When you are newly self employed or are starting a small business, one of the key decisions you need to make is whether to be a sole trader or to run your business as a limited company (there are other options for business structures including partnerships, but we have focussed on the most common two structures).
A sole trader is basically just someone trading as themselves – there is no separation between them and the business. This is what HMRC refer to as “self employment”. A limited company on the other hand is a separate legal entity to you personally – it might be called “Joe Bloggs Limited” and it might be run entirely by Joe Bloggs, but it’s still a separate legal entity.
There are quite a lot of differences to consider, but in this article we have focussed on three of the key differences between the two structures:
– Administration / paperwork
– Limited liability
When you are a sole trader you will prepare and file a personal tax return which will disclose your self employed profits as well as any other income you might have in the personal tax year. You can refer to our online tax return checklist to see what other income has to be reported on your personal tax return.
Based on the 2014/15 tax rates your first £10,000 of income will usually be free of tax (known as the personal allowance), then between £10,000 and £41,865 it will be taxed at 20% and above that the tax rate increases to 40%. There are other tax rates and issues to be aware of, but for most people new to self employment or starting a small business these are the main levels.
You will also have two types of National Insurance to pay, Class 2 and Class 4 – you can find further information on these at Gov.uk.
A limited company, on the other hand, pays corporation tax at a rate of 20% of its profits. You also need to think about how to extract money from your company and the most tax efficient way of doing that currently for a one-person business is usually through a combination of a low salary and then dividends.
With a typical simple one person business (with no other income outside of the business) the tax and national insurance (ni) savings of a limited company vs a sole trader (based on the 2014/15 tax year) are roughly as below:
£20k profits = tax & ni savings of £1.0k
£30k profits = tax & ni savings of £1.9k
£40k profits = tax & ni savings of £2.8k
Generally, purely from a tax point of view we don’t tend to recommend people trade through a limited company unless their profits are going to be £30k+. However, as discussed below, there are non-tax issues to consider.
It is much simpler to be a sole trader – you will need to keep a record of your income and costs and will have to file a personal tax return, but as a limited company you have to file company accounts, corporation tax returns and annual returns as well as being aware of the other duties you have as a director and shareholder under company law. You will also need to set up a bank account in the name of the limited company and be more structured about how you take money out of the business (salary and dividends). If you engage an accountant then generally you will find the accounting fees are on average about £1k higher per year when you’re a limited company because of the increased filing requirements.
This is a big advantage of a limited company – your personal assets will be protected by trading as a limited company (as long as you haven’t signed any personal guarantees). You will have duties as a director, but as long as you have adhered to these duties and operated within company law then if the business fails you should not be held personally liable.
Generally our advice is that if you are just starting out and you are not likely to be earning a lot of money to start with and if you are not operating in an industry where you are likely to be sued then it is probably simpler to start off as a self employed sole trader and as the business grows consider a limited company structure further down the line. If, however, you are likely to be fairly profitable from early on then a limited company structure may be more appropriate.
We have written a couple of articles relevant to this subject which you might find useful: