Limited company or sole trader – which is best?

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Choosing a suitable business structure for you and your company can be challenging, especially if you are starting a new business. Each has its own set of legal, tax, and liability considerations when deciding whether to operate your firm as a sole trader or a limited company – but what is the difference between them?

There is no one-size-fits-all solution and adopting the best business structure should be determined by the type of business you are running, your financial goals, and what sort of clients and business relationships you looking to attract.

In this blog, we examine the benefits and drawbacks of running your business as either a sole trader or as a limited company. We recommend that you seek additional professional advice before making a final decision. The list below is not exhaustive.

The legal differences between a Sole Trader and a Limited Company

Sole Trader/PartnershipLimited Company
You are the business and get to retain all of your profits (after-tax).

You are personally liable for any business debt.
Should you incur any losses, your assets, like your car or house, may need to be sold to clear your debts.
The business (Ltd Co) is a separate legal entity. The liability is ‘Limited’ to the Capital invested by you as the shareholder.
 
This is a more complex route and requires more paperwork. Legal separation can be both an advantage and a disadvantage.
Any risks can be mitigated (though may not be completely removed) through Public Liability Insurance.Although it is extremely rare for the Director of the Limited Company to be personally liable, there are exceptions:

Fraudulent Trading (a court may declare that the directors or others who were knowingly parties to the fraud are liable for some or all the debts and other liabilities)

Wrongful Trading (trading whilst in the knowledge the company cannot meet its debts).
 
Those who fail to comply with even one of these obligations may face fines or prison time.
All your financial information is kept private, meaning your finances aren’t available in the  public domain, which many entrepreneurs prefer.Limited companies must register with Companies House.
 
Several sections of your accounts are published on Companies House and can be viewed by anybody, including your company’s registered address.

Accounting & Tax Implications – The taxes you pay on earnings

Sole Trader/PartnershipLimited Company
Tax Return:
 
You are legally required to submit a year-end self-assessment tax return.  The tax year runs from 6th April to 5th April the following year.  You are required to pay your taxes on 31st January the following year.  
Tax Return:
 
You are legally required to submit a year-end self-assessment tax return.  The tax year runs from 6th April to 5th April the following year. You are required to pay your taxes on 31st January the following year.  
Extracting Profits from Business

 
Income Tax:
You pay an income tax of 20% if you are a basic rate taxpayer (earnings £12,571 – £50,270)

40% if you are a high-rate taxpayer (£50,271 – £150,000). 

 
NIC:
 
Class 2 if your profits are £6,515 or more a year

Class 4 if your profits are £9,569 or more a year
 
Class 2 (currently at £3.05 per week)

Class 4 (9% on profits between £9,569 and
£50,270; 2% on profits over £50,270)

 
National Insurance on the taxable profits of the business.

You usually pay 2 types of National Insurance if you are self-employed.
Extracting Profits from Business
 
You can take profits from the business in 2 ways,

1. Dividends
When taking out funds through dividends you will need to pay both corporation tax and dividend tax.
 
1a. Corporation Tax
Corporation Tax on taxable profits. This is much lower than Income Tax rates. The current corporation tax rate for small companies is 19%.
 
1b. Dividend Tax:
Once corporation tax has been paid, the remaining profits can be extracted as dividends.  These incur additional personal taxes depending on the individuals’ financial circumstances.

You can carry out tax planning here to help reduce overall tax – See our blog on dividends v’ salary.
 
2. Salary
Where funds are extracted through salaries these attract:
* Income Tax
* Employee & Employer National Insurance Contributions of 13.8%

What does this mean in financial terms?

