Sole trader vs limited company: Which is the best option for a small business?
Making the decision as to which structure your business operates as can be crucial, whether that be in terms of tax savings, perception to the outside world, keeping things simple or future plans you may have.
Some of the main differences between trading as a self-employed sole trader compared to a limited company are tax consequences, administration, liability and other non-financial aspects. Here we'll cover these, with a specific emphasis on what's best for startups, micro businesses and small businesses.
As a sole trader, an individual must pay tax on all profits over and above their personal allowance. Once the personal allowance has been breached tax is paid at the rate set by HMRC for the basic rate of tax, then as a higher rate taxpayer and potentially also in the additional rate band. These rates and bands are set out here.
There are now slightly different tax rates for Scottish taxpayers so please check these if they apply to you.
There are also further personal tax issues to consider, such as child benefit starts to be withdrawn once your income goes over a certain level, and the personal allowance begins to be withdrawn once your income is over the relevant threshold.
As well as tax, for a sole trader there will be two forms of national insurance to consider, Class 2 and Class 4.
A limited company, on the other hand, pays corporation tax on profits at a rate set by HMRC (see HMRC for details).
Over and above this there can be personal income tax to be paid with regard to dividend extractions from the business. In order for the extractions to be as tax efficient as possible, the director normally would draw a small salary from the company within their personal allowance but not above the point at which national insurance becomes payable (see our 2019/20 recommendations for dividend/salary mix). This salary would be an allowable business cost for corporation tax, so corporation tax is saved on the gross salary.
The remainder of their withdrawals would be in the form of dividends, which are paid out of post-tax profits and are not deductible expenses for corporation tax purposes, so offer no tax saving. However there is no national insurance to pay on dividends and there is currently a "dividend tax allowance" in place, which is a tax free allowance.
In addition, and unlike a sole trader, there is no requirement for the owner to withdraw all profits from the business if they do not want to. If you've had an excceptionally good year, it can prove tax efficient to leave some profits retained in the company for extraction at a later date or to re-invest in the company (e.g. to invest in equipment or staff).
The overall tax saving of a limited company vs a sole trader
For profits of £20k in 2017/18, the saving of running as a limited company vs a sole trader is circa £600, rising to £3,000 if total profits reach £55k.
However, there are further benefits for a limited company if you want to keep cash in the company - for example if you're a contractor who might want to take some time out, or you're expecting sales or income to drop after a couple of good years. In this case, the benefits of keeping profits in the company can be significant; for example, if total profits reached £60k in 2017/18 and a limited company retained £20k for future investment or salary/dividends, the tax saving is just under £6k.
There are subtle differences in the types of costs that are allowable for tax purposes and the way they can be claimed between the two types of entity, self employed or limited company.
As a director of a limited company you are considered an employee, therefore can access a range of tax free benefits and perks. One of the most common of these is being provided with a mobile phone or a computer. So long as there is some business use, these items can be provided tax free. As a sole trader you would need to add back to profits any private use element of any type of equipment.
Please note that in both types of business structure expenses claimed need to be wholly and exclusively for the purposes of the trade of the business.
Another key difference is in regard to pension contributions.
As a sole trader you can gain tax relief on payments into a pension but these amounts can be fairly restricted dependent upon your level of income. For an individual where income is below the higher rate tax threshold there is a tax benefit but this is added to your pension contribution by way of grossing up the contribution and the tax benefit is currently somewhat hidden in the current year as it sits in your pension fund.
As a director the rules can be more generous, the company may pay a contribution into your pension of up to £40,000 per tax year (2017/18) and more in some cases where there has been little by way of pension contributions in the preceding years. Company pension contributions on the whole will usually also be an allowable cost for corporation tax purposes (HMRC look at the combination of salary and company pension contributions to ensure the total ‘remuneration’ is not excessive). Please consult a pensions specialist if you need further advice on this.
Shareholders and dividends
Dividends are paid per shareholder; there may be the opportunity to give your partner some of your shares so that they can receive some of the dividends. You may want to discuss this before making a decision.
