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Sole trader vs limited company

Starting your own business is unique and daunting. Working for yourself can be very rewarding but requires work and responsibility. One of the top choices you’ll make when starting a business is whether to operate as a sole trader, partnership, or limited company.

The appropriate business structure will rely upon your situation, and there is no one-size-fits-all solution to that. This article highlights the similarities and differences between a sole trader and a limited company. So, you can decide which option is better for you and helps you understand how both options work.

What is a sole trader?

Suppose you decide to run your business as a sole trader. In that case, you are personally responsible for the decisions that affect your business and must file a personal tax return. As a sole trader, you should work hard and delegate your responsibilities. You need to hire staff to make sure you get everything done.

You are personally accountable for any losses or debts incurred by your company because the law considers your business and yourself the same. It also means that any gains made after taxes are yours to retain. Hairdressers, plumbers, and electricians are typical examples of business owners that prefer to manage their business as sole traders.

What is a limited company?

Suppose you decide to run your business as a limited company. In that case, you will need to create a private limited to run it. Your company will have its own legal identity distinct from yours, and its money will be maintained separately from yours. You will have limited accountability as a director of your limited company for any losses or debts incurred by the company.

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What makes a sole trader different from a limited company?

The most fundamental distinction between a sole trader and a limited company is that the limited company owner will not be personally liable for the business. Instead, the company itself will have unlimited liability. At the same time, sole traders will have unlimited personal liability for their business. Limited liability is a provision that protects companies from personal liability for any debts and losses they incur.

When starting a business as a limited company, shareholders have limited liability for the company, which may entail less personal financial risk.

Sole trader advantages

  • Simple to set up and maintain, apart from a yearly self-assessment tax return.
  • A sole trader has more privacy than limited companies, whose information is available to the public via Companies House.

Sole trader disadvantages

  • Sole traders have more responsibility, meaning there is no legal distinction between them and their business. The owner is at risk of assuming the business runs into obligation.
  • As banks and other investors prefer limited companies, raising capital can be difficult for sole traders and have limited expansion options.
  • Tax rates for sole traders aren’t usually as favourable as those for limited companies. When you reach a particular income level, remaining a sole trader may not be as profitable.

Book your free consultation with our sole trader accountant. It’s a chance to get to know you and find out more about what help is right for your business.

Limited company advantages

  • Unlike a sole trader, a limited company is legally separate from its owner, who has limited liability.
  • This implies that your assets aren’t at risk; you’re only at risk of losing the money you put into the company.
  • No one can use your company name once you’ve registered it, unlike sole traders who don’t have the same protection.

The principal benefits of a limited company are that it’s not taxed at a higher rate than a sole trader. It also has other benefits. For example, a limited company can claim tax deductions for all the costs incurred to run its business. A limited company is also required to pay corporation tax on its profits. This means it can be more profitable to form a limited company than a sole trader.

Overall, a limited company can be more profitable and tax-efficient than a sole trader. It also gives a limited company a more comprehensive range of tax-deductible costs, including business insurance, depreciation, and office equipment.

Limited company disadvantages

  • Limited companies have more significant duties. The director’s fiduciary responsibilities define what a limited company director is legally required to perform.
  • Going limited might be costly and time-consuming because of these additional duties. You’ll either must deal with the extra paperwork yourself or employ an accountant.
  • Companies House can access information about your company, which means facts about directors and earnings must be made public. This level of transparency may not be appealing to everyone.

The main downside is that there is no limit on the number of directors who can be on the board of a limited company, which means that a limited company can have a large board. This might be an issue, assuming you’re looking to keep your business small.

Book your free consultation to find out how our accountants for a limited company can help with your business tax and accounts.

Why is a limited company better than a sole trader?

There are many kinds of business structures. As you start with a new business, you’ll want to be aware of all options. Suppose you’re thinking of starting up a business. In that case, you’ll want to consider whether you’re a sole trader, a limited company, or a partnership.

Sole traders are a famous business structure for small businesses in the UK. In 2021 there were 3.2 million sole traders in the UK. The second most popular type of business structure is a limited company, accounting for 2 million companies in the UK.

Most small business owners opt to register their business as a limited company. There are many advantages, including its protection against potential liability.

Sole traders often have difficulty managing their business and dealing with government taxation requirements. Still, an established limited company may be better for you than becoming a sole trader.

