Sole Trader or Limited Company - 2018/19
What's going on?
From time to time we're asked to comment on whether a new business would be better setting up as a sole trader or a limited company. As always, the answer isn't necessarily simple.... Here we set out the main issues and how they've changed for the 2018/19 tax year.
What are the differences between a sole trader and a limited company?
Let’s start with a bit of basic information on what the two types of business are..
You start to “trade” when you sell a product or service to a customer. If you just do this as a single individual, you are a sole trader (if two or more of you are working together, you are a partnership - and you can also be a "limited liability partnership" if that works for you. For now, though, we'll assume it's just one person).
- You need to tell HMRC that you’ve started trading and, each year, send in a tax return and pay tax and national insurance on your profit above a set level.
- You can continue to trade as a sole trader for as long as you like, regardless of your profit level.
- Once your turnover reaches the VAT registration threshold which for 18-19 is £85,000 you will need to register for VAT. You can choose to voluntarily register for VAT before your turnover reaches this level if you wish. At this level of turnover you'll need to think about the requirements of Making Tax Digital as well.
- You can also still have employees as a sole trader.
A limited company is a separate legal entity, with you as its owner (if you are working with one or more other people, you can own the business jointly as shareholders. For now, we'll assume just one shareholder (i.e. owner).
You will be the director of the limited company – which means you run the business and are responsible for it – and you will also be the shareholder, which means that you own the company and can receive dividends from available profits.
- You must legally create the company by registering it with Companies House.
- Companies pay corporation tax on their profits and you must register with HMRC for this.
- You can be paid a salary by your limited company and will pay personal tax and national insurance on it in the same way as if you were working for someone else. The company can also have other people as employees.
- Any profit left after you’ve paid your expenses, salary and corporation tax can be paid to you as a dividend. You will pay personal tax on your dividends in the same way as you would on dividends received from any other UK company.
- As with a sole trader, you have to register for VAT once your turnover reaches the registration threshold (with some exceptions) and you can choose to register for VAT before your turnover reaches this level if you wish. Once the company turnover reaches the VAT threshold you'll need to think about the requirements of Making Tax Digital as well.
So, how do you decide which of these two business structures would be best for you? There are several things to think about, and here we outine the 6 main ones. For the purposes of this discussion, we'll assume you are a UK non-Scottish resident, have no other sources of income and that you want to draw all available profit out of your limited company. We will also assume you are the sole director and shareholder of the company.
Of the two business structures, operating as a sole trader has the advantage of simplicity and lower cost; 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, there may also be payments on account.
- For the 2018/19 tax year (6th April 2018 to 5th April 2019) the tax return and tax payment is due to HMRC by 31st January 2020.
- On the tax return you will need to declare your sole trader income and expenditure – in some cases where your annual sales are below the VAT threshold (£85,000 for the 2018/19 tax year) you can simply report three figures on the return – total sales, total expenditure and the profit made.
- Your tax return will also need you to declare any further income received from other sources. You don’t need an expensive bookkeeping system (although there are benefits if the business is growing); often a simple spreadsheet will be fine, at least until you approach the VAT threshold for the business.
Trading as a Limited Company is generally more complicated, from seup the company with Companies House to registering shareholders and Directors. 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 some companies choose to pay Whitehill a small fee to use their registered address service, for example.
- As a director of a limited company you have certain legal duties that must be fulfilled in order to comply with the Companies Act.
- A limited company is usually required to file its full accounts and corporation tax returns with HMRC and abbreviated accounts with Companies House. The corporation tax is usually due for payment within 9 months of the company’s year end. In most cases the directors of a company will need the help of someone like Whitehill to ensure this is all done correctly and accurately. Directors also need to complete a Self Assessment tax return, just the same as a sole trader.
2. Limited liability
This is one of the main reasons why a lot of businesses choose to trade as a limited company. This means that creditors of an insolvent company could not sue the individual shareholders for money that was owing to them. This rule of law can prove extremely useful in protecting private assets if the company is unable to pay its bills.
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 goods or services which the company can't pay for), in these instances they can become personally liable.
For a sole trader there is no 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 off by having sufficient insurance policies in place.
