Starting a business can be one of the most challenging things you can do, as it often involves having to learn a completely new skill set and operate on very unfamiliar ground.
To add to this, it’s tricky that one of the biggest decisions about whether to incorporate your business at companies house or be a sole trader, has to be made on day one, before you’ve even sold anything or had a chance to properly plan and build a strategy. Yes, having to pick what kind of business structure to use is often the first port of call for any eager entrepreneur.
What is better sole trader or limited company?
It’s likely you came to this article hoping I could give you a yes or no answer on whether to be a sole trader or limited company, but it’s really not that simple, because the correct answer for you depends very much on your unique situation.
To get this right we need to consider your past, current and future expected profits, plus the other things that you have going on with your family finances and the nature of the services you provide and how you do it.
I’ve made it my mission to write the most concise article on this topic, so you can walk away with complete confidence that you made the right decision on choosing to run your business as either a sole trader, or as a limited company.
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The four factors to consider when deciding to be a sole trader or limited company
Instead of breaking this article down in to the usual limited company pros and cons, or sole trader pros and cons list you’ll see in other articles, I’d like to cover the sole trader vs limited company topic from four different angles and discuss the key difference in each.
1. How to save tax by setting up a limited company
There was a time when limited companies were a no brainer when it came to saving tax, however the introduction of dividend tax at the basic rate from April 2016 closed much of the gap in the overall tax bill between the two types of legal structure. More recently from April 2024 the reductions in national insurance for employees and sole traders, plus the reduction in the dividend allowance and increase in dividend taxes, have closed the gap further.
Is it more tax efficient to be a limited company?
In many scenarios there is very little difference in tax between being a sole trader or a limited company, however depending on your other sources of income and overall business profits there can be instances where the difference can be huge.
Controlling your dividends
One of the greatest tax benefits of having a limited company arises because of the opportunity to control how much money you withdraw and when. A sole trader would typically pay income tax and class 4 national insurance on all of their business profits after their personal allowance.
Pay Corporation Tax
Likewise a company will pay corporation tax on all the profits after the personal allowance (director’s salary), however the key advantage of going limited is that dividend tax is only due at the point money is withdrawn from the company. This means that if you chose to not withdraw money because you don’t need it, you can drastically reduce your overall tax rates.
It is often also possible to withdraw money from a company through mechanisms that don’t trigger dividend tax, usually by paying out profits to a holding company and then using those to reinvest in other ventures or winding the business down and claiming the flat 10% entrepreneurs relief rate on any money left in the business.
Timing of dividends
A great strategy can be to avoid dividend payments in a year when you have already used up your personal allowance and basic rate of tax and you don’t want to pay higher rate tax. You can then issue those dividends later on in a year when you might have more of your allowances available.
The directors loan account can be a great tool in allowing you to take money out when you need it, by giving you the ability of controlling when you declare taxable income and dividends.
When you’re starting out in business there are circumstances where working as a sole trader can give you a huge tax advantage. The reason for this is that if you make losses in your first year of trading, perhaps because you purchased a lot of equipment or had upfront licencing costs then you can offset them against your other income tax from that tax year as well as the three before that.
In addition you can also attract national insurance relief on future class 4 NIC payments, by carrying your losses forward at the same time.
Tax rebates on start up losses
Imagine if you were in a well paid job where much of your income was taxed at 40%, if you then started a business you would be able to claim a tax rebate for your losses at the 40% rate you previously paid tax at.
Even if you were a 20% tax payer in your life before becoming a small business owner, you would still be better off because you would be able to claim a rebate on your start up losses. And in addition to the income tax savings, you can also separately carry the losses forward to reduce future class 4 national insurance contributions.
An accountant can really help here as you will want to claim loss relief in a way where you don’t waste your personal allowance in a year and increase your tax bills in the long term.
Limited company loss relief
The alternative when you’re running your own business through a limited company, is that start up losses just get carried forward to reduce future years profits and the tax relief is usually at the 19% corporation tax rate.
