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Sole Trader vs Limited Company – Our Analysis

Which is the better option for you?

You may be planning to set up your own business, or you may already be working as a sole-trader ( self-employed), and you’re in the process of looking into whether using a limited company instead would be a better option. Our guide takes a dive into the main considerations for both trading structures.

Let’s start by giving you a top-level overview, before we go into the detail.

What are the basic differences conducting business as a sole-trader vs a limited company?

  • As a sole-trader your ‘trade’ and ‘you’ are effectively the same legal entity, whereas setting up a limited company creates a separate legal entity. Your relationship with that company can be as a shareholder (you own some or all of the company), a director (you have certain legal responsibilities), and an employee (the company you own, can also employ you, but doesn’t have to).
  • As a director you do have certain prescribed legal responsibilities. In reality, as long as you are being diligent and lawful, you’ll find it hard, but not impossible, to come to any personal harm, whereas as a sole-trader you as an individual could be sued directly or personally incur debts resulting from your business activities. There is no other entity between you and the problem. This is the big difference.
  • In both scenarios you should be considering appropriate insurances to help reduce these risks.
  • A limited company gives off a more professional appearance. Potential customers may feel more comfortable dealing with ‘a company’, than ‘a sole-trader’, although in reality there is more comeback for the customer to the latter, as the former may decide simply to shut up shop, as often happens in the building trade.
  • It would seem sensible to use a limited company structure if you are employing people. If you’ve ever had experience of an employee trying to extract compensation for a work-based accident they blame you for, you’d think twice before employing someone through a sole-trader structure.
  • A limited company can have a slight tax advantage over a sole-trader structure.
  • There is another structure called a partnership, not considered here, which you should also ask your accountant about, but it is far less common, and if you are planning being the main shareholder/director, (maybe along with members of your family) you’ll most probably end up with a limited company structure.
  • We also note that with good software, and low-cost accounting services, the barriers to using what may have seemed more complicated arrangements, in other words a limited company, are effectively no more.

Useful link: Director’s responsibilities Companies House

Sole-trader vs Limited Company – the detail

Let’s look at the key differences one at a time, and then we’ll finish off by looking at how the take-home pay compares with each trading structure at the same levels of operating profit.

Legal differences

The business of a sole-trader, whether that be building work or graphic design, is in no way legally distinct from you as a private individual. This means that if you make an honest mistake, a building you are working on suffers some damage, or your graphic design work is delivered late and causes your client expensive cost overruns, you could personally be held liable. Now hopefully you will have used contracts and insurance to provide some, but do you really feel 100% confident in an insurance document or some legal wordings. Probably not.

A limited company is a free-standing legal entity, completely distinct from you. It as the building company, rather than you as the builder, who would generally be held responsible for a client’s building suffering damage, or in the case of a late delivery of a piece of graphic design work, the client would generally sue the limited company. We must stress that although it would be much harder for the client/creditor to sue you personally, it does happen. It is therefore essential you understand your responsibilities. Some areas where you can open yourself up to liability would be as follows:

  • Breach of duty as a director
  • Where you’ve made a personal financial guarantee
  • Where you’ve misrepresented the company
  • Where it is not clear that you are representing the company
  • Ignoring court orders
  • GDPR breach
  • Acting illegally when on company business
  • Acting outside the authority of the company
  • Trading when insolvent
  • Health and safety breach
  • Discrimination/harassment
  • Environmental damage
  • Manslaughter
  • Bribery

This is not meant to be a complete list, but it gives you a sense of what sort of behaviour a limited liability company structure wouldn’t necessarily keep you immune from. The general principle is that the risk to you is much lower than with a sole-trader structure, and particularly if you are careful to conduct yourself in a diligent lawful manner.

Your relationship with a limited company can manifest in the following ways: you own some or all of the shares, you are a company director, and you may also be an employee. As a shareholder you will be entitled to any income distributed as dividends – a share of the profits. You may also choose to employ yourself – you don’t have to – you could get someone else to do the work – just making the point, that owning a business and being employed by it are two totally different things.

