend to be perceived as one-man bands.

Forming a limited company or limited liability partnership will allow competitors to find out more about you. Accounts must be filed with Companies House and are made publicly available.

1.5. Consider how you plan to develop the business in future.

It is possible to change company form, but it is still a good idea to plan for the future.

If you will be seeking to raise finance from a bank or investor to develop the business, your options will be more restricted if you act as a sole trader rather than forming a limited company.

You will need to set up a limited company if you want to sell or pass on shares in the business. This also allows you to give employees the chance to own shares in the business.

2. Becoming a sole trader

2.1. Setting up as a sole trader is the easiest way to start a business.

The administrative burden is far lower than that necessary to set up a limited company. You keep simple, unaudited accounts recording your business's income and outgoings.

You can form a limited company later and transfer the business to it, though some stamp duty may have to be paid.

Despite the name, a sole trader can employ people.

2.2. You are generally taxed as self-employed if you become a sole trader.

Income tax will be payable on any profits. The amount you can be taxed will vary.

National Insurance contributions are usually lower as a sole trader. However, you will be entitled to fewer social security benefits.

If you are self-employed you must register with HM Revenue & Customs within three months of starting up.

Contact the HM Revenue & Customs Helpline for the Newly Self-Employed on 08459 154515.

2.3. Remember that you are personally liable for any debts incurred by the business.

There is no limit to the extent of a sole trader's liability. Your possessions - including your home - can be at risk if you fail to pay your debts.

3. Forming a partnership

3.1. A partnership is a business set up by two or more people, which allows you to share profits, management responsibilities and risks.

As a member of a partnership you will be personally or jointly liable for any debts incurred. This means that if another partner is unable to pay, you become liable for their share of the debts.

Your possessions - including your home - can be at risk if you fail to pay your debts.

You may be able to raise money by introducing new partners.

Remember that one partner can enter into binding business contracts without the consent of the other partners.

3.2. Members of a partnership are generally taxed as self-employed.

Income tax will be payable on any profits. The amount you can be taxed will vary.

National Insurance contributions are usually lower as a member of a partnership than as an employee of a limited company. However, you will be entitled to fewer social security benefits.

If you are self-employed you must register with HM Revenue & Customs within three months of starting up.

Contact the HM Revenue & Customs Helpline for the Newly Self-Employed on 08459 154515.

3.3. Draw up a comprehensive partnership agreement - this is essential to avoid disputes.

It's a good idea to get a solicitor or professional adviser to draw up a suitable agreement.

A partnership agreement should include the names of the partners, the name of the business and what the business does.

State the date the partnership starts and how long it will last if it isn't a permanent arrangement.

Set out how much capital each partner will contribute.

State how profits and losses will be shared and how much money each partner can draw from the business.

Clarify how the business will be run. For example, how much time each partner is to put into the business, how much each partner will invest, what their responsibilities will be, how much money can be withdrawn from the business and how fast you want the business to grow.

Set out details of holiday entitlements.

Explain what will happen if partners die, become ill, want to retire or reduce their involvement. Set out what the arrangements will be for introducing new partners.

4. Setting up a limited company

4.1. Setting up a limited company can reduce the risk of personal financial loss.

Personal risk is generally limited to how much you invest in the business and any personal guarantees given to obtain finance (such as bank loans).

If the business goes into liquidation owing money, any outstanding creditors are paid with money from the sale of the company's assets. Company debts should not affect directors' personal credit ratings.

However, in some circumstances personal liability can still arise. For example, by giving personal guarantees on company borrowings or if it can be shown that a director has traded wrongfully, fraudulently or without due care.

4.2. Your company must pay corporation tax on its profits and you will be taxed as an employee.

Company directors pay income tax on salaries and benefits through PAYE in the same way as any other employee.

National Insurance payments are higher than for a sole trader or partnership. You have to pay employer's as well as employees' National Insurance contributions on salaries (including those of directors).

For more information on corporation tax and PAYE, see Get to grips with tax and VAT.

4.3. You must register your limited company with Companies House before you can begin trading.

You must draw up a memorandum of association and articles of association. These set out what the company and its directors and shareholders can and cannot do and where it will be based. Forms for these documents are available from legal stationers.

The memorandum and articles must be sent to Companies House along with standard forms 10 and 12.

You must nominate at least one director of the company and a company secretary, who can be a second director (but does not have to be). The same person cannot act as both sole director and company secretary. From April 2008, you will not be required to appoint a company secretary, but you may do so if you wish. It will also be possible for a director to hold both roles.

Company registration costs £20, or you can pay an additional fee for a same-day process.

Visit www.companieshouse.gov.uk/about/gbhtml/gbf1.shtml to read more about forming a company and the memorandum and articles of association.

Visit www.companieshouse.gov.uk/forms/formsOnline.shtml to download forms 10 and 12 (PDF).

4.4. Consider getting help with registering your company.

You can complete the process yourself to save money on professional fees, but this can be complex.

A solicitor, accountant or company formation agent could help you ensure you get it right first time.

