Sole trader vs. limited company – which one is best for you?

Sole Trader vs Limited Company

Table of Contents

Is it better to trade as a sole trader or a limited company?

Many startups start as a sole trader and later incorporate (move the sole trader business into a newly formed limited company). Many articles on the internet discuss the advantages and disadvantages of trading as a sole trader vs. a limited company. Most of these articles hedge their bets about the appropriate business structure at the end of the article. However, after decades of advising small businesses, we have a pretty strong opinion of what is best for most businesses.

Trading as a limited company has many advantages over trading as a sole trader

The most apparent and killer difference is the legal separation between you and your business. All businesses have risks, and this legal separation reduces the risks to you personally if your business goes wrong. There are potentially other advantages in trading through a limited company, such as tax savings and a better image.

It’s not a one-way decision, though, as there are some cases where trading as a sole trader might be appropriate. For very small businesses, the costs of the extra compliance work for a limited company can be high. Additionally, there are other business cases where trading as a sole trader might be appropriate such as a rental business where getting a property loan in a limited company can be more problematic.

Read on to find more detail on why we think for most businesses, trading as a limited company, except for the smallest of businesses, is probably the appropriate business structure for them.

See our accounting services for small businesses here.

Sole trader – No legal separation

If a person trades as a sole trader, there is no legal separation between the person and the business. For example, even though it is good practice to have a separate bank account for the business, this is not a legal requirement.

To trade as a sole trader is easy. You inform HMRC that you are trading. They issue you a unique tax reference (UTR). You submit an annual self-assessment return, including the self-employment pages with a profit or loss calculation. You are then charged income tax and national insurance on your profits.

However, the big issue with trading as a sole trader is what happens if your business hits some difficulties. As there is no legal separation between the business and the individual, the business’s debts are the individual’s debts. Businesses sometimes fail through no fault of the owner. If the business fails owing money to suppliers or HMRC, these debts will remain with the person who may have to declare personal bankruptcy to escape the debts.

Limited liability – A no brainer

To start up and register (incorporate) a UK limited company costs £10 at Companies House. This charge is an incredible bargain for the protection that it can afford you from business failure. Many accountants, including ourselves, will advise you on the company structure and set up the company free of charge.

Limited liability is not a total panacea, though. As we will see below, Directors have a legal duty not to rack up debts and close the company. However, in the event of a genuine business failure, the company’s obligations may be written off by an insolvency practitioner. In some cases, suppliers or lenders may require a director’s personal guarantee for loans. This breaks the limited liability model as this is a mechanism to pursue the directors personally for any debts. Directors should take care in assessing the risk before signing these types of agreements.

Extracting money from a limited company

When considering sole trader vs. limited company, one thing to remember is that the company and the person now have separate money. In a sole trader business, the owner can take money from the business bank account (if they have one) any time they like. This flexibility is not valid for limited companies. If an owner (shareholder) takes money from a limited company, they must do it by salary, dividends, or a loan.

There are complex rules for loans from a limited company to a director or shareholder. There can be a potential benefit in kind tax charge. If a loan is outstanding at the company year-end, there may be corporation tax consequences if the loan is not repaid by nine months after the year-end.

Additional compliance for a limited company

One possible downside of trading as a limited company is the additional reporting that is required. A sole trader has no requirement to submit anything to Companies House, only to HMRC. A limited company, at a minimum, must file annual accounts, an annual confirmation statement (confirming the standing data for the company and any share transactions), and documents to show the ultimate control of the company. These filings are made to Companies House, and there are small fees involved with some of them. Additionally, other filings must be made if there are changes to the structure of the company, changes in address for the directors or business, or a mortgage charge is put on company assets.

On the tax side, a limited company comes under the corporation tax regime for business profits, so a corporation tax return must be filed and the self-assessment forms for the directors. This is a more complex filing than the self-assessment form for a sole trader, so again the company is adding more work. Payroll and VAT filings are the same in a sole trader or limited company.

Compliance for a limited company can be complicated, and it is quite challenging to do all the filings yourself. The majority of people will engage an accountant specialising in limited companies to do this work for a monthly fee of about £150 a month upwards depending on the work carried out.

Additional responsibilities for directors

Along with the compliance come additional responsibilities for the directors of a limited company. In a small limited company, the shareholders (owners) and the directors are often the same people though they do not have to be. The directors are responsible for the day-to-day running of the company. They are responsible for ensuring all the compliance is dealt with and that the company is run sensibly. More details on the duties of a director can be found here.

Tax advantages of a limited company

One possible advantage of running a limited company may be a tax saving for the owners. There are several different ways that a company can be more tax-efficient than running your business as a sole trader. One significant tax benefit comes from paying dividends from the company, which means that there can be a saving on national insurance.

Sole traders pay national insurance on their profits as well as income tax. A shareholder will still have to pay income tax on their dividends through their self-assessment tax return.

Still, there is a tax-free dividend allowance, and the dividend tax rates plus the corporation tax charge are broadly equal to income tax rates. Another benefit could come from splitting the income with a spouse through share ownership. We note some of these advantages in more detail here.

Possible tax advantages for a sole trader

There are a few circumstances where a sole trade may be beneficial vs. limited company status. When a business starts up, it often has losses in the first year or two. In a sole trader business, these losses can be offset against other income for the business owner. This relief is available up to £50,000 of losses and can be useful if a person still has a PAYE job, for example, while they are starting their business.

There are also arguments in some cases for running a property letting business through a sole trader business as buy to let mortgages are harder to get. However, this situation is changing over time as more people are using a limited company for their letting properties, especially due to the mortgage interest tax relief restriction on personally held properties.

Contact us for advice on whether a sole trader or limited company is suitable for you

We have advised hundreds of clients on the pros and cons of being a sole trader vs limited company. As we said at the start of this article, we would typically make the following recommendation rather than hedge our bets.

For all but the smallest of businesses, it makes sense to trade as a limited company. There are potential tax savings in most situations, and the limited liability makes it a safer alternative for most people. As soon as a business has potentially large VAT or PAYE bills, a limited company can protect an owner from becoming personally liable for these debts if the worst happened.

Contact us here to talk to us about your new venture or if you have a sole trader business that you would like to incorporate.

John McLaughlin Chartered Accountant Scotland

John McLaughlin

Sutherland Black are plain talking accountants based in Scotland. We’ll support your business growth and goals. Talk to John today for friendly yet expert accounting advice.

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