When you decide to run a business you must decide on a business structure, whether that be self-employed as a sole trader, or setup as a limited company. Each structure has its advantages and disadvantages, and it is important to understand and consider these so you can choose which business structure suits your needs most.
We’re going to cover the main differences between starting a business as a sole trader compared to a limited company, in terms of liability, tax, credibility and a few other aspects that could affect your decision.
What is a sole trader?
Basically, if you are self-employed and are the sole owner of your business where you are liable for all its costs, you are classed as a sole trader.
Check out our article What Is A Sole Trader? to find out more.
What is a Limited Company?
A limited company is a type of business structure that has its own legal identity, it is legally separate from the people who run it, and has separate finances from your personal ones. The ownership of a limited company is divided into equal parts called shares, and whoever owns one or more of these is called a shareholder. You can run a limited company on your own, or with others.
To set up a private limited company you must first register with Companies House. You must then register for Corporation Tax within 3 months of starting to do business.
The biggest differences and probably the most important aspects to consider when choosing which business structure to go with, is liability and tax.
Sole Trader vs Limited Company: Liability
Sole traders have unlimited liability. This means that they aren’t viewed as a separate entity by law and therefore are personally liable financially for the business debts. Sole traders are often exposed to the loss of personal assets if things turn bad.
Unlike a sole trader, a limited company has the benefit of limited liability. This is because there is a legal distinction between the business owner, and the business itself. This means that personal assets aren’t exposed, and you only stand to lose what you have put into the company.
Sole Trader vs Limited Company: Tax
Tax is another important factor to consider when you decide which business structure is best and it is often down to the amount of income your business generates.
As a sole trader you must pay tax on all profits over your personal allowance. For most taxpayers the personal allowance is £11,500 for the 2017/18 tax year.
Once above this threshold tax is paid at the rate of:
- Basic rate – 20% up to £45,000 income
- Higher rate – 40% over £45,000 income (£43,000 in scotland)
- Additional rate – 45% over £150,000 income
As well as tax, as a sole trader you will also have to pay Class 2 & 4 National Insurance.
A limited company however, pays corporation tax on profits at a flat rate of 19%.
There will also be personal income tax to be paid through PAYE and NICs on the earnings from employment.
In order to be as tax efficient as possible you can withdraw a small salary from the company within the personal allowance, but not above the point at which national insurance becomes payable. This salary would be an allowable business cost for corporation tax so 19% corporation tax is saved on the gross salary.
The remainder of the withdrawals would be in the form of dividends, which are paid out of post-tax profits and are not deductible expenses for corporation tax, however there is no NICs to pay on it as dividends are taxed separately.
In the 2017/18 tax year dividends are taxed at 7.5% in the basic rate of tax, with rates of 32.5% & 38.1% in higher and additional rates respectively.
The first £5,000 of dividends that would otherwise be taxable at the above rates are currently subject to a tax free allowance (called the ‘dividend allowance’).
There is no requirement for the owner to withdraw all profits from the business if they do not want to, and it can prove tax efficient to leave some profits retained in the company for extraction at a later date or to re-invest in the company (e.g. to invest in equipment or staff).
You best option, will depend on how much your business makes. Generally speaking once a business starts to make £20,000 then company tax rates work out lower than paying Income Tax.
Sole Trader vs Limited Company: Other Factors
Although most people will make their choice based on liability and tax, there are other factors that should be considered.
Most people would agree that being a limited company adds credibility and a professional image to your business.
This can be important when looking for funding or when looking to work with larger companies as they prefer to deal only with limited companies rather than sole traders.
Operating as a sole trader is much simpler than operating as a limited company, as limited companies have more complex accounting and taxation requirements.
Setting up as a sole trader is a very simple process. All you need to do is inform HMRC of your intention to go self employed, you can start trading right away. Limited company directors, on the other hand, have to deal with more paperwork, and have various legal and statutory obligations. Limited companies are regulated by Companies House, and directors are ultimately responsible for providing accurate and timely accounts on an annual basis, even if your accountant does the actual work.
Once you’ve registered a company name nobody else can use it, and it is protected by law. Sole traders aren’t offered the same protection and someone else can trade under your name, damaging your business.
Sole traders have greater privacy than incorporated businesses, whose details can be found via Companies House. Limited Company information is disclosed on public record, including details of directors, owners and people with significant control (PSCs).
As you can see, choosing between a sole trader or a limited company involves several important factors to be considered.
Overall, trading as a limited company can offer tax advantages after you reach a certain income. However every business is different and certain factors surrounding credibility and flexibility might matter more.