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When venturing into the world of self-employment, you’re faced with a choice – do you register as a sole trader or form a limited company through which you can provide your services?
It’s a question that nearly all 4.5m people working for themselves in the UK asked themselves before making the leap into self-employment. It’s also one that requires a well-informed decision.
So to help you understand the difference between a sole trader and a limited company, and in turn, equip you with the information you need to make the right choice, we decided to compare and contrast these two popular business structures.
As the term suggests, a sole trader is the sole owner of their business. Sole trader businesses aren’t incorporated, which means it’s quick and easy to start working this way. It also has the added benefit of fewer reporting responsibilities.
Sole traders essentially are the business because it isn’t a separate legal entity, in the way that a limited company is. This means that you are personally liable for debts and overheads you incur when trading – something commonly referred to as ‘unlimited liability’.
To learn more about being a sole trader, feel free to read our guide to ‘what is a sole trader’. Or to weigh up the pros and cons, check out ‘sole trader advantages and disadvantages’.
A limited company is an incorporated business, which has a separate existence from its owners. As a result, its shareholders are not personally liable for the company’s debts – in other words, this type of business has ‘limited liability’.
Registering and running a limited company is considered slightly more complex than working as a sole trader, however it does offer the advantage of greater tax planning opportunities.
When weighing up sole trader vs limited company, the amount and type of tax you’re required to pay is likely to factor into your thinking. We’ll now look at how both structures are taxed:
Broadly speaking, a sole trader pays income tax on the profits of their business, while directors at a limited company will pay corporation tax on the business profits and income tax on any salary or dividends received from the company.
We’ll break this down below:
Sole traders and limited company owners can claim a number of expenses incurred when running their business. By claiming tax relief on these expenses you’ll reduce the amount of tax you pay, whether personally or from your limited company.
While the expenses you can legitimately claim as either a sole trader or limited company are mostly similar, there is a key difference. A sole trader will pay for these expenses out of their own pocket, but when it comes to limited companies, it is the business that incurs these rather than the owner. That said, if the owner pays for something personally (i.e. from their personal bank account), they can claim this back from the company depending on what it is.
From marketing spend to website costs, accountancy fees and office rent, there are plenty of allowable business expenses. Most can only be claimed if they are incurred ‘wholly and exclusively’ as a result of trading. For others, like home internet costs or your mobile phone contract, you may need to run a sum to claim a proportion of the bill as an expense, given it has what HMRC calls a ‘dual purpose’.
Paying into a pension isn’t just a smart way to save for retirement – it also helps reduce your tax bill. While sole traders are only able to pay into a personal pension (because their business isn’t incorporated), limited company owners have more choice. Owners of these businesses can set up a workplace pension scheme alongside a personal pension and can also make payments in a more tax efficient manner.
Sole traders can pay themselves as and when they like throughout the course of the year without it having any impact on the amount of tax they owe. This is because income earned as a sole trader is personally yours (not the company’s), meaning there is no tax efficient way of paying it to yourself.
Things are different for limited company owners, who may choose to withdraw money from their business at certain times for greater tax efficiency. For example, if an owner is creeping towards the higher income tax band, they might choose to reduce the amount they take from their business until the next tax year, when things reset to zero.
When it comes to paying yourself through a limited company, most people take a combination of salary and dividends, allowing them to operate in a tax efficient but compliant manner.
If a sole trader sells their business, they will need to pay Capital Gains Tax (CGT) should the profit they make take them above the £12,300 CGT threshold for the 2022/23 tax year. If your annual income is less than £50,270 you’ll be taxed 10%. Anything above this and you will need to pay 20% CGT.
It can be a little more complicated for limited company owners, should they sell shares within the business and withdraw some of these profits for themselves. In this scenario, they will be expected to pay CGT (on money taken personally), along with Corporation Tax on any profit the company has made when selling shares.
To get a better idea of Capital Gains Tax, which is a tax on profit made when you sell an asset that has grown in value, head over to the government’s website to get a better idea of Capital Gains Tax.
Whether you opt to work as a limited company or as a sole trader, employment status can be a minefield.
This is compounded by the fact that employment law recognises three types of legal statuses (employee, worker and self-employed) and tax law only recognises two (employed and self-employed).
Whichever structure you use it is important for you and your client that you are both clear on the responsibilities placed on you.
When you’re classed as self-employed, you do not receive employment rights from a client and remain responsible for paying your own tax. If you are in a deemed employment relationship, your client should be bringing you on to their payroll and making deductions for PAYE tax and national insurance, in addition to paying employers national insurance. Where you are classed as a worker, you will also get some employment rights such as entitlement to National Minimum Wage and holiday pay.
When working through your own limited company you may need to consider IR35 legislation and the off-payroll reforms. If your assignment is assessed as being one of ‘disguised employment’ you will be regarded as inside IR35, which means you are ‘employed for tax purposes’ and will therefore be taxed as an employee. People working inside IR35 won’t be granted employment rights in return, though, which is a big bone of contention.
Confused about IR35? Read our simple guide to IR35.
It’s not a case of one being better than the other. Whether you operate as a sole trader or through your limited company should boil down to personal choice and preference – perhaps even the industry you work in, your growth plans and even tax strategy, if you’re looking that far ahead.
Whichever route you take, rest assured it’s not a decision that you need to make on your own. If you would like expert, no obligation advice to help you better understand the ins and outs of being a sole trader, or are looking to get help with your limited company accounting, don’t hesitate to contact one of our friendly accountants.