Limited liability

Limited liability is one of the essential advantages of having a limited company structure instead of a sole trader. You can have limited liability in your company. Suppose you want to operate as a sole trader. In that case, you will be entirely responsible for your business and finances because the owner and the business are treated as one substance.

Whereas a limited company as a business is a separate entity. To keep your business separate and prevent losing your money, if your business ventures into insolvency, or bankruptcy, it’s better to incorporate a limited company in the UK.

However, being a sole trader, you should take out as many small business insurance policies as possible to stay profitable.

As a sole trader, you and your business are the same in the eyes of the law; if you don’t have business insurance policies, you’ll be sued and personally liable for any losses incurred. Another advantage of forming a limited company is that you will not be personally sued because the company is distinct from you as an owner.

Limited company tax

A limited company offers another significant advantage of operating your business as a limited company — it makes you liable for fewer business taxes. That’s because a limited company only must pay corporation tax or dividend tax.

Sole traders can expect to pay income tax on profits above £12,570. However, in the 2021/22 tax year, they’ll need to consider changes in calculating their profits when planning tax affairs.

Annual accounts

Choosing a limited structure means preparing your annual accounts. This is a legal requirement for the owners of a limited company. Annual accounts are not only essential but they are also legally required.

You will also need to file a corporation tax return with the Companies House. Sole traders are not liable for filing any accounts, and therefore they have no legal obligations to do so.

When starting up your limited company, you must seek help from one of our limited company accountants. We will ensure that the accounts are up-to-date and keep them in order.

Perception of limited companies

A limited company is an excellent way to work in the business world because you’ll receive more legal protection and lower your liability. A limited company offers benefits and protections that aren’t available to a sole trader, such as limited liability, shareholder entitlement, protection from creditors, and much more.

Limited liability protects shareholders against business liabilities, such as bankruptcy, fraud, or product liability. Suppose you’re a business, contractor, or client. You’ll be more likely to work with a limited company because people think that a limited company is more professional than sole traders.

A limited company is a valuable way to establish a business that can build a good reputation making it easier for others to consider working with your business. A sole trader business structure is the easiest to set up, so it has become the most popular choice for new businesses. However, limited companies can have some benefits over a sole trader structure.

Make sure you weigh up the pros and cons of the different legal structures available to you before deciding which structure will work best for your circumstances.

Tax differences between a sole trader and limited companies

When deciding between a sole trader and a limited company, the amount and type of tax you’ll have to pay is likely to play. The profit of a sole trader’s business is subject to income tax. A contractor who works through their own limited company will pay corporation tax on the company’s profit and income tax on any compensation or dividends received.

However, we’ll break each of the structures down below:

Sole trader tax responsibilities:

  • The annual self-assessment tax return is used to pay income tax on the business’s profits.
  • National insurance contributions Class 2 and 4
  • VAT (Businesses that have a turnover of £85,000 or more in a year must register for VAT)

Limited company tax responsibilities:

  • Self-assessment tax returns are used to collect income tax
  • Corporations pay a tax (a 19% tax on the profits)
  • The annual accounts and confirmation statement for your company must be filed with Companies House
  • Employees and directors are paid a salary from the company that PAYE covers
  • HMRC payroll reporting is required regularly

Business expenses for sole traders and limited companies

You will incur expenses when running your business as a sole trader or limited company. You can lower the amount of tax you pay, whether you’re personally claiming tax relief on business expenses or running your business through a limited company.

You can claim the expense items mainly like those for a limited company as a sole trader. As a sole trader, depending on what you pay for personally (i.e., from your bank account), you may be able to get it back from the HMRC. There are many allowable expenses for sole traders, such as:

  • Office costs (stationery or phone bills)
  • Travel costs (fuel, parking, train, or bus fares)
  • Clothing expenses (uniforms)
  • Staff costs (salaries or subcontractor costs)
  • Things you buy to sell on stock or raw materials
  • Financial costs (insurance or bank charges)
  • Costs of your business premises (heating, lighting, business rates)
  • Advertising or marketing (website costs)
  • Training courses related to your business (refresher courses)
  • Food cost (cost occurred when on a business trip)

These are all the allowable expenses that sole traders can claim back from HMRC as tax relief.

