Accounts Tax Vat

Accounts, Tax and Vat explained in plain English

Sole Trader vs Limited Company

sole trade or limited companySole Trader vs Limited Company

A lot of people get confused about the differences between a limited company and a sole trader, and for that reason it is one of the most common questions asked when starting a business.

There is no straight forward answer to which one is best as it will depend on a number of circumstances including the type of business involved and how it will be run.  Hopefully by the end of this you will understand the difference and the advantages and disadvantages of each.

What is a sole trader?

A sole trader is an individual in business who are classed as self employed and will be required to prepare a yearly self assessment tax return.

It is the most basic form of running a business and often the choice for small business owners due to its simplicity.

To become a sole trader it is simply a case of notifying HMRC that you intend to commence self employment, something which needs to be done within 3 months of starting business to avoid any potential penalty.

What is a limited company?

A limited company is a privately owned company (public companies are plc’s) where the owner(s) is/are usually the director(s).  The company will have shares and shareholders (these may just be the director(s) and as indicated by the name the company will have limited liability (explained below).

A limited company is often referred to as being incorporated.

Setting up a limited company can be done on your own through Companies House using the necessary forms, via a formations agent or with the help of an accountant.

The process can cost as low as £18 for a basic setup through Companies House, more if statutory books and records are required or the company needs to be set up differently.  An accountant can advice on the best course of action, which could help save money in the long run as an incorrectly set up company could have financial implications in the future.

How does a sole trader differ to a limited company?

A sole trader in simple terms is a self-employed individual (if more than one person are involved in the business then it is often referred to as a partnership).  The individual is the business and usually the only person involved in the day to day running, he/she will receive all of the profits of the business and in turn is liable for all of the debts.

A sole trader pays tax on their income i.e. the profits of the business and from a tax point of view will complete a self assessment tax return and usually make payments on account to HMRC for any tax due, together with national insurance both in the form of Class 2 fixed rate contributions and Class 4 on profits.

A limited company can be one or more person and pays corporation tax on profits it makes, however unlike a sole trader a limited company has limited liability hence the name.  This means that any debts incurred or any legal claims are against the company not it’s owners or shareholders.

A limited company can choose to pay shareholders dividends from the company which can be used as a tax benefit  due to the different rates of tax for dividends.

A limited company must publish annual accounts and make them publicly available through Companies House, together with details of directors and shareholders, a sole trader on the other hand must still keep accounts although only need to prepare a more basic version for use when preparing a self assessment tax return.

Which is best?

This depends on a number of things, such as;

  • How much profits are being made in the business.
  • How these profits are going to be used.
  • The type of business.
  • What direction the business is likely to go in.

Many businesses start as a sole trader as it is easy to do and removes the legal formalities requires with a limited company.  However a limited company does have the benefit of protection both in terms of limiting the liability the business has and in terms of personal assets.   Often a limited company is created due to the tax benefits especially where a business is making reasonable profits.

A limited company also has the benefit of giving a more professional opinion, those in business and the general public will tend to feel more comfortable dealing with a limited company rather than a sole trader, that’s not to say it is the best option all of the time.

A sole trader business requires fewer formalities such as statutory annual accounts, yearly paperwork and associated fees with the completion of these.  This is where the tax benefits of one over the other need to be considered as once a certain point is reached a limited company will be a more beneficial set up for tax purposes which is turn will outweigh the costs involved with maintaining a limited company status.

Tax benefits

A lower corporation tax level offered a limited company advantages over being a sole trader in recent years.  With the basic rate of corporation tax at 20% (2012/13) for small companies there may seem little advantage compared to the current 20% (2012/13) rate of tax for sole traders under self assessment.  Once sole trader national insurance is considered the saving become apparent as detailed in the below table.

The real benefit however comes into effect once a sole trader reaches levels of profit at which higher rate tax comes into play being £34,370 (2012/13), at which point a sole trade would pay 40% tax.

Annual Profits (2012/13 rates) £10,000 £50,000 £90,000
Sole Trader
Income tax (20%/40%) 379 9,884 25,884
National Insurance – Class 2 (£2.65 pw) 138 138 138
National Insurance – Class 4 (9% £7,065 – £42,475 +2% above) 216 3,289 4,089
Total 733 13,311 30,111
Limited Company
Corporation tax (20%) 502 8,502 16,502
Additional tax on dividends 630 8,630
Total 502 9,132 25,132
Saving 231 4,179 4,979
The above table is based on the 2012/13 tax rates and uses standard tax codes.  It is also based on a salary being taken at the maximum allowable before tax and national insurance is due and that the maximum dividend is taken.  The calculations are for guidance only.

Obviously at the lower end the benefit is minimal and you would need to factor the additional costs of preparing statutory accounts through an accountant, plus the initial set up fees of becoming a limited company.

One problem with running a business as a sole trader is that there is little option to spread the profit as it fall taxable in the same tax year regardless of whether the individual has spent the profits of the business.  Running the business through a limited company would allow the individual to draw profits when necessary and therefore avoid the need to go into a higher rate of tax unless needed.

There is also the benefit that as a limited company shareholders can be paid via a dividend, dividends are subject to a lower level of tax of 32.5%  when the basic rate of tax is exceeded.  Therefore if higher rates of income are needed then dividends have the benefit or reducing the need to pay 40% (and higher) tax.

Other Considerations

  • IR35 issues and rules
  • Pension contributions (more beneficial to pay via a company in general terms)
  • Personal mortgage issues (Sole traders may have issues with mortgage applications – self certification etc.)
  • Insurance requirements (may be less expensive to pay if a limited company)
  • Customer requirements (some customers for example government agencies may require limited company status).
  • How long the business will continue to trade in the future.

If you wish to discuss this or any other topic with a qualified accountant then please use the enquiry form or get in touch via the contact page.


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