Every business needs to operate within a defined legal structure. If you’re considering setting up a business, one of the questions you need to ask yourself is whether to be a sole trader or a private limited company.
What is a sole trader?
Being a sole trader means you’re self-employed and can keep any profits you earn after tax. It is important to be aware that as a sole trader, you will be personally responsible for any losses your business makes.
Setting up as a sole trader is simple and you can start trading immediately.
Once you earn more than £1,000 in a tax year (which runs from 6 April to the following 5 April in any given year) you’ll need to register for Self-Assessment. If turnover reaches £85,000 you’ll need to register for VAT. You can do that here.
As the most popular business structure in the UK, 60% of businesses fall into this category.
What is a private limited company?
This business structure has its own legal identity, separate from that of its owners (shareholders or members) and directors (who may also be shareholders). Shareholders receive dividends from available profits the company has made. Directors may be paid a salary or, if they are also shareholders, they might choose to draw dividends instead, or as well.
There are more legalities involved with running a limited company. The company must file annual accounts and a Confirmation Statement (previously the annual return) with Companies House and submit a tax return to HMRC. This is the responsibility of the directors.
The limited liability nature means that if the business runs into financial difficulty, the personal assets of shareholders won’t generally be at risk.
What are the advantages of being a sole trader?
- Simple to establish: to register and set-up Self-Assessment, click here – this is how income tax is collected by HMRC. You will be sent a 10-digit Unique Taxpayer Reference. Be aware that you can be fined for not registering – you must do this by 5 October in the tax year you start trading.
- Free to set up: unlike a limited company, you don’t pay to get started, though company formation packages generally start at only £9.99 plus VAT. So, setting up a limited company is not expensive.
- Less red tape: sole traders generally have fewer Government departments to deal with. Just submit a tax return once a year.
- Less paperwork: aside from completing your annual online Self-Assessment, paperwork is minimal. Keep all your receipts and invoices for the year.
- Privacy: being a sole trader allows for more privacy, unlike a limited company where company accounts and registered office address are in the public domain. Details of other directors, owners and people with significant control (PSCs) will also be on the public record at Companies House. You can see what this looks like here.
What are the disadvantages of being a sole trader?
Despite this being the most popular business model, there are disadvantages of being a sole trader:
- Personal liability: because sole traders aren’t a separate legal entity to their business, any liabilities or debts are your liabilities and debts. You will have to pay what’s owed to any creditors from your personal assets. Furthermore, because liability is unlimited, you could risk losing your home and face potential bankruptcy.
- Perceived lack of prestige: although not necessarily true, clients may view sole traders as having less kudos than a limited company, believing they are less professional or lack potential longevity.
- Reduced access to finance: sole traders may find difficulty raising capital. Banks often prefer the accounting transparency provided by limited companies. Loans might be smaller than those offered to limited companies. In addition, sole traders are unable to offer shares or other securities in exchange for investment.
- Some customers avoid small traders: some clients prefer to deal with limited companies because sole traders are perceived as higher risk. Indeed, some sectors will only deal with limited companies.
- Tax planning limitations: sole traders’ profits are subject to income tax in the financial year they were made, which can lead to certain restrictions when compared with the options available to limited companies – see tax advantages section below..
What are the advantages of being a limited company?
- Your financial liability is limited: limited financial liability (of shareholders) is one of the main advantages of being a limited company. Should the company cease operation, you generally only lose the sum you invested.
- Limited companies can be easier to finance: securing finance can be easier because limited companies are separate legal entities. It is possible to raise capital by issuing new shares to shareholders and investors. This doesn’t include members of the public.
- A limited company is a separate legal entity: the advantage of being a separate entity from its owner(s) is that the company will continue to exist and operate if members die or retire – thereby making employees’ futures more secure.
- More tax efficient: limited companies are taxed at the 19% corporation tax rate – not the higher tax rate of sole traders. Profits can be ploughed back into the business to invest in new equipment or staff, rather than taking it out as taxable payments. Any withdrawal of personal profits (i.e. as dividends) can be deferred.
- Increased trust and credibility: because limited companies have to comply with more statutory rules, accounts are public which can instil trust – especially useful if you’re looking for new investors. If your competitors are mainly limited companies, this helps you compete with them on a level playing field.
