Sole Trader vs Limited Company?

We often get enquiries from people setting up their own business about whether they should list their business status as a sole trader or as a limited company.  What gives the best protection and offers the best in terms of taxes?

First, let’s establish the facts!

What is a sole trader?

You are the business, owner, manager or proprietor. In essence you are a self-employed person who is the sole owner of the business. It is the simplest business structure available and is probably why it’s the most popular.  You can set this up via the gov.uk website.

Setting up as a sole trader is easy and involves little paperwork.

If a legal dispute arises you can be sued personally unless you have relevant insurance in place such as professional indemnity or products and services liability.

In UK Law a sole trader is not viewed as a separate entity by UK law and so he or she has unlimited liability.  This means that if something goes wrong you can be sued and if the business gets into debt you are personally liable and could be made bankrupt. This also means that your personal assets such as house and car are not protected.

If you are running the business with another person you can run the company as a partnership, a Limited Liability Partnership (LLP). This can offer some protection from personal liability.

Raising finance can be harder for sole traders as banks and investors prefer limited companies and this can limit growth plans.

Sole traders enjoy greater privacy than incorporated businesses.

You can offset trading losses against your other income.

There is a cap on the amount of relief that you may claim for losses and interest payments.

You can withdraw tax from the business without tax effect.

You can only have a Personal Pension.

You can borrow from the business bank account.

If your business bank goes into an overdraft due to the amount of funds that you have withdrawn as an individual, then interest and tax relief on bank charges will be proportionately restricted.

You will pay Class 2 and 4 National Insurance and Income Tax on the taxable profits from your business or your share of profits in a partnership. The amount of tax you pay will depend on your income.  For a sole trader, the amount that can be made before paying income tax (personal allowance) is £11,500. In the last tax year (2017/18) the basic rate of 20% on income was liable on income up to £33,500, then the higher rate of 40% on income between £33,501 and £150,000 and the Additional rate of 45% on income over £150,000.

Sole traders can set their losses off against other income in the same tax year, carried back to previous years or carried forward against future income.

Sole traders are not legally required to maintain or file annual accounts, but they must still record their expenses and income for completing tax returns via the self-assessment tax return system each year by 31 January.

What is a limited company?

A limited company is its own legal identity which is separate from its owners (shareholders) and its managers (directors).  Even if the business is owned and run by just one person a business can still be a limited company. A shareholder’s liability is limited hence the name – limited by shares.

This means that personal assets cannot be touched, the owner/director only stands to lose what they put into the company.

Generally, unless there is proof of fraud, corporate manslaughter and a few other circumstances a company director cannot easily be held personally accountable for the actions of the business.

Tax rates are kinder for limited companies.

Losses can only be carried forward and set against future profits or set against the previous year’s profits.

A limited company is required to prepare annual accounts (statutory accounts) from the company’s records at the end of each financial year. These are filed with HMRC as part of the company tax return and should be sent to the shareholders and Companies House.  They must also file a Confirmation Statement with Companies House, which includes information about the directors, shareholders and the registered office.

As your business grows and you start employing people the benefit of separate legal liability increases.

There is more prestige involved in running a business as a limited company.  An incorporated company doesn’t necessarily guarantee reliability, but it gives the impression that you are a bigger operation and seem more credible.  Banks and investors prefer limited companies to sole traders. Contractors and agencies in some sectors prefer to work with limited companies rather than sole traders because of the legal protection that limited companies provide.

In a limited company, tax is deducted from directors’ salaries via Pay As You Earn (PAYE) and paid regularly to HMRC.  All directors are also required to complete and file tax returns unless they have not received any pay or benefits; regardless of whether any tax is owed. Directors of a company are also shareholders and they can receive dividends (shares of profits) from the company. Tax is payable on dividends and we can advise further on this.

Irrespective of the size of a limited company corporation tax corporation tax is charged each year at a rate of 20% or 21% (depending on profits and ring fencing) and is payable nine months after year end.  Company tax returns must be filed 12 months after year end.

In a limited company, both employer’s and employee’s National Insurance (NI) is payable on the salaries and bonuses earned by directors. The NI charge is greater than that paid by a sole trader, who pay Class 2 NI contributions of £2.85 per week and Class 4 contributions on profits in excess of £8,164 (rates as per 2017/18).

Basically, a limited company is more tax efficient than being a sole trader as you pay Corporation tax on profits rather than paying Income Tax as a sole trader. This is a more beneficial tax rate and means that limited companies can be more profitable.  Also, a limited company can claim for a wider range of allowance and tax-deductible costs against its profits.

A limited company can register a company name and no one else can then use it, whereas sole traders are not able to access the same protection.

Details on directors and company earnings are required to be publicly shown and this information is available on the Companies House website.  Depending on your personal and business circumstances this may be beneficial or not.

Being a limited company does create added responsibilities such as keeping accounts, sending information to Companies House, HMRC and a Director’s Fiduciary Responsibilities which includes filing the annual accounts and a yearly annual return.  This can involve costs and is time consuming, but we can help ease your burden.

Which should you choose?

There are advantages and disadvantages in being a sole trader and a limited company. They are completely different things and you will need to choose one as your business status.  We hope the above information has answered your questions but if you are still unsure please call us. We have worked with many start ups so we can use our experience and knowledge to help you to work out which status is best for you personally and your business. Call us now or email us to set up a time to chat.