Tax used to be a major driver of the choice to operate as a limited company rather than a sole trade, but with recent tax changes the tax benefits are more marginal. Here's the main differences;
3.1 Sole trader tax
As a sole trader an individual must pay tax on all profits over and above their personal allowance. For most tax payers the personal allowance is £11,850 for the 2018/19 tax year.
Once the personal allowance has been breached, tax is paid at the rate of 20% in the basic rate tax band (the next £34,500 of income above the personal allowance), 40% as a higher rate taxpayer and 45% in the additional rate band (over £150,000 income).
There are slightly different tax rates for Scottish taxpayers which are not covered here.
There are also potential other tax hits including the withdrawal of your personal allowance once your earnings go above £100,000 and high income child benefit tax if your income goes above £50,000.
As well as tax, for a sole trader there will be two forms of national insurance to consider, Class 2 and Class 4 – both Class 2 and Class 4 national insurance are calculated and paid via your self assessment tax return.
Class 4 national insurance
This is purely based on your self-employed profits (i.e. it is not affected by other sources of income you have). It is calculated along with your self-assessment tax return and is payable at 9% of profits between £8,424 & £46,350 and 2% for any profits above this.
Class 2 national insurance
In the past this was paid directly to HMRC (not as part of your tax return) but this is now paid through your tax return. It is charged at a rate of £2.95 per week if your business profits are above £6,205.
3.2 Limited company tax and income tax on dividends
A limited company pays corporation tax on profits at a rate of 19% for 2018/19.
As the director of your own company, you will probably only draw a salary of £8,424 in 2018/19. This will be tax free as it is covered by your personal allowance of £11,850.
You will draw your remaining post tax retained profits out as dividends (you don’t have to draw out all profits but for comparison purposes to a sole trader for this article we are assuming you do).
Dividends are tax free if you have any remaining personal allowance. Above this, you get a £2,000 tax free dividend allowance for 2018/19 (so a total of £5,426 dividends tax free).
Above this, dividends within your basic rate tax band (total income up to £46,350 in our example for 2018/19) are taxed at 7.5%. Dividends in the higher rate are taxed at 32.5% and any dividends where your total income is above £150,000 are taxed at 38.1% in the upper tax band.
As mentioned earlier, there are also potential other tax hits including the withdrawal of your personal allowance once your earnings go above £100,000 and high income child benefit tax if your income goes above £50,000.
3.3 Comparing tax payable
Several comparisons of the tax payable under the two schemes are available and these show a benefit of operating as a limited company of £330 (for a total profit of £20,000) rising to £1,115 (total profit of £40,000) and £2,711 (total profit of £60,000). At higher levels the benefit reduces to £1,381 (total profit of £100,000).
In other words, at each profit level the take home pay through a limited company is higher, but at lower levels the benefits are unlikely to offset the extra costs of operating a limited company.
Please note: Whitehill are not tax advisors - we would recommend discussing tax with a tax advisor before making any decisions.
3.4 Timing of taking income
The comparisons given above assume all profits are taken in the year they arise. For a sole trader, there is no choice on this. You pay tax on the profit you make each year, regardless of whether or not it remains in the business bank account.
While the same is true for the profit made by a limited company, since it pays a flat rate of 19% corporation tax on its profits (2018-19 tax year), there is no requirement for any or all of the profit to be taken as dividends, so many owners of limited companies only take sufficient dividends to cover their personal expenses and leave the rest of the profit in the company bank account.
In this way, they can potentially avoid the higher rates of income tax and unless the business makes a loss, the profit will still be available to draw on in later years.
this can be useful for cyclical businesses that have a couple of strong years but expect a couple of tougher years. They can smooth their dividends over the years (assuming sufficient post tax profits overall to support the dividends).
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, although they are not as significant as they once might have been.
- 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.
In both types of business, expenses claimed need to be wholly and exclusively for the purposes of the trade of the business.
5. Pension payments
The treatment of pension contributions made through a limited company is very different to contributions made personally.
- 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 whose 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 short term 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 (based on 18/19 rates) and more in some cases where there are allowances unused from previous 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, benefits and company pension contributions to ensure the total ‘remuneration’ is not excessive).
Please note: Whitehill are not pensions advisors - we would recommend discussing pensions with a pensions advisor before making any decisions.
It’s important to be aware of IR35 which is legislation around employment status when you trade through a limited company – this is something that particularly affects contractors and freelancers. We have a separate article on this.