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Sole Trader or Limited Company? What Legal Structure is Best for You?

If you are setting up as a small business in the UK, deciding whether you should set up as sole trader or Limited Company can stop you in your tracks.

With so much information online and everyone having conflicting opinions, it can be difficult to know what is best for YOU.

The main reason for choosing the right business structure when you are setting up a business is so crucial is that you have the opportunity to:

  • Maximise your take-home pay and;
  • Minimise your tax bill.

That is a luxury that someone who is employed doesn’t have.

In this post, I’ll show you the main differences between becoming a sole trader or Limited Company along with their pros and cons. 

I also share with you my ‘Sole Trader or Limited Company Tax Calculator’ so you can check which one will give you the biggest tax-saving.

Brace yourself. There is a lot of information in this post. And it is quite technical in parts. So take your time and favourite this page so you can come back to it once you have gone away and considered your own personal situation.

The information contained in this post is for guidance and information purposes only. It should not be relied upon as professional accounting, tax and legal advice. For specific advice relevant to your own situation, always contact a professional

Why is the choice between Becoming a Sole Trader v Limited Company So Confusing

If you ask anyone who knows about being self-employed, they will no doubt have an opinion on becoming a sole trader v Limited Company debate.

Even accountants will give conflicting advice!

This is because coming up with the right answer is based on PREDICTIONS.

Predictions about income, profits, the salary you want to take home and how quickly you plan to grow your business.

No one has a crystal ball and trying to estimate these factors with any certainty is going to be tricky. Especially if you are new to self-employment.

If you have more than one source of income or a non-standard tax code it can prove even more tricky. To get the right answer you should probably contact an accountant.

What is a Sole Trader?

The definition of a sole trader is someone who works for themselves. They are also referred to as self-employed.

There is no difference between a sole trader and self-employed, in fact, the words are used interchangeably.

As a sole trader, there is no legal distinction between you and your business. Even if you name your business, you will be personally liable for any debts and invoices your suppliers send you.

The Pros of Setting Up as a Sole Trader or Self-Employed

It’s easy to become a sole trader or self-employed

Registering as a sole trader with HMRC is easy. You just fill in an online form and the ball is rolling. It’s quick, easy and free to do.

How to Set Up as a Sole Trader

Just for its simplicity alone, it is the reason people favour this way to start working for themselves. It’s a great way for someone to dip their toes into the sole trader waters and see how things go.

Don’t forget if you are getting started you can also use the £1,000 HMRC Trading Allowance. This allowance entitles you to earn an income of up to £1,000 every tax year without needing to let HMRC know about it or filling out a tax return.

It’ll make your taxes simpler

When you set up as a sole trader you only need to fill out a self-assessment tax return once a year. On there you’ll only need to declare just your income and expenses.

Many self-employed people and sole traders have very simple accounts so they often file their own taxes. That saves them the hassle and costs of using an accountant.

Self Employment Basics
Open a separate business bank account
Claim all your expenses
Keep all your receipts
Budget for your taxes.
File your tax return by 31 January each year, and pay your taxes

It’s easier to back away from self-employment if things don’t work out

Deregistering as self-employed is fairly straight-forward. You just need to let HMRC know that you are giving up, declare all your income and complete final tax returns.

All the profits belong to you

When you become a sole trader all the money you make, after deducting your expenses and tax, belongs to you. So whatever remains you can simply pay to yourself as a salary.

It’s much simpler to become a limited company from a sole trader

You can set up a Limited Company at any stage of your business, subject to letting your customers and suppliers know.

You can become a limited company from a sole trader by keeping an eye on your profits. That way you can find the optimum time to set up a Limited Company and avoid all the costs and administration while you are starting out and aren’t sure what is right.

No Public Disclosures

All your income, expenses and tax returns are for your eyes only. You don’t have to make any legal disclosures that are put on the public record.

The Cons of Setting Up as a Sole Trader

You are liable for all the debts

There is no difference, legally, between you and your business. If you can’t pay a supplier they will chase you personally. Then, depending on the outcome, it could put your personal assets at risk.

Less Tax Efficient

Setting up as a sole trader can become less tax efficient quite quickly, especially if you grow quickly. 

If you become a sole trader you’ll pay:

  • Income tax
  • Class 2 national insurance
  • Class 4 national insurance

There are fairly few tax breaks that sole traders can take advantage of to maximise take-home pay and minimise tax bills. 

They most likely have to stick rigidly to paying these tax types.

Tax and National Insurance When You Are Self-Employed

It Can Look Less Professional

Depending on your line of work and the types of customers you deal with, it can look like you are less professional to be a sole trader.

There are some businesses who prefer to deal with people who have set up a Limited Company.

There are ways around that like setting up a professional email address, website and business bank account. It may stop your potential customers focusing solely on your legal status. And depending on your line of work, your legal status may not even come into the conversation.

It Can Make Loans and Securing Funding More Tricky

If you need to borrow money or secure funding for your business, it can be harder to do so if you are self-employed.

The reason for this is that you are looking for a personal loan in effect. The situation can be even harder if you have a poor credit rating.

What is a Limited Company?

A Limited Company is a separate business entity from you. Think of it like a person in its own right who has their own finances and owns all the profits that are made.

Limited It is often abbreviated to ‘Ltd’.

A Limited Company has Directors and shareholders. Directors run the Limited Company and Shareholders own it.

Directors and shareholders don’t necessarily need to be the same person and certainly for large businesses and corporations that is often the case. 

Think about Marks and Spencers. You can buy shares in the business but you wouldn’t have a hand in running it. The Directors are responsible for doing that as well as deciding whether they will pay a dividend.

Often you’ll find that freelancers or contractors are the Director and the Shareholder of their own Limited Companies.

That’s because it is just them in the business and they have most likely incorporated for tax reasons.

If you set up a Limited Company you will be the Director. It will be your responsibility to run the Company to the best of your abilities and electing to pay dividends to its shareholders.

If the Directors and shareholders are the same people, then that’s easy of course.

Limited Companies are registered at Companies House, which is the government body that:

  • Holds a register (or list) of UK Limited Companies;
  • Sets out the rules Limited Companies need to follow in terms of reporting and disclosures;
  • Fines Limited Companies who do not stick to the rules;
  • Discloses certain information about Limited Companies like who the shareholders and directors are and certain financial information;
  • Ensures every Limited Company that is formed has a unique name.

If you have a Limited Company you’ll pay

  • Corporation tax at 19%;
  • Dividend tax;
  • Class 1 National Insurance (both employee and employer)

The Pros of Having a Limited Company

The Limited Company is responsible for debts

Limited Companies have what is known as ‘Limited Liability Status’. 

That means the Company is responsible for the debts of the Company, rather than you personally. So your personal assets are not at risk.

More Credible

Forming a Limited Company and being able to describe yourself as a Company Director can be a prestigious move. 

The added credibility may make you seem larger than you are, especially if you are chasing after large contracts and projects.  

Tax Efficient

The reason Limited Companies are such a popular choice is that they do generally tend to be very tax efficient. Especially when combined with the perfect mix of dividends v salary

As a Limited Company, you’ll be able to take advantage of tax breaks like:

  • the dividend tax allowance
  • corporation tax which is 19%, rather than income tax which goes up to 40% once you earn more than £50,000.

It makes Funding and Borrowing Easier

As your business grows, so too does it’s own credit rating. That can make searching out borrowing or funding much easier to help you grow your business.

The Cons of Having a Limited Company

It Can Be Complicated to Set up

Forming a Limited Company can be complicated to set up. If you have to engage a professional to help you or a website it will attract charges.

More Administration

Running a Limited Company and complying with all the rules of Companies House, HMRC and filing returns can be time-consuming. 

You’ll be required to prepare full statutory accounts and a tax return, which usually requires the help of an accountant.

Accountancy Fees

If you are an Ltd then I would recommend that you engage an accountant. They will help to file your accounts, manage taxes and help you pay yourself in the most tax-efficient way.

But this will have a cost. And this may be an expensive administrative cost on top of all your other expenses.