If you’re expecting to make a significant first year loss and you paid a lot of income tax before you started your business, then becoming a sole trader can be very attractive
Family Tax Planning
Splitting your income as a family can be a great way to save tax, providing it’s done responsibly without artificial arrangements. If you have a family member involved who’s over 18 and isn’t using up their personal allowance, then it can often be better to employ them through a limited company and potentially give them shares, rather than as a sole trader.
HMRC can challenge aggressive tax avoidance where a family member is given a salary that isn’t commercially appropriate, as in a salary that you wouldn’t give to someone of the same qualification and skill set, who wasn’t family.
Adding family members as a company director or shareholder can circumvent this as directors are paid for their responsibility and strategic insight, while shares can be gifted to family members who will then receive dividends as investors tend to.
It’s essential that any salary and dividend payments to family members are given without an obligation to return money to any of the parties involved, because that would be aggressive tax avoidance and can be challenged by HMRC.
Tax deductible expenses
Whilst there are many tax deductible business expenses that work in the same way for both limited companies and sole traders, there are some exceptions which result in the treatment being different and more tax being paid. I’ll briefly explain the differences below:
Phone and Broadband
Limited companies need a phone or broadband invoice or contract made out to the company, for it to qualify as tax deductible. This can be a challenge for people who work from home as usually they have these in their personal names and don’t want to pay the higher rates for a business contract.
Unfortunately this is usually an all or nothing scenario so there is nothing to claim on a personal contract, even if there is business use. In contrast a sole trader can apportion part of the bills as a business expense based on how much they use for business and personally.
Unlike limited company directors, sole traders can’t take advantage of relevant life cover, key person insurance or death in service as they are not employees, which is a shame as these policies are tax deductible for a business.
The tax deductibility of training for directors and employees is far more generous where limited companies are concerned. While sole traders need to demonstrate clearly that they are updating current skills for the training to qualify, Limited companies enjoy the luxury of having any business related training count as a tax and VAT deductible expense.
There are still exceptions where tax relief will be restricted if HMRC feel you have also used the training to reward performance or as a holiday.
R&D tax credits
Research and development is an important part of improving your offering and launching new products and services. Limited company owners benefit from enhanced tax relief when it comes to their investment in R&D, which means they can save a lot more in tax compared to regular business expenses and also their sole trader counterparts.
The various tax reliefs regarding vehicles and business travel can be very different depending on the the legal structure of the business. Limited companies have the option of giving their directors and employees company cars and then paying for their fuel at the approved mileage rate, or reimbursing them mileage on their personal vehicle use at 45p a mile.
A self employed person on the other hand would put their 45p a mile through their accounts and reduce their tax bill that way, or they can claim for their actual vehicle and fuel costs but reduce them for the proportion of personal use they get from their vehicles.
Gifting directors presents or vouchers that are under £50 is a great way to treat them in a tax efficient way, unfortunately sole traders can’t benefit from this saving.
Can sole traders claim tax deductions for Christmas parties
The £150 a head annual event allowance is not available to non limited companies, which means sole traders cannot claim this valuable deduction.
2. Why limited companies help you reduce risk in your business
Running a business can be a risky venture, especially when you consider how vulnerable it is to changes in the economy and other external factors. Often the most pressing thing on a business owners mind is worrying about their finances and the risk of losing everything they have, which is why going limited can be so appealing.
Separate legal entity
Unlike being a sole trader where you and your business are considered to be one legal entity and your business issues can spill over into the rest of your personal finances, and vice versa, limited companies offer an opportunity to reduce risks.
Why is a company better than a sole trader at reducing risk?
Limited companies are considered to be legally separate from their owners, so in the same way you can’t be held financially or legally responsible for a family members personal liability and conduct, the same applies to that of your company.
This level of legal and financial protection is known as the corporate veil and provides an essential level of legal separation between a company and it’s multiple shareholders.