Example 1

Sole Trader

You make £10,000 of profit

Profit from self-employment  £10,000

Less: Personal allowance: £10,000

Income subject to tax: £0

Income tax at 20% (Basic rate): £0

Class 2 NIC at 3.05 per week: £158.6

Class 4 NIC: £39

Total taxes and NI Payable: £197.48

Limited Company

You make £10,000 of profit

Salary from company: £8,788

Profit Before Tax (PBT): £1,212

Corporation Tax (CT): £230.28

Profit After Tax (PAT): £982

Example 2

Sole Trader

You make £50,000 of profits

Less Personal Allowance: £12,570

Income subject to tax     : £37,430

Income tax at 20% (Basic rate): £7486

Class 2 NIC at 3.05 per week: £158.60

Class 4 NIC: £3638.88

Total taxes and NI Payable: £11,283.48

Limited Company

You make £50,000 of profits

Salary from company: £ 8,788

PBT : £41,212

CT: £7830.28

PAT: £33,382

Taxable income Non-savings

Dividends         

Salary from Co:                £8,788  

Dividends                             £33,382

Taxable income:               £8,788               £33,382

PA:                                      -£8,788             -£3782

Taxable income:               £0                      £29,600

Dividend NRB: £2000 @ 0 %                       £0

Dividends at 7.5%             £27600             £2070

As you can see that the overall tax savings depend on the amount of money you expect to make.

Other differences to consider

Sole TraderLimited Company
Making a loss
Can be offset against Personal Income.
 
If you have other earnings and expect to make significant losses in the initial year of trading, it may be more tax-efficient to start up as a Sole Trader first.
Can only be offset against Company profits.
 
Since the Company and you are separate entities, any losses incurred in the company can be offset against income from the Company.
AuditNot required to have one.A Limited Company will be audited if any of two of three conditions apply:
 
• Annual Turnover of more than £10.2 million
• Assets worth no more than £5.1 million
• 50 or fewer employees on average
PerceptionViewed as a small business
 
May be difficult to secure contracts as larger organisations are less willing to work with SMEs with one member of staff.
 
You may not have the legal protection that a limited company provides. You should avoid large loans or other risky business commitments as all liability rests with you. 
Gives the impression of a more trustworthy or larger organisation.
 
A Limited Company has more credibility than a Sole Trader in managing bigger contracts and client demands. 

If your work entails dealing with high-risk environments (i.e security or sensitive data), then a limited company is the best business structure as it provides you with limited liability protection if anything goes wrong.
BorrowingThe sole trader will borrow on their own name.  Banks will lend based on the credit history or the financial situation of the sole trader. 

May struggle to find an appropriate lender to borrow the money from.
This is because sole traders are perceived as ‘high risk’, and many lenders will refuse to lend on the basis of bank statements alone.
The company can borrow its own name
 
Bank can usually take security by means of a ‘fixed or floating charge’ over the assets of the Limited Company.
PensionYou can have your own Personal PensionYou have the option of having a personal pension or joining a company scheme.
Passing awayWhen a sole trader passes away, the business essentially dies with them because their business and personal money are combined.
 
Anything owned becomes part of their estate which will be handled through a will or inheritance.
The business lives on.
 
The company is a separate legal entity and can continue to operate after the death of the owner.
 
The company shares become part of the estate.

Making the leap from a sole trader to a limited company

Many small business owners and self-employed people begin as sole traders because it is the simplest business structure to set up. It is possible to move from being a sole trader to a limited company at any time.

There are many reasons to transform your business into a limited company. They are:

  • Your profits are growing, and you want to reduce your taxes.
  • You need to raise capital.
  • You want to improve your company’s image among current and potential customers.

Conclusion

The main distinction between sole traders and limited firms is the ‘liability’ element. Limited companies have a limited liability company structure, which means they are divided into equal ownership shares. On the other hand, Sole traders are the sole owners and operators of their business. As the single company director, a sole trader is individually responsible for the firm’s choices.

If you need help deciding whether to operate as a sole trader or a limited company and dealing with the associated Corporation and Income taxes, then we can provide you with a dedicated team of accountants who can help you with your monthly bookkeeping and accounting needs. We will assist you with precisely documenting the revenue generated by your company, ensuring that you comply with HMRC and Companies House regulations.  Contact us to find out more.