Limited company expenses you can claim from Companies House are as follows:

  • Health check and eye test expenses
  • Business insurance expense
  • Advertising, marketing, and PR expenses
  • Accommodation expenses
  • Bank charges
  • Childcare expenses
  • Use of home as office
  • Gifts, entertainment, and trivial benefits
  • Professional subscription expenses
  • Phone bills
  • Equipment expenses
  • Professional development expenses
  • Travel expenses
  • Start-up costs
  • Salary
  • Pensions

Sole trader vs limited company pensions

Retirement is more than simply paying into a pension; it is about saving for retirement. You reduce your tax bill as well. Sole traders can only pay a personal pension. Still, limited companies can also contribute to a personal pension and other tax-sheltered investments. The ability to set up a workplace pension scheme and make payments in a more tax-efficient way are some of the advantages of limited companies.

As a sole trader or a limited firm, you must pay yourself.

Paying yourself throughout the year without affecting the tax you owe is the preferred method for sole traders. If you want to use an accrual accounting method, you can. This is because the earnings you make from your own business are entirely yours. It doesn’t become the company’s until you pay tax, and there is no way to pay it to yourself in a tax-efficient manner.

Limited company owners need to consider different things when making payments to their business. They can either make the payment as a salary, dividends, or capital repayment. Still, the options are not always equal tax-wise.

Suppose a contractor’s income is approaching the higher tax brackets. In that case, they can lower the amount of money they take from their company until the next tax year, when everything is reset to zero.

A combination of salary and dividends is one of the most popular ways to pay oneself through a limited company. This will allow you to operate tax-efficient but compliant and earn a higher profit.

Selling your business

A sole trader who sells their business will pay capital gains tax if their profit exceeds the £12,300 threshold for the 2020/2021 tax year. As a sole trader, you will be taxed at 10% of your annual income if it is less than £50,000. If you earn more than this, you’ll have to pay CGT at 20%.

Limited company owners need to pay attention to the tax implications of selling shares in their business, especially if they withdraw some profits. When selling shares, they will be required to pay CGT (on money received individually) and corporation tax (on any company profit).

A good starting point for learning about capital gains tax is to visit one of our blogs related to everything CGT.

Employment status for sole traders and limited companies

Whether you are a sole trader or a limited company, there is a minefield of employment status issues. Choosing to work as one can be tricky. Sole traders and self-employed people need to understand the different employment statuses that apply to them.

Employee, worker, and self-employed are the three legal categories recognised by employment law. In contrast, only two are recognised by tax law (employed and self-employed). No matter which business structure you choose, it’s essential that you and your client agree on what each of you is responsible for.

If you’re self-employed, you don’t have employment rights and are responsible for paying your tax. Suppose you’re in a formal employment agreement. In that case, your client should add you to their payroll, deduct PAYE tax and national insurance, and pay employers’ national insurance.

Workplace rights or employment rights cover what you are paid, how many hours you work, how long you work, and where you work. These rights are called employment rights. Along with them, you are also entitled to the national minimum wage and holiday pay.

It’s important to consider any IR35 legislation and the off-payroll reforms when working through your limited company. If your appointment is determined to be “disguised employment,” you will be classified as IR35, and you are “employed for tax reasons” and taxed as an employee.

Contractors working within IR35, on the other hand, will not be granted employment rights, which is a significant source of contention.

Picking either a sole trader or a limited company is troublesome.

Finally, weighing the differences between a sole trader and a limited company would be beneficial, as any business structure you choose might affect anything from profits to paperwork. Don’t make hasty decisions, and if you’re unsure, consult one of our chartered certified accountants, as their knowledge of tax and business structure is often invaluable.

In addition, regardless of the structure you choose, investigate insurance because owning either business structure comes with its own set of risks. So, it is essential to learn more about the sole trader and limited company insurance and a general outline of the requirements you’ll require.

How Naseems Accountants can help

Our objective at Naseems Accountants is to assist you in reducing the amount of administrative work, and tax obligations and simplifying those chores that get in the way of you doing what you do best.

We’re dedicated to giving you the most proper guidance possible. We’ll suggest a business structure based on your priorities, so you can rest assured knowing you’re on the right track. We’ll be there for you throughout your career, providing guidance and support needed.

We recognise that your work style will not be 9-5, and neither will we. Our online portal allows you to manage your account on any day or night. Our extended operating hours allow you to chat with one of our chartered certified accountants whenever convenient for you.

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