Sadly for sole traders it can be common for them to end up in serious financial difficulties if they rack up business liabilities like trade and tax creditors, enter into large credit agreements, or even in situations where there is legal action against their business and it’s not covered by their insurance.
To further minimise the risk within a limited company it is also possible to own it indirectly through a holding company. This enables the pay out profits without triggering dividend tax, but enables the money to sit within another company, which is it’s own legal identity and therefor is protected from issues caused by it’s subsidiary.
Benefits of using a holding company
This can be doubly beneficial if the company has multiple owners with different personal circumstances and other forms of personal income, because in addition to the risk reduction it is also possible to benefit from being able to independently receive dividends from the other owners.
Limited company vs limited liability partnership
One thing that a limited company and limited liability partnership have in common is that they offer the owners or partners protection from being held personally liable for any business debts. This gives them a certain degree of legal protection which makes it difficult for them to lose personal assets because of mistakes their business makes.
LLP’s are typically still the equivalent of the business and owner being the same entity, however they come with legal protection from losing personal assets. People often confuse them with LTD’s, however the difference in terms of how they are operated is light and day.
Unlimited liability companies
It is also possible to have a company with unlimited liability, which means that unlike a limited company the shareholders are personally liable for the companies debts should it default on them. This structure for a company is rare due to there being no obvious benefits over an above that of a partnership or sole trader set up.
Do we have to be a limited company if there are multiple owners?
The answer to this is no, because two sole traders can work together as a partnership. My advice here would be that unless you really trust your partner, then definitely go limited because the liabilities they cause when running the business through a partnership business structure can jeopardise your personal assets.
Customers liability as deemed employer
Providing services to customers through a limited company can be very appealing to them because most of the time unless the IR35 large company rules apply, it eliminates the risk of you as a supplier being deemed an employee of your customer and HMRC demanding employer taxes from them relating to your disguised employment.
Hiring employees as a self employed person
I have always highly recommended that anyone employing staff or hiring self-employed workers should do it through a limited company due to the increased risks that come with employment, whether it’s injury, negligence or tribunal action.
3. How being a sole trader helps you keep your costs down
Accounting fees are usually much lower for sole traders than for limited companies, mainly because there is just less work to do from an annual accounts and tax point of view, due to the time consuming company accounts having to be filed in one format with Companies House and another format with HMRC along with the CT600 tax return.
Aside from more paperwork with the accounts the quality of accounting work needed with limited companies is also higher as much of it is available for public inspection, whereas with sole traders only a self assessment tax return is needed.
When considering the sole trader versus limited company options a common misconception is that the Payroll and VAT side of things doesn’t apply to the self employed, this is not the case and the tax requirements for both are the same regardless of the business type.
4. Why incorporating your business is good for your reputation
The main reason why it can be beneficial to incorporate your business from a reputation point of view is because the annual accounts, albeit in a summarised form that doesn’t show profit are available online for potential suppliers and customers to see.
The caveat to this is that if you run your company responsibly and profitably then people will be able to see that, but if you’re regularly late with filings and are becoming unprofitable then that will be obvious as well.
Switching between being a sole trader or limited company
It is possible to switch between the two different structures depending on the needs of your business, but this should not be done often as there is work and cost involved. It is still possible to keep using your business name when you go limited even if the exact company name isn’t available, as it is quite common for a limited company choosing to have a different business trading name to its company name.
Business details and business bank account
One of the challenges between switching between the two structures is that you often have to set up a new bank account as well as change any contracts and terms and conditions you have in place. This can be quite a burden on a business owner so it’s better to pick one, and stick to it.
Hopefully this article has made you aware of the various factors to consider when making the decision about whether to be a sole trader or limited company. I run a firm of accountants based in Northampton, Northamptonshire, however we work with a range of clients throughout the country. I’d like to invite you to reach out if you have any questions or need advice for your specific situation.