Getting set up

Sole-trader set up

You don’t have to register as self-employed until the 5th of October in your business’s second tax year [but] you could be fined if you do not.’ [Source HMRC]. This will give you time to submit an online self-assessment by the 31st January. You may wish to register before this point ‘to prove you’re self-employed, for example to claim Tax-Free Childcare’ or ‘you want to make voluntary Class 2 National Insurance payments to help you qualify for benefits’. [Source HMRC]

You’ll only need to set up officially as a sole-trader if you’ve earned more than £1,000 in that tax year. Do bear in mind that even a small ebay habit might tip you, inadvertently, into the realms of a sole-trader.

The process is very straight forward and involves registering with HMRC for Self-Assessment as a sole-trader. Just follow the online forms.

Useful link: HMRC -  register for Self-Assessment as a sole-trader

Limited company set up

Setting up a limited company is a little more involved, but can be done very quickly, and you can do it yourself, with the required forms, or easier still, simply ask your accountant to do the paperwork on your behalf.

There are three ways to register your company with Company’s House: online using the forms provided, using an agent, using third-party software, and by post. If you choose to do it yourself it’s just £12 online and £40 by post. You can also register for corporation tax at the same time, but at the latest you should have done this within 3 months of starting to do business.

There are a number of steps you need to make before registering your company.

  1. Choose a name
  2. Choose directors and a company secretary (note, there are one director companies)
  3. Decide who the shareholders are
  4. Identify those individuals with significant control over your company (most probably yourself)
  5. Prepare the documents about how you run your company
  6. Understand what records you’ll now need to keep

And finally, you can now register.

We recommend conducting your own research into the above actions. Choosing a name, for example, is obviously important, and there are various rules you need to abide by, which will save you a lot of time and money in the long run.

The following link goes to the page where you can start this process. It also outlines what information you’ll need to have at hand to register your company.

Useful link: Register your limited company https://www.gov.uk/limited-company-formation/register-your-company

Business reporting requirements

Whether you are running a sole-trader enterprise or a limited company you are required to record your business activities and report on them. The main benefit of working as a sole-trader is that the reporting requirements are not quite as heavy as with a limited company. Saying this, we do feel that with the aid of a low-cost accountant, and/or an inexpensive accounting software package, like Xero or FreeAgent, that limited company reporting isn’t necessarily that onerous.

Sole-trader - reporting requirements

Keeping records

Every year you are required to submit a Self-Assessment tax return by the 31st January, for the previous financial year, ending on the 5th April. You are also required by this time to pay your tax and national insurance. If you have registered for VAT you will be required to make quarterly submissions.

In order to do these two things you will need to keep a record of all your transactions, and in fact it would be prudent to know how much tax, VAT and National Insurance you owe at any one time, to avoid not having it put aside for when you need to pay it. It’s all too easy to be taken by surprise by a larger than expected tax bill, but it is entirely avoidable.

You will need to keep record of all invoices issued, invoices paid, and expenses invoiced for and paid.

We thoroughly recommend having a separate business bank account. Otherwise it is all too easy to get your personal and business money muddled. There are some straight forward inexpensive accounting packages that can manage all this record keeping, linking up with your business bank account, allowing for easy reconciliation of invoices to payments, and issuing of invoices. Some of the packages will deal with your VAT submission, and run your Self-Assessment calculation and even submit this information to HMRC.

We particularly like GoSimpleTax as it allows you to track income and receipts, and then calculates your self-assessment and even submits the information directly to HMRC. It’s very simple, and pretty inexpensive at £46 per year. Not bad for your total accounting overhead.

If you decide to register for VAT, you’ll have to submit a quarterly VAT return. You will have to register if your trading income is above £85,000.

To run any business, you will incur certain expenses which are entirely proper to pay before calculating any tax. The expenses you can claim for are broadly as follows:

  • Materials or equipment that you sell
  • Employee salaries
  • Certain travel costs
  • Business rates on rent, water, light, heat, insurance and security
  • Office equipment (Computer, stationary and phones)
  • Advertising
  • Interest on bank loans
  • Training/professional subscriptions

Useful link: Our Guide to Self-employed expenses you can claim.

Limited Company reporting requirements

When you’re running a limited company there are more documents that you’ll need to submit to be financially compliant.

As a director, you personally will have to submit your own Self-Assessment tax return by the 31st January every year for the previous tax year.

Then on behalf of the company you’ll need to submit the following information:

  • Annual accounts
  • Corporation tax return (otherwise known as CT600) which you’ll submit to HMRC
  • Confirmation statement
  • VAT returns (if you are registered for VAT this is)
  • Employer (PAYE) returns (including P11D, P14, P35 and P60)
  • Event-based filings to Companies House

When you register your company with Companies House you will be given a Tax Reference Date. This is the last day of the month in which you started your business. So register on the 10th December, and your company will have a Tax Reference Date of the 31st December.

As with the self-employed sector there are plenty of simple inexpensive accounting and bookkeeping software packages that will make managing this side of your business straight forward.

It’s worth highlighting that the annual set of accounts, and event-based filings that you submit to Companies House, will be accessible to anyone who wants to view them. This lack of privacy can be seen as a downside of being a limited company, but the information you submit to Companies House can be quite limited in extent.

If paperwork isn’t your thing, you can use an accountant for about £1,000 a year or less with one of the new low-cost accounting services (assuming your tax affairs are straight forward) which will probably be provided in conjunction with a simple software package. It’s not a scary as it sounds, particularly if you keep on top of your paperwork i.e. doing it once a month is always a good idea.

As with a sole-trader business there are a list of expenses which you can legitimately pay for through your business before calculating tax. It’s sadly worth pointing out that client entertaining is calculated post tax (nor can you claim the VAT back).

Useful link: HMRC lists them out in full on its website https://www.gov.uk/expenses-and-benefits-a-to-z

As with setting up any business you’ll also need to open a business bank account and take out appropriate insurance.

How much tax?

One of the attractions limited companies have over sole-trader businesses is that at a similar rate of operating profit (that is before you pay yourself in anyway), you can manage the way you extract money from the business with a combination of salary and dividends to pay less tax and National Insurance than through a sole-trader business. Over the past few years this tax difference has reduced, but for now it still exists.

The government’s response to the Covid crisis saw those who pay themselves via a mixture of salary and dividend being at a disadvantage against the self-employed – which was explained on logistical grounds, but no one really believed it was anything other than political.

Sole-trader tax

The basic principle here is that your profit is subject to standard personal tax rates and national insurance.  Your profit being your income, less allowable expenses.

The amount of income tax you then pay is exactly the same as if you were employed.

Rate 2020/21 and 2019/20
Personal allowance: 0% £0 to £12,500 you will pay zero income tax on your profits
Basic rate: 20% £12,501-£50,000 you will pay 20% tax on your profits
Higher rate: 40% £50,001-£150,000 you will pay 40% tax on your profits
Additional rate: 45% Over £150,000 you will pay 45% tax on your profits

[Source HMRC]

Self-employed National Insurance rates

Class 2 NICS are £3.05 per week. You pay if your profit is at least £6,475 in 2020/21. If then you earn between £9,501 and £50,000 you’ll then pay 9% of the profits in this band, and 2% of profits over £50,000.

You will either pay your tax and national insurance on or by the 31st January, for the previous tax year, but it is most likely you will be asked to pay your tax and class 4 National Insurance liability on account, based on your previous years total tax and class 4 National Insurance.

Making tax digital

One of the big changes that HMRC have been introducing is the mandatory ‘online’ reporting of tax information. At present a sole-trader only has to report VAT electronically, if it is registered for VAT that is. There is no requirement to report other tax information in this way just yet, although you should be prepared for this to happen from 2021/22 (as yet to be confirmed). When Making Tax Digital is confirmed, you will then be required to electronically submit regular financial reporting.

