Sole trader vs limited company: what’s best for you?

When you start your own business or begin freelancing, you'll need to decide which company structure to use. The two most common options are becoming a sole trader or setting up a limited company. 

Your choice can impact everything, from how much tax you pay to how much paperwork you need to do. Here are the advantages and disadvantages of each approach and how to choose between the two.

What is the difference between a sole trader and a limited company?

The main difference is that when you are a sole trader, you and your business are considered one legal entity. That means you benefit from all the profits but also take on all the liabilities. If something went seriously wrong, you could spend all your savings, lose your home or even be declared bankrupt. It also means there can only be one owner of the business. 

On the other hand, a limited company is a separate legal entity from its director(s); the owners are not responsible for any business liabilities, and their personal assets are not tied to the company. That means that shareholders and directors cannot be pursued personally for any debts the company runs up. There may just be one owner, but having multiple owners and shareholders is also possible.

Another key difference is how you get paid and what tax you pay. A sole trader pays income tax on all their business profits. If you have a particularly successful year, you’ll pay more tax. 

A limited company has more flexibility. You can choose to draw a regular salary, which is taxed as normal income, but you can also earn dividends, which are taxed at a lower rate. You don’t have to take all the profits out of the business in the year they are earned, so you can make sure you’re drawing money tax efficiently. However, you will pay corporation tax on annual profits.

Complexity is another key consideration. Becoming a sole trader is easy. There’s limited paperwork, and you simply need to fill out a self-assessment form each year. A limited company has to be registered as a business, and a fee is attached. You will need to keep company records, file company tax returns each year, and fill in your own personal self-assessment form. You may also need to pay employer national insurance contributions.

How to choose between being a sole trader or a limited company

The right company structure for you will depend on several factors. You need to think about how much money the business is making, how much income you want to draw and how much administration you can handle. 

GoSimpleTax calculates that for someone with profits of £15,000 a year, it is more tax efficient to be a sole trader – with an annual saving of around £150. However, once you earn more than £20,000 per annum, it calculates that setting up a limited company will save you money. 

The amount saved by incorporating (becoming a limited company) increases significantly in line with annual profits. For instance, someone with annual profits of £20,000 will save £130 per year, but profits of £30,000 mean an annual saving of £590.

Of course, this saving needs to be offset against the cost of the administration of a limited company, both in terms of time and accountant fees (if you have one).

If you’re not sure what’s right for you, speak to an accountant. They will be able to run the numbers for your business and tell you what the most efficient structure is in your specific circumstances.

Pros and cons of a sole trader

Pros

• You keep all profits after tax

• Administration is simple and easy

• Tax efficient for businesses with lower profits

• First year losses can be used to reduce other tax due

Cons

• Unlimited personal liability for the business

• Could lose personal assets if things go wrong

• Harder to pass on the business through inheritance or via a sale

• Some clients will not work with sole traders

• Less tax efficient once profits exceed £20,000

• Can be harder to raise finance

Pros and cons of a limited company

Pros

• Limited liability for company debts

• Personal assets are protected

• Easier to pass on the business through inheritance or to sell it

• Can take advantage of lower dividend tax rates and structure your income tax efficiently

• Clients typically prefer working with limited companies

• You can have multiple shareholders or directors

• You can make company pension contributions to reduce your tax bill

Cons

• More expensive to run

• Time-consuming paperwork and administration

• Complex tax and national insurance requirements

• You may have to guarantee loans or large credit agreements

• Higher accountancy fees

• Information about your company can be found on Companies House, which is available to anyone

Do you need to register your business?

You can earn £1,000 per year from self-employment tax-free. Once you exceed this, you need to register as a sole trader or set up a limited company.

How to register as a sole trader

To set up as a sole trader, you need to register to pay tax through a process known as Self Assessment. You can do this quickly and easily on the GOV.UK website. The deadline for registration is October 5, and missing this could lead to a fine.

You’ll need to file a tax return every year. You also need to:

• Keep business records and records of expenses

• Pay Income Tax on your profits 

• Pay Class 2 and Class 4 National Insurance

• Register for VAT if your turnover is over £85,000.

You don’t need to pick a name for your business, but you can. If you do decide to have a business name it must not include ‘limited’, ‘Ltd’, ‘limited liability partnership’, ‘LLP’, ‘public limited company’ or ‘plc’, or be offensive.

How to register a limited company

The first step in setting up a limited company is to choose a name. This must be different from other registered companies – if it is too similar, you will need to change it. It also needs to end in Limited or Ltd.

Next, you need to appoint a company director (or directors). This person has several responsibilities, including keeping company records and doing tax returns. You can see a full list of responsibilities on the GOV.UK website. You can use an accountant to carry out these tasks, but you are still legally responsible for making sure the information is correct. 

You may also choose to appoint a company secretary, (but you don’t have to). You also need to appoint at least one shareholder or guarantor (you can choose a director).  As part of the process, you need to identify all the people with significant control over your business.

Next, you need to create a memorandum of association and articles of association. The government explains how to do this here, but you can employ an accountant for this task if you prefer. You should also check what records you need to keep.

Finally, you need to register your company with Companies House. You can usually register for corporation tax at the same time.

Can I change from being a sole trader to a limited company?

Yes, many people start out as sole traders and register as legal companies later on. You need to go through the process outlined above and deregister as a sole trader with HMRC.