You can speed up the process by buying a ready-made company from a solicitor or formation agent for a fee. A reputable agent may be able to incorporate a company on the same day for a fee.

Companies House provides a range of guidance on forming a limited company. Contact 0870 333 3636 or visit www.companieshouse.gov.uk/about/guidance.shtml

4.5. You will also have greater administrative costs and obligations once your company is operating.

You must submit annual accounts and tax returns to HM Revenue and Customs.

A set of accounts should also be submitted yearly to Companies House.

You must also submit an annual return to Companies House containing various details of the company and its directors.

You risk a fine if you miss deadlines or submit incorrect information.

Small companies with a turnover of less than £5.6 million do not usually need to have their accounts fully audited. Those turning over between £5.6 million and £22.8 million do not generally need a full audit, but still require a report from a qualified accountant. If you are claiming the small companies audit exemption, you are not required to appoint an auditor.

You will need to set up a payroll and register as an employer with HM Revenue & Customs.

If you decide to cease trading, it can be more difficult and expensive to wind up a limited company.

For more information on setting up a payroll, see Get to grips with tax and VAT.

Companies House provides a range of guidance on running a limited company. Contact 0870 333 3636 or visit www.companieshouse.gov.uk/about/guidance.shtml

5. Limited liability partnership

5.1. A limited liability partnership (LLP) is a way of forming a partnership while limiting your personal liability for business debts.

An LLP has the organisational flexibility of a partnership. Members share management responsibilities and you may be able to introduce new members to raise money.

Each member's liability is limited to any personal guarantees they have made to secure finance and any money they have personally invested.

Any withdrawals of capital from the business can be clawed back if the partnership is declared insolvent within two years of the withdrawal.

5.2. Bear in mind that forming an LLP is more expensive and complicated than setting up a partnership.

You must register with Companies House, which costs £95.

You have to complete and return form LLP2 to Companies House.

Visit www.companieshouse.gov.uk/about/gbhtml/gbllp1.shtml for more information on forming a limited liability partnership.

Visit www.companieshouse.gov.uk/forms/formsOnline.shtml to download form LLP2 (PDF).

5.3. Members of an LLP are generally taxed as self-employed.

Income tax will be payable on any profits, whether or not they are distributed to members.

National Insurance contributions are usually lower as a member of an LLP than as an employee of a limited company. However, you will be entitled to fewer social security benefits.

Self-employed members of an LLP must register as self-employed with HM Revenue & Customs within three months of starting up.

Contact the HM Revenue & Customs Helpline for the Newly Self-Employed on 08459 154515.

5.4. You must comply with a range of administrative requirements similar to those faced by limited companies.

Annual accounts must be prepared and filed with Companies House to be made publicly available.

You must also submit an annual return giving details of the LLP and its members.

There is also a requirement to have your accounts externally audited. However, those with a turnover of less than £5.6 million and a balance sheet total of less than £2.8 million are usually exempt. If you are claiming the small companies audit exemption, you are not required to appoint an auditor

Visit www.companieshouse.gov.uk/about/gbhtml/gbllp2.shtml to read more about the administration and management of LLPs.

5.5. Draw up a partnership agreement if you are setting up an LLP.

The partnership agreement is confidential to members.

It's a good idea to get help from a solicitor.

See section 3.3 for more information on partnership agreements.

6. Choosing a name

6.1. As a sole trader or partnership you can trade under your own name (or names) or choose a different business name.

The name you choose must not include the words limited, plc or equivalent.

You might want to check that another local business is not using the same name. Check the Internet and local phone directories. You can also search on Companies House to ensure it is not a name registered by a company or limited liability partnership.

Visit www.companieshouse.gov.uk/about/gbhtml/gbf3.shtml for more information on business names.

6.2. The name of a limited company or limited liability partnership must be registered with Companies House.

Make sure the name you want to use, or one similar to it, isn't being used by another business in a similar line by checking on the Companies House index of company and LLP names. Remember that this will not include names of sole traders or partnerships.

All company names must end with the words 'Limited', 'Unlimited', 'Public Limited Company' or their abbreviations.

Limited liability partnerships must have Limited liability partnership or LLP in their names.

Check the Companies House database of company and LLP names.

Visit www.companieshouse.gov.uk/about/gbhtml/gbf2.shtml for more information on company names.

6.3. You must not choose a name which is misleading or offensive.

The use of certain words - such as 'Royal', 'British', 'Institute' and 'Bank' - is restricted by law.

Visit www.companieshouse.gov.uk/about/gbhtml/gbf3.shtml for details of restricted words.

6.4. Check you are not infringing any trade marks with the name you use.

Contact the UK Intellectual Property Office for information on trade marks on 08459 500505

6.5. Check that the business name you want is also available as a website address.

Even if you do not intend to set up a website now you might want to do so in future.

Nominet is the official registry for .uk domain names. It provides advice on registering and maintaining your domain name.

Visit www.nominet.org.uk for more information on domain names.