Of the two business structures, operating as a sole trader has the advantage of simplicity.
When setting up you simply need to contact HMRC and register for self-assessment. Every year that you are self employed you will be required to file a self-assessment tax return and pay any tax due by the 31st January following the end of the tax year in question.
For example, for the 2017/18 tax year (6th April 2017 to 5th April 2018) the tax return and tax payment is due to HMRC by 31st January 2019.
On the tax return you will need to declare your sole trader income and expenditure, plus any income from other sources. At the moment, you don’t need a proper accounting system; often a simple spreadsheet will be fine. However, as Making Tax Digital is rolled out, this will change over the nexzt few years. Details of the impact of this initiative are in our news centre.
Trading as a limited company is generallymore complicated, although we can help make the process very simple and cost-effective. The company will need to be registered with Companies House who will provide an incorporation certificate showing the company number and confirming the company is now a legal entity.
A limited company usually has shareholders (unless it's a charity or other company limited by guarantee). Shareholders own the company, and appoint directors to run the company on their behalf. The two positions are often held by the same people but it’s important to understand the differences; dividends are paid to shareholders, and salaries are paid to the directors.
As a limited company the business is more traceable as details of the company directors and shareholdings are held on public record. The company will also be required to have a registered office address which is often the premises from which the company does business. If preferred, perhaps for privacy, there is scope to use a different address as a registered office and we offer this service to clients for a small fee.
As a director of a limited company you have certain legal duties that must be fulfilled in order to comply with the companies act. See our article on this as it relates to dividend records. Other duties include, but are not restricted to:
- Maintaining full & accurate accounting records
- Prepare and filing of annual accounts with companies house
- Filing of a confirmation statement, confirming details of directors and shareholdings etc.
- Ensuring that the company complies with relevant tax and employment law
A limited company is usually required to file its full accounts and corporation tax returns with HMRC and abbreviated accounts with Companies House, as well as a confirmation statement with Companies House. The corporation tax is usually due for payment within 9 months of the company's year end.
Whitehill can provide a complete bookkeeping, accounting and company secretariat service together with a registered address service, all for a fixed monthly fee. The difference in cost between sole trader accounting and limited company accounting is relatively small; see typical prices for each.
In general, the additional costs can be more than covered by the tax savings.
We all hope that the business will be successful, people will pay us and we'll be good payers of our bills as they arise. But in case things go wrong, it's important to be aware that a limited company can potentially proect your personal assests such as home, car etc in a way a sole trader isn't.
This is known as "limited liability" status. Limited liability status was first fully established in the 1890’s when the House of Lords upheld that a company had its own legal personality.
This ruling ensured that creditors of an insolvent company could not sue the individual shareholders for money that was owing to them. This rule of law still holds true today and as such incorporation can prove extremely useful in protecting private assets.
In the event of a limited company incurring an unforeseen liability (such as a legal claim), in most cases this liability will be limited to the assets owned in the name of the company. The directors do need to be careful with regard to personal guarantees and the potential for wrongful trading (e.g. continuing to acquire credit which the company has little chance of servicing). In these instances they can become personally liable, as the "limited liability" status is stripped away.
For a sole trader there is no such distinction between personal and business assets as the business and the individual have no separate legal status. Therefore personal assets such as the family home could be at risk, certainly where the business operates in a fairly litigious or highly sensitive sector. This risk can be somewhat covered by having sufficient insurance policies in place.
We've covered IR35 in some detail in a separate article, since it's important to check whether it applies to you. If it does apply, you may be better off as a sole trader, assuming your employer allows this.
The bottom line
It's tempting to take the administratively simple route and just start trading as a sole trader, and in some circumstances (e.g. if IR35 applies), with appropriate insurance in place this maqy well be the better course.
However, although it's more administration and involves shareholders, Directors, accounts and more, there are significant benefits to operating as a limited company, both financially and in terms of limiting personal liability if things go wrong. Whitehill can provide a complete service to set up, operate and manage the accounts for a limited company, and it's generally more cost effective to do this than lose the benefits. Get in touch to discuss further.