Information About Your Limited Company is Publicly Available

Companies House disclose certain information about every Limited Company on its register. That includes:

  • Balance sheet
  • Directors
  • Shareholders
  • Security lenders have taken

With all this information available on public record, people can learn quite a lot about you and how you are running your business.

All the Profits Do Not Belong to You 

All the money you earn through your Limited Company belongs to it, even if you are Director and Shareholder.

You are legally required to make sure there is sufficient profit to pay you a dividend after accounting for all expenses and corporation tax.

All too often I have seen stories of people who have taken money out of their Company without estimating their corporation tax and checking that there is sufficient profit available.

This leads to a situation of illegal dividends, where money needs to be paid back.

It can be a scary situation for an individual who ends up owing corporation tax, needing to repay their company AND a personal tax bill on their dividends.

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Sole Trader or Limited Company? Which is Best for You?

To help you figure out which business entity is right for you, here are some comparisons of sole trader v. Limited Company.

Advantages of Choosing Sole Trader v. Limited Company

  • It’s easy to get started as a sole trader and registering with HMRC is free;
  • Going from sole trader to Limited Company is much more straight-forward that trying to go from Limited Company to a sole trader;
  • There is a lot less paperwork and it is simpler. You can probably complete your own tax return and HMRC even works out your taxes for you if you file your returns online;
  • All the money you make belongs to you. As long as you can cover your taxes you can just take your money. With a Limited Company you’ll need to make sure you have sufficient profits; 
  • Budgeting for your tax bill and take-home pay is much easier if you become a sole trader. If you set up as a Limited Company you’ll need to manage corporation tax, PAYE tax and dividend tax which can be complex;
  • If you set up a Limited Company you’ll need to find the right balance of salary v. dividends to stay tax efficient. The slightest mistake will wipe out any tax savings of incorporating;
  • It is becoming increasingly common for lenders to ask for personal guarantees on any borrowings through a Limited Company. That means you are personally responsible for the debts of the Company regardless of it being a separate entity;
  • HMRC are slowly changing the rules to deter people from closing down their Limited Companies if they owe tax. They will start to require these individuals to put down a cash bond on any futures Companies they register.
  • Even if you have a Limited Company, you’ll still need to register with HMRC and submit a self-assessment tax return each year as a Company Director.

Advantages of Choosing Limited Company v. Sole Trader 

  • Your Limited Company is responsible for all the liabilities of your business, not you. So your personal assets are not at risk;
  • If you draw your money from your Limited Company correctly you will make a tax saving;
  • As a sole trader, all your profits are taxable, whether you take them out of your business or not. WIth a Limited Company, you’ll only be taxed on what you take as your salary;
  • You do look more professional, which may be helpful, depending on the industry you work in.

Sole Trader vs Limited Company Tax Calculator

Setting up as a Limited Company is extremely popular in the UK, mainly because it does save tax.

I’ve set up a sole trader vs Limited Company tax calculator. Use this to check how much tax you will save and to help decide whether it is best to be a sole trader or self-employed.

Wrapping Up

When it comes to deciding whether it is best to become a sole trader or Limited Company I encourage people to be realistic about how much money they think they really will earn.

Starting a business is exciting but it can take time to build up your income. In your first year, you’ll be busy setting up your business and finding clients. That means you may not be at full earning capacity.

For that reason, you may like to consider whether the following scenario will work for you:

  1. Taking advantage of the £1,000 trading allowance while you get your business up and running;
  2. Register as self-employed as your business grows and you surpass the trading allowance rules;
  3. Incorporate when the time is right, you feel ready to deal with the administrator. And when the tax-saving outweighs any accounting fees you’ll need to pay to take care of administration and structuring your earnings tax efficiently.

If you want to hedge for the future, then as part of choosing your business name, I would recommend you check the name you would want is available at Companies House.

If it is available, set up your Limited Company and keep it as a Dormant Company. That way you’ll only need to deal with very minimal filing requirements.

What is a Dormant Company

Anita Forrest
About Anita Forrest

Anita is a Chartered Accountant with over a decade of working with small business owners. She is the creator of the ‘Go Self Employed’ website, where she simplifies complicated self-employment topics such as taxes, bookkeeping, banking and insurance.