Sole Trader Vs Limited Company
When it comes to starting a business, one of the most fundamental decisions that you'll need to make is what legal structure to choose. Two of the most common options are sole trader and limited company. While both structures have their advantages and disadvantages, there are important differences between them that can impact everything from taxation to personal liability. In this blog, we'll explore the key differences between sole traders and limited companies, weighing up the pros and cons of each option to help you make an informed decision about which structure is right for your business.
A sole trader is a self-employed person who is the only owner of their business. This means that there is no legal separation between you as the business owner and the business itself. As you and your business are one and the same, you keep the profits you have made after tax and are personally responsible for any losses your business makes.
A limited company is a separate legal entity from the business owner that can be formed whether you are a one-person business or have employees. By forming a limited company, you serve your business as its director.
As director, you are responsible for the legal and financial decisions your business makes, but your business’s assets and liabilities are separate from your own individual finances. This means that all profits and losses belong to the company, meaning you must always act on behalf of the company.
How to setup as a sole trader
To become a sole trader you need to inform HMRC by registering for self-assessment if you’ve earned more than £1000 in an individual tax year.
How to set up a limited company
To set up a limited company, you need to register your company with Companies House,
The online registration fee is £12, and it usually takes 24 hours for your business to be registered. You can either do this yourself, or we can register the company with Companies House on your behalf.
When registering your company with Companies House, you will also be able to register your business for Corporation Tax, which needs to be in place within the first three months of starting your business.
Once the company is registered, you will receive a ‘certificate of incorporation’, which will detail your company number and date of formation and provides confirmation that your company legally exists.
As a sole trader, you need to pay Income Tax and National Insurance on your business profits, this is calculated when preparing and submitting a personal Self-Assessment Tax Return to HMRC at the end of each tax year. You can find the current tax rates and personal allowance limits here.
Limited companies must pay Corporation Tax on their profits. To find out more about how to pay Corporation Tax and the most up to date tax rates, visit GOV.UK
You must pay your Corporation Tax no longer nine months and one day after the end of your accounting period. And because your accounting period for Corporation Tax can’t be longer than 12 months, if it goes beyond this limit you could have two payment deadlines in your first year as a limited company.
Directors of limited companies need to submit a self-assessment of their personal income and allowances to HMRC. This personal tax return must include information about all income earned from employment, dividends paid to you by your company and any other sources of income, such as rental income or bank interest received.
The deadline to file your self-assessment is the 31st of January each year, following the end of the tax year.
It is not a legal requirement for a sole trader to prepare a formal set of accounts. Accounts for a sole trader are only required to work out an individual’s personal income for self-assessment tax purposes, or if requested by the bank for a mortgage/bank loan application.
It is a legal requirement for a limited company to prepare a set of accounts each year. Under the Companies Act 2006 and accounting standards, details about your business’s finances need to be made accessible for the public. This means that you need to submit a yearly set of accounts to Companies House at the end of your accounting period.
Companies House will issue you with an accounting reference date, this will be the end of the month that you incorporated the company. You have 9 months to prepare and file your accounts following the end of your first 12-months of trading.
As a sole trader, you will be taxed on the full profits of the business regardless of the amount of money you personally draw from the business. You can take money out of your business as and when you need it. These withdrawals are treated as drawings.
As a director, you can pay yourself via a PAYE salary, if you do this, your company must be registered with HMRC as an employer.
A tax efficient way of drawing funds from the limited company is to pay yourself a minimal salary and take the rest of your income as dividends. The first £2000 of dividends are tax free, and they are also taxed at a lower rate than salaries.
As company director, you can choose to leave dividends in your business to help build it up or you can choose to take your share of these business profits as dividend payments. If you’re the sole shareholder in your business, you’re entitled to get all remaining profit after costs, expenses and tax.
Sole traders don’t have a separate legal existence from their business, which means any business decisions, profits and debts are the responsibility of the owner.
For example, should your business fall into debt or fail, as the business owner you would be personally liable, meaning you could lose personal assets if things go wrong.
