When starting a new business, one of the most crucial decisions you'll face is choosing the appropriate legal structure.
Your choice can impact everything, from how much tax you pay to how much paperwork you need to do.
In this guide, we will break down the key differences between operating as a sole trader and forming a limited company.
What's the difference between a sole trader and a limited company?
The main difference is that when you are a sole trader, you and your business are considered one legal entity. That means you benefit from all the profits but also take on all the liabilities. If something went seriously wrong, you could spend all your savings, lose your home or even be declared bankrupt. It also means there can only be one owner of the business.
On the other hand, a limited company is a separate legal entity from its director(s); the owners are not responsible for any business liabilities, and their personal assets are not tied to the company. That means that shareholders and directors cannot be pursued personally for any debts the company runs up. There may just be one owner, but having multiple owners and shareholders is also possible.
Another key difference is how you get paid and what tax you pay. A sole trader pays income tax on all their business profits. If you have a particularly successful year, you’ll pay more tax.
A limited company has more flexibility. You can choose to draw a regular salary, which is taxed as normal income, but you can also earn dividends, which are taxed at a lower rate. You don’t have to take all the profits out of the business in the year they are earned, so you can make sure you’re drawing money tax efficiently. However, you will pay corporation tax on annual profits.
Complexity is another key consideration. Becoming a sole trader is easy. There’s limited paperwork, and you simply need to fill out a self-assessment form each year. A limited company has to be registered as a business, and a fee is attached. You will need to keep company records, file company tax returns each year, and fill in your own personal self-assessment form. You may also need to pay employer national insurance contributions.
Is it better to be a sole trader or a limited company?
The business structure that is the best option for you is dependent on your personal circumstances.
There are both advantages and disadvantages to being a sole trader or limited company.
Sole trader is the easiest business structure to set up and it involves a limited amount of paperwork and obligations, but you might be at a disadvantage when it comes to accessing business finance, benefiting from tax reliefs and attracting customers.
Setting up as a limited company is more complicated and involves more costs and paperwork, but it can open you up to many advantages including raising funding, boosting your reputation among customers and being more tax efficient.
Advantages of being a sole trader
Sole trader is the most popular form of business structure in the UK.
The advantages of being a sole trader include:
Start immediately: There is no requirement to register with Companies House so you can get going with your business as soon as you want to.
Very little paperwork: You only need to submit an annual self-assessment tax return you don’t need to pay Corporation Tax or file company accounts to the Government. There are also minimal record keeping requirements, unlike limited companies which must follow strict record keeping regulations.
Control over your business: You are the only one in the business so you can make all the decisions without needing to consult shareholders or partners.
Keep everything: You run your business as an individual and retain all the profits that you make after you’ve paid tax.
More privacy: Your financial information remains private, unlike that of limited companies which is accessible by anyone via Companies House.
Disadvantages of being a sole trader
The disadvantages of being a sole trader include:
Unlimited liability: You take on all the risks associated with running a business and you hold all the responsibility for its debts. You may need to sell off personal assets such as your house to pay those debts.
Limited funding opportunities: Raising business finance can be difficult as lenders and investors tend to favour limited companies. This means the growth of your business could be slower than if you were running a limited company.
Less tax efficient: Sole traders pay 20-45% income tax, compared to limited company owners who pay 19% corporation tax. Sole traders are taxed on the profits or losses of the sole trade personally, regardless of what profits they physically withdraw from their business bank account. Consequently, when the business is doing well, and you can afford to leave some of the profits in the business, it may be time for you to form a limited company.
Less credibility: Some organisations choose to not work with sole traders due to the lack of legal protection compared to limited companies.
No protection over your business name: Unlike limited companies, your business name is not protected. This means anyone can trade under the same name as you which could cause confusion.
Advantages of being a limited company
The process of becoming a limited company is known as incorporation.
Before setting up as a limited company, it is important to understand the advantages and disadvantages.
The advantages include:
Limited liability: A limited company is legally separate from shareholders and directors so you are not personally liable for any losses made by the business.
More tax efficient: Running your business as a limited company provides the potential for more profitability. Unlike sole traders who pay 20%-45% income tax, limited companies pay 19% corporation tax so they tend to be more tax efficient. They also qualify for a wider range of allowances and tax-deductible expenses. In addition, shareholders can withdraw dividends from the business which don’t attract National Insurance and have a lower income tax rate than a salary.
Funding opportunities: Being a limited company opens you up to more opportunities to access funding. Business finance lenders and investors tend to favour limited companies over sole traders due to the level of legal protection and tax benefits.
More credibility: Operating as a limited company can encourage more confidence and trust among suppliers and customers. Some businesses prefer to not work with non-limited companies.
Disadvantages of being a limited company
The disadvantages of being a legal company include:
More complex to set up and run: Being a limited company involves more paperwork and administration than operating as a sole trader. The actions you need to take include registering with and paying a fee to Companies House, filing annual accounts to Companies House, filing company accounts and tax returns to HM Revenue & Customs, following PAYE (Pay as You Earn) procedures and filing a Confirmation Statement to Companies House. All these complexities mean it is advisable to employ an accountant.
Less privacy: Limited companies have less privacy than unincorporated businesses because the accounts and other documents they file with Companies House are on public record and can be accessed by anyone.
Can I change from being a sole trader to a limited company?
Being a sole trader is a good option for many small business owners and self-employed people starting their own venture as it’s the easiest business structure to set up. However, there may become a point when you decide it’s better to be a limited company and it is perfectly possible to make the switch.
There are various reasons for why you might decide to change your business structure to a limited company. They include:
Your profits are increasing and you want to be more tax efficient.
You are looking to raise business funding.
You want to boost your business’ reputation and image in the eyes of existing and potential customers.
You want to bring on board new talent