VAT

If your income is in excess of £85,000 you will need to register for VAT. This means you’ll need to start charging VAT on your work. This is something you’ll need to consider carefully. It you are selling to the public, slipping into VAT territory may put you at a disadvantage. You will of course be able to claim VAT back on certain supplies. Once you are registered for VAT you will then have to report VAT returns on a regular basis.

Tax for Limited companies

Sole-traders have to pay income tax, national insurance (and VAT if registered); Limited companies have to pay corporation tax, employer’s national insurance, (and VAT if registered). You as the owner and maybe employee of the business, in order to receive income, would potentially pay yourself a mixture of dividends (a share of profits, if you have any), and salary for your work. There is a schedule of personal tax to pay on dividends, and you will have to pay the correct level of employees national insurance on any salary.

As you can see, there are a lot more layers of tax before you can receive your financial reward for running your limited company; but strangely given these extra layers there is still a tax advantage to optimising the amount of salary vs dividends you take from the business. There are also a range of benefits you can receive as an employee.

VAT

If you’ve registered for VAT, which you’ll need to do if you are going to have an income in excess of £85,000, or because it makes sense for another reason, like the net impact of what you can claim back, or using the flat rate scheme, or simply because it gives you the outward impression of a more successful operation, then you’ll need to report your VAT receipts on a quarterly basis. You’ll then have to pay any VAT owed by each quarter’s deadline. You can set up direct debit to manage this.

Self-assessment

As director you’ll have to submit annual personal self-assessment by 31st September (paper) and 31st January (online). With 31st January the deadline for paying any unpaid income tax, although you’ll find that HMRC are keen to take estimated tax owed during the year itself.

At the very least, we would recommend using some inexpensive software to do these calculations, and indeed submit directly to HMRC on your behalf. Most directors could do with tax advice from an accountant to ensure they are being as tax efficient as possible. There is no point paying any more tax than you are required.

Tax examples – Sole-trader vs Limited

We’ve said that those paying themselves through a limited company can be at an advantage over those paying themselves from a sole-trader business. This can be achieved by a limited company director paying themselves an ‘optimum’ salary, one that does not attract any employers or employees National Insurance, and then paying everything else as dividend. The optimum salary in the example we use is £8,788. Your company will pay corporation at 19% (20/21) on net profits, and you will pay the tax on your dividends. This works out less than a sole-trader paying class 2 and class 4 national insurance, plus income tax.

You currently don’t pay income tax on the first £2,000 of dividends – that’s your tax-free allowance, and then as follows:

  • Basic-rate taxpayers - 7.5%
  • Higher-rate taxpayers - 32.5%
  • Additional-rate taxpayers - 38.1%

Conclusion

Limited companies offer the protection of limited liability. They separate you from your business or trade. They also separate ‘you as a business owner’ from ‘you as a worker’. They can be more tax efficient, and in a lot of circumstances make complete sense. Just the fact that your house is no longer automatically on the line is enough for us.

It’s worth noting that those who get caught by something called IR35, which is legislation to catch people trying to disguise their employment, will either need to contract as themselves with the third-party, work through an umbrella company, or contract via their limited company, but pay both employer’s and employee’s national insurance, and not pay any of the income from that contract out in the form of dividends. You may feel this is all still worth doing to benefit from the protection of the limited company. This is an area where you really should take professional advice - the rule of thumb is, if what you do looks like you are employed then you probably are within IR35.

Useful Link:  Listentotaxman guide to IR35

The sole trader route is more suitable for those on lower incomes, with work which is associated with a lower risk of running up debts or being sued. Sole-traders should ensure they use proper contracts and protect themselves with clearly worded insurance policies.

We’d strongly recommend getting professional advice in all circumstances, keeping good up to date with your records, and using simple software linked to your bank account.

A little bit of admin shouldn’t stand in the way of the most appropriate structure for your business.

Please note: this guide does not constitute tax advice and is purely our view on the situation.

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This article was published in our Guides section on 20/05/2020.

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