A limited company is a separate legal entity from the business owner that can be formed whether you’re a one-person business or have employees. By forming a limited company, you serve your business as its director.
As director, you are responsible for the legal and financial decisions your business makes, but your business’s assets and liabilities are totally separate from your own individual finances (unless you provide a personal guarantee as a director for any debt the company may take out). This means that should the business fail, only assets held within the company can be taken.
Given that there’s no legal distinction between a sole trader and their business, if your company is involved in a legal dispute, you’ll be sued personally for any reparations. This could lead to a loss in your personal assets.
As the director of your limited company, you’re legally obliged to adhere to the Director’s Fiduciary Responsibilities. As fiduciaries, directors are held to a higher standard of conduct than other employees within the company.
Broadly, the director’s two main priorities are to provide a duty of care and a duty of loyalty to their company.
In accordance with the ‘Enlightened Shareholder Value’, limited company directors are required to:
Act within their powers
Promote the success of the company for the benefits of its members as a whole – When making decisions, directors must consider the potential long-term consequences for the company,
the interests of employees, company reputation, the promotion of good relationships with suppliers and customers and the company’s impact on the environment and local community
Use independent judgement
Exercise care, skill and diligence
Avoid conflicts of interest
Not accept benefits from third parties
If directors fail to the adhere to the duties listed above, which leads to shareholders or creditors experiencing a loss or reputation damage, directors can face serious consequences. These repercussions range from being stripped of your role as company director to facing a court order for the business to get financial compensation, which could result in personal bankruptcy.
Sole traders are not required to make their personal information or business accounts available for the public to review.
Limited companies are required to be transparent by law. Information about company records, accounts, directors and shareholders needs to be shared on public registers at Companies House, which is available for the public to review free of charge.
Main advantages of using a Sole Trader vs Limited Company
Accounts are optional for a sole trader. Although you may need accounts for mortgages etc. A limited company must prepare annual accounts which have to be filed at Companies House. These are available for public inspection as is other information about the company.
A sole trader does not have to comply with Company Law. Directors are personally subject to company regulations and can be fined or found guilty of a criminal offence for failing to comply.
Sole traders can just cease trading and inform HMRC. It’s more complicated to wind up a company.
You usually pay slightly less accountancy fees as a sole trader. A limited company generally involves higher accountancy fees as there is more paperwork to deal with.
Sole traders can offset losses against other income to save tax e.g. employment income. You can’t offset a limited company’s losses against the owner’s other income. But you can offset the losses against future or past profits to save tax.
Main disadvantages of trading as a Sole Trader vs Limited Company
A sole trader is just an individual in business. Limited Companies may appear more credible and substantial although, this is not always the case.
Sole traders are individually liable for the business for an unlimited amount. A limited company’s shareholder’s liability is limited to the amount of the share capital invested. So it offers protection to the shareholders’ personal assets. In the event of company failure and not being able to pay its creditors, a limited company protects your personal assets. However, banks, landlords and others will often require personal guarantees from the shareholders or directors when dealing with small limited companies.
A Limited Company has better borrowing potential than a sole trader because it can use current assets as security by creating a floating charge over its assets.
It’s more difficult to share or hand over a sole trader business with other people. Different people can hold different proportions of shares in a limited company. This means you can easily pass shares onto the next generation. Also, you can pay different amounts of dividends to different shareholders
A sole trader owns all of the business. In a company, you can have different classes of shares with different rights. Such as non-voting shares for someone who wants to invest some money into the company but doesn’t wish to take part in the management.
Having a limited company can create significant tax advantages. That’s because it pays tax on its profit at just 20%. These are a lot lower than the higher rates of personal tax (40%). However, when the funds are extracted from the company extra tax or national insurance charges may arise.
If a sole trader leaves profit in the business there is no tax advantage – he/she is still fully taxed on all of the profit made. One can leave profit in a limited company by paying less dividends or salaries which will save the owner tax.
Please contact us if you would like any advice or assistance with your new business.