Choosing whether to set up as a sole trader or a limited company is a key decision for a new business. As two of the most common legal structures, there are some important differences that you'll need to consider. Which option you choose will have an impact on your admin and tax responsibilities amongst other things. 

Sole trader vs limited company: What's the financial risk?

Most people who set up their own business register as a sole trader (i.e. become self-employed). The other popular option is to “incorporate” a business, which means registering a private limited company with Companies House.

The personal financial risk is a key factor to consider when weighing up whether to register as a sole trader or set up a private limited company.  

If you register as a sole trader, in law, there’s no distinction between you and the business. This makes you personally liable for business debts, which can place your personal assets – possibly including your home – at risk if the business fails.

Some people aren’t comfortable with this personal financial risk, so they set up a private limited company, of which they become a director and shareholder. 

In law, the limited company is a separate entity, so providing you don’t trade recklessly or fraudulently, and don’t give personal guarantees for loans, your risk of loss is restricted to shares you own in the company and any personal cash you invest.  

Sole trader or limited company? Tax and NI payments

Sole traders (i.e. self-employed people) pay income tax on their business profits. There is a Personal Allowance of £11,850 a year (2018/19 tax year for all figures quoted), upon which you don’t pay Income Tax. Thereafter, the rates are:

  • 20% on £0-£34,500 income (basic rate)    
  • 40% on £34,501-£150,000 (higher rate)    
  • 45% on £150,000-plus income (additional rate). 

If you’re self-employed and earn profits of £6,205 or more a year, you must also pay Class 2 National Insurance contributions (NICs) of £2.95 a week. 

And if your annual profits are £8,424 or more, additionally, you’ll pay Class 4 NICs of:

  • 9% on profits £8,424-£46,350
  • 2% on profits over £46,350.

Class 2 and Class 4 NICs are paid through Self Assessment.

Each year, limited companies must submit a Corporation Tax Return and later pay any Corporation Tax they owe (19% of profits less allowances and reliefs). 

Company directors are classed as employees and (via PAYE) pay NICs on their salary and bonuses over £8,424. The company also pays NICs on director earnings. 

Company directors usually also receive dividend payments. You don’t pay tax on the first £2,000 of dividends you receive within that tax year, but amounts over this are subject to Income Tax. The amount will depend on which band you’re in, but you’ll pay:

  • 7.5% on earnings up to £34,500 (basic rate)
  • 32.5% on earnings £34,501-£150,000 (higher rate)
  • 38.1% on earnings above £150,000 (additional rate)

Sole trader vs limited company: What’s more tax-efficient?

If you set up a private limited company, combining a minimum basic wage (so you enjoy the benefits of paying National Insurance) with dividend payments may be a more tax-efficient way to earn income. 

But do not take it for granted that being a director of a limited company is the most tax-efficient option. Not too long ago, company directors could receive £10,000 in tax-free dividends. However, the dividend allowance was reduced to £5,000 and more recently it has fallen to just £2,000 a year. 

All things fully costed, setting up a private limited company might not be the most tax-efficient option, being a sole trader might work out cheaper and simpler, although there are other considerations. Some believe that customers and suppliers perceive limited companies to be more professional, stable, better managed, etc., although others dispute such claims. 

And while registering as a sole trader is quick and free, setting up a limited company can be achieved quickly for just £12 if you do it yourself online (it’s £40 if you do it by post). Registration costs are not much of a differentiator when choosing a legal structure, but monthly admin costs might be.   

Various online tools will give you a rough idea how much tax you’ll pay as a sole trader when compared to setting up a limited company, but there’s no substitute for seeking tailored advice from an accountant on the most tax-efficient structure for your new business.

Sole trader or limited company? What's the admin burden?

You’re likely to have to deal with much more tax-related admin/paperwork if you register a private limited company (as opposed to becoming a sole trader).

A limited company director, bookkeeper or accountant must prepare annual accounts from the company’s financial records at the end of its financial year. These must be filed when required with HMRC with the company’s Corporation Tax Return (form CT 600) and sent to all shareholders and Companies House. 

A limited company must also file a Confirmation Statement with Companies House, which includes information about its directors, shareholders and registered office. Many small businesses pay monthly fees to accountants to manage such admin, which saves time and should ensure that all paperwork is completed and filed as required. 

Sole traders do not have to file annual accounts, but they still have to maintain accurate and timely financial records. They also have to complete a Self Assessment tax return each year, detailing sales and costs, so that Income Tax and NICs can be calculated. 

Some sole traders pay an accountant or bookkeeper to maintain their financial records, fill out their Self Assessment and take care of tax correspondence with HMRC. Others, do it all themselves to save money, although it adds to their workload.

Sole trader vs limited company: Business partners and staff

You can set up a limited company with others. You become joint company directors and shareholders.

Alternatively, you could set up a partnership, whereby you share responsibility and rewards. With an ordinary (sometimes called standard or general) business partnership, you pay Income Tax and National Insurance contributions (NICs) based on your share of business profits, as well as other sources of income, if applicable. 

The partners are jointly responsible for filing the partnership’s Self Assessment tax return and HMRC must be informed of any changes, for example, a partner leaving or a new one joining. As with being a sole trader, the partners are also personally liable for the business’s debts, but to this remove this, you can set up or restructure as a limited liability partnership (LLP).

Although the tax and financial admin will be more complex than an ordinary partnership and formation isn’t as simple, registering an LLP with Companies House provides protection from personal financial liability.

Even if yours is a sole trader business, it can still have employees. But, if so, you’ll need to collect Income Tax and National Insurance contributions (NICs) and pay them to HMRC via a compliant PAYE (ie Pay As You Earn) payroll scheme.
 

Next Steps

How do I register as a sole trader?

Registering as a sole trader is the most common and simplest way to register as self-employed. 

Read more

How do I register as a limited company?

Setting up your business up as a limited company can be a more tax-efficient way to earn income, but do not take this for granted. 

Read more

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