What are the disadvantages of being a limited company?
- More paperwork: ongoing requirements to comply with include filing annual accounts and a Confirmation Statement. Quality Company Formations can provide a Confirmation Statement Service for only £34.99 plus VAT.
- Added expense: unless you have the time and skills to dedicate to accounting responsibilities, you may decide to enlist the services of an accountant, which is an added expense to factor in. The cost of an accountant preparing annual accounts for a small business is generally between £800 and £1,500 per year, depending on their complexity.
- Company records are made public: certain information is available to the general public, including company accounts, names of directors, owners/individuals with significant control, along with the company address. Information is held on the Companies House website.
Can I switch from being a sole trader to a limited company?
Absolutely. You may decide that you want the security of limited liability; or if profits are flowing in, you may want to benefit from the greater tax efficiencies, etc.
Whatever your reasons for wanting to make the switch, it’s not difficult to do. You can do it yourself or enlist the help of an accountant.
Here are a few things you have to do if you decide to change your business’s legal structure:
- Inform HMRC. Changing the legal structure will have a bearing on the amount of tax you have to pay.
- Register your business with Companies House, i.e. form a limited company.
- Set up a dedicated business bank account for your new limited company.
- Let your insurer know your business structure has changed.
Can I change from being a limited company to a sole trader?
Although more unusual, it is possible. There is a formal winding up procedure to follow:
- Prepare the final set of company accounts and submit to HMRC and Companies House
- Settle any outstanding tax payments with HMRC
- Ensure that any money in the company’s bank account is transferred out
- Transfer out any assets held in the company’s name (for example domain names)
- If the company is party to any outstanding contracts, arrange for these to be novated or have new contracts drawn up in the name of new limited company
- Once completed, the company should formally request to be dissolved. This is done on the authority of the directors agreeing to close the company, after which an application is submitted to Companies House.
- Creditors, suppliers, employees, directors, or members of the company should be informed of the application to dissolve the company.
- Once the application to dissolve company has been received and accepted by Companies House, the company will be dissolved and struck off the company register within 2-3 months.
Note: As an alternative to dissolution, you may want to make the company dormant, in case you ever need it again in the future.
What’s better for tax – being a sole trader or a limited company?
There is no hard and fast rule – but in general, operating as a limited company offers more opportunities for tax planning and optimising efficiency. Limited companies currently pay 19% corporation tax on profits, compared to 20-45% income tax paid on sole trader profits.
Reinvesting profits – instead of withdrawing the full extent of profits each year, as is the case with sole traders, it is possible to divert any surplus income to pay for equipment, operational costs, taking on new staff and growing a business. There is more flexibility in terms of timings, as sole traders generally need to utilise any surplus profits in the same financial year in order to avoid paying tax on these.
Deferring dividends – the withdrawal of any profits as dividends can be deferred to a later tax year (e.g. to avoid a higher income tax or dividend tax bracket).
Are some businesses better suited to being limited companies or sole traders?
The legal structure you choose for your business depends on personal preference and the stage you’re at in your business journey.
If you’re a small business with few or no overheads (e.g. you’re a dog walker) there might be little advantage of being a limited company. However, if your business model means that you have a number of suppliers you regularly pay – or your sole trader business starts developing in this way – then you may decide you’d like the protection that comes from forming a limited company.
The bottom line – what is better for me?
We know this is a difficult decision to make and so we have created some simple scenarios and made our recommendations for each.
- My business will not expose me to financial risk should it fail, my turnover will be small and there will be no reputational benefit from limited company status.
- I will require paying a lot of suppliers for stock and I will need a bank overdraft facility and possibly a business loan in the first 24 months.
- My competitors are in general terms quite large businesses who are all limited companies or plcs. I will require taking a brick and mortar lease for business premises, and other leases for equipment and delivery transport.
- My 5-year business plan incorporates a steep growth curve where I will be aggressively expanding the business and employing staff. I will have a substantial turnover, with considerable business expenses; therefore, flexibility with regards tax matters is of interest to me. I may also wish to take on new investors during this period.
We recommend: Sole trader.
We recommend: Limited company.
We recommend: Limited company.
We recommend: Limited company.
Please note – the above recommendations are only our opinions and if in doubt we strongly advise you obtain professional advice, especially on tax matters.