Limited Company or Sole Trader – The Ultimate Guide
Everybody that sets out to go on a new business venture will need to choose which legal structure they will use for their business. Choosing the best structure for your business is imperative as it will have an impact on almost all aspects of your business, including how much tax you will pay, the level of paperwork involved in running your business and the impact that getting into difficulty could have on personal assets. It is vital to get this one right at the outset of your new adventure.
There are 3 choices:
Limited Company or Sole Trader – Which is Best?
To set up as a sole trader is very simple which explains why it is the most popular legal structure in the UK. You need to set up as a sole trader once you have earned more than £1,000 from self-employment in any one financial year (between 6th April and 5th April).
To set up as a sole trader, you will need to inform HMRC that you pay your tax through Self-Assessment. You will need to file a tax return every year. The financial year runs from 6th April to 5th April. i.e. any income received from self-employment between 6th April 2020 through to 5th April 2021 will be need to be reported to HMRC by completing a self-assessment. You have until 31st January the following year, in this case until 31.01.22 to submit a self-assessment. If your return is late, HMRC will issue penalties.
You can simply click on the link below to register for self-assessment.
If you decide to set up as a limited company, you will have to choose a name. Firstly we need to see if your chosen name is available by checking the “company name availability checker.
With your name chosen, we must now appoint directors. You can have a single directorship, or more depending on your requirements.
Next you need to decide who the shareholders are. The shareholders are the people who actually own the business. Being a director does not mean you own the business. Anyone who owns shares of a limited company will receive a percentage of the trading profits depending on the percentage of their ownership. Alongside appointing directors, we need to identify the person/people with significant control. The PSC is the person who has the voting rights. This is the person who can make changes to the business. The PSC is usually the shareholder who owns the majority of the shares. Therefore if there is only 1 director, you are also the PSC.
A memorandum of association and articles of association will need to be prepared. These are available for download when registering your limited company.
Finally we register your company. You will need to register an official address and choose a SIC code which is what identifies what your company does.
When you register your company, at the same you need to register for Corporation Tax. Let’s now take a look at the pro’s and con’s of the different legal structures, which will hopefully help you decide which is the best option for you.
Advantages of a Limited Company
One of the biggest benefits of operating as a limited company instead of a sole trader is that a limited company has the benefit of limited liability. This is because incorporation forms a legal distinction between the business owner and their business. This means that personal assets are not threatened should you get into difficulty, and you only stand to lose what you have put into the company.
Often, limited companies stand to be more tax efficient than sole traders. This is because the profits of the business will be split between a personal tax return and a company tax return. We generally put our directors on a payroll, paying them approximately £8k per year. Money taken over this threshold would be classed as dividends. We all have a personal allowance which currently stands at £12,500. In addition to this you can take £2k worth of dividends tax free, which in essence takes your personal allowance up to £14,500. Therefore, you can earn £14,500 through your limited company before you pay personal tax. Dividends are taxed at 7.5% instead of the tax rate of 20% used for sole traders. The reason for putting directors on the payroll is that this will be a direct expense to the business, thus bringing the corporation tax liability down. Dividends are not seen as a direct expense so will not decrease the corporation tax liability.
So we have covered the personal tax. Now we need to look at the company tax. As mentioned above, this is called Corporation Tax. This is paid on the profits of the business. The profit of the business is calculated by taking the sales figures and deducting the expenses figure. This leaves you with your net profit. Corporation tax is charge against the net profit at 19%.
Another benefit of trading as a limited company is that you have a far wider scope of expenses that can be claimed for, thereby, bringing the profit of the business down, bringing the tax liability down.
Life as a limited company will bring added responsibilities. There will be more paperwork which will in turn bring more costs.
The main disadvantage of trading as a limited company, rather than a sole trader, is that as a limited company owner, you have to prepare annual accounts. These need to be filed with Companies House. You will also need to file Corporation Tax accounts for HMRC.
The cost for having your year end accounts submitted against having a self-assessment tax return completed are very different. I would expect to pay approximately £200 for a self-assessment with the cost increasing to £750 for a set of limited company accounts. Of course the latter could vary considerably depending on your turnover. If you are a start-up company, I would expect to pay as little as £350 for the first year end accounts, which would then increase as your tunrover increases.
To do things properly as a limited company, you do need to keep on top of your bookkeeping. This may introduce additional costs, if you were to bring a bookkeeper in to the business to complete this on your behalf.
Another thing to bear in mind is that if you have a limited company, your business information can be found via Companies House. Details of directors and your company balance sheet are required to be shown publicly. Not everybody is comfortable with this, however in the grand scheme of things, this is nothing to worry about.
Limited companies offer you limited liability. There is more paperwork involved which will bring increased costs. Limited companies often are more tax efficient.
Probably one of the most attractive reasons for setting up as a sole trader is the simplicity of it. This is both in terms of set up and running the business. There is less paperwork involved with trading as a sole trader. The cost for your year end accounts i.e. self-assessment, will be considerably less than the cost of year end accounts for a limited company.
Sole traders are offered greater privacy than an incorporated business whose details, as mentioned above, can be found via Companies House.
Sole traders are not protected by limited liability. In fact, you will be completely responsible for your business and its finances. As a sole trader, the business owner and the business are treated as one entity. If you have business debts as a sole trader or your business gets into difficulty, your personal finances and assets are in danger. This is because legally there is no difference between your assets and the business’ assets.
As well as your finances, you will need to keep in mind any legal disputes. You need to ensure that you have the appropriate insurances as a sole trader to ensure that you will not get sued personally. As mentioned above, in the eyes of the law, you and your business are the same, without insurance, you will be sued personally.
To summarise, being a sole trader allows you complete control of your business, with less paperwork, less accountancy expenses, but it does come at a cost of an increased level of risk.
Profit Before Tax
Take Home After Tax
Based on the tables above, as a Limited Company your take home money after tax has increased by £1,557.14.
The best advice when deciding which legal structure you want to use for your business is to say “do not rush into any decision and speak to an accountant if you are unsure which structure will be best for your business”.