Choosing between becoming a sole trader or limited company
When you start working for yourself, one of the first big decisions will be choosing between becoming a sole trader or limited company. Picking the right option for your personal circumstances and business objectives could save you a lot of time and money.
What is a sole trader?
Sole traders (also known as sole proprietorships) are the most common examples of self-employment, with 3.2 million people working for themselves at the start of 2022 (56% of UK private sector businesses).
The main reason is that it’s simple to get started. You can simply register with HMRC and begin working, including hiring staff and taking on premises. For legal and taxation purposes, you and your business are viewed as a single entity, which makes accounting easier, and all profits after tax are yours.
But it also means you’re also personally liable for any business losses or debts. And in addition to submitting a Self Assessment tax return each year, and registering for VAT if your turnover exceeds £85,000 per year, you’ll also be subject to the new Making Tax Digital for Income Tax Self-Assessment rules in the coming years. For more details, we have a dedicated guide on how to pay yourself as a sole trader
What is a limited company?
Setting up a limited company means that your business becomes a separate legal entity, with its own financial and legal reporting requirements. Whether you’re the sole director or not, it means you’ll have a limited liability for any losses and debts.
There are more regulations applied to limited companies, which mean you can’t just dip into business profits when you want to. And you’ll need to file more paperwork, including company accounts and corporation tax returns. This is before you also file your personal taxes and pay any amounts due on your individual income from both wages and dividends. You can find more information in our guide on how to pay yourself as a limited company director.
Advantages of a sole trader
Along with being quick and easy to set up, it’s easier to manage your own accounts when you’re operating as a sole trader. At the moment, there’s minimal paperwork beyond submitting your annual Self Assessment tax return. That will change over the coming years as Making Tax Digital (MTD) rolls out, but you’ll just need to use MTD-compliant software to provide quarterly updates.
Even with the new MTD regulations, it’s still easier to operate as a sole trader. There are less administrative requirements and costs. You don’t even need separate business and personal bank accounts (although differentiating incomings and outgoings is recommended). Plus, you’re entitled to all profits, making it simple to take money from your business as and when you need it.
Another benefit to operating as a sole trader is that you retain more privacy. Unlike a limited company, you don’t need to supply company accounts and confirmation statements to Companies House, which are then made available to the public.
When you’re just starting out, losses can be used to reduce other tax due in your first year, or relief against profit from the past, even from prior employment. It’s also possible to make use of Capital Gains Tax if you sell any business assets.
In summary, the main advantages of setting up as a sole trader are:
- Quick and easy to set up, and minimal paperwork
- Accounting can be simpler, and you’re entitled to any profits
- Privacy for your details and business accounts
- No corporate tax overheads
- Ability to use Capital Gains Tax allowances
Disadvantages of a limited company
It’s more difficult and time-consuming to meet the administrative and tax requirements of a limited company. This can often necessitate an accountant or other support on a regular basis, as you’ll need to file accounts to Companies House and HMRC, follow PAYE (Pay As You Earn) procedures, and also file a Confirmation Statement to Companies House each year.
If you’re issuing dividends, this requires a director’s meeting, and issuing a dividend voucher. And your company can’t pay out more in dividends than the available profits from current and previous financial years.
Even if you’re a sole director, you’ll still be classed as an employee which requires payroll to be reported to HMRC in real time. And you’ll obviously also have to file your personal tax returns in addition to the business. If you take any director’s loans, they will incur tax for you and potentially also your business.
Ongoing changes to tax rates mean that the tax savings from operating as a limited company are lower compared to working as a sole trader than in the past, so it’s worth speaking with an accountant or specialist financial advisor to check which option is best for your personal circumstances now, and in the future.
Whilst your personal financial risk might be more limited, you’re still legally responsible for the business. This includes safeguarding company assets and ceasing trading if you know the company can’t survive. This can lead to fines, prosecution and disqualification for up to 15 years. And can prevent you from certain occupations including working as a solicitor, barrister or accountant.
By submitting details of your business, including the names and addresses of directors, this information is available to the public via Companies House and other services. Your accounts will also be visible, allowing anyone to see if your company is doing well or struggling.
Operating as a limited company also makes it more likely that you can fall ‘inside IR35’, where you’re deemed to be working as a disguised employee by HMRC. Given the potential costs, it’s worth investing in IR35 Contract Reviews, with a discount available to IPSE members.
In summary, the main disadvantages of setting up as a limited company are:
- More tax and admin responsibilities and overheads
- Lower savings for smaller self-employed businesses than previously available
- Limitations on withdrawing profits as salary, dividends and director’s loans
- Legal responsibilities as a company director, including putting the business before personal interests
- Public records of business details and accounts
Looking for more advice? We can help.
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