One of the first questions many new clients have when starting their business is whether that business should be a sole trader or limited company.
Each option has its own advantages and disadvantages and business owners should weigh these up carefully before deciding which route they wish to go down.
Firstly, let’s look at the basics.
- An individual sole trader is the business. There is no legal separation between the business and the individual
- A limited company is a separate legal entity from the individual directors or shareholders
- An individual sole trader would be liable for the debts of the business; a company director (normally) would not
- As a sole trader you are self-employed ; as a director you are an office holder and in most cases an employee of the company
Now that we’ve covered the basics, let’s look at the issue which is asked more than any other – tax!
Generally it is deemed to be beneficial to trade as a limited company from a tax perspective but doing so requires adherence to certain rules and conditions, which I will cover next week in a separate article.
As a sole trader you will be required to pay tax on profits above your personal allowance at your relevant tax rate in addition to Class 2 and Class 4 National Insurance. For a basic rate tax payer this will be 20% tax, £153.40 annual Class 2 and 9% Class 4 on profits above the threshold.
As a limited company shareholder you can use up your personal allowance by drawing a directors salary and then extract further profits via dividends from your company. Corporation tax is paid at 19% meanwhile dividend tax (above £2,000) is paid at 7.5% for basic rate taxpayers.
For a business with profits of £25,000 you can expect an approximate tax saving of £800 per year if incorporated as a limited company as opposed to a sole trader. (This saving has reduced in 2018/19 as the government have reduced the dividend tax allowance from £5,000 to £2,000).
As a sole trader you can withdraw money from the business without any tax effect and this can be done easily and at any time convenient to you.
As a limited company however there are certain rules that must be obeyed. Directors salary should be drawn as directed by your payroll. Dividends can then be drawn but must be paid to all shareholders in amounts proportionate to their shareholding. Unlike a sole trader, withdrawing dividends will affect your personal tax liability and so timing your dividend payments can be an important consideration.
Sole traders are not legally required to produce accounts for tax purposes, although in most cases these are required to complete your Tax Return. These accounts do not get submitted to HMRC.
Limited companies on the other hand must prepare accounts by law and file these with both HMRC and Companies House. The accounts to HMRC must be full accounts and submitted online in iXBRL format. The abbreviated accounts to Companies House, usually consisting of a balance sheet and notes, will appear publicly on the Companies House records.
- Limited companies offer the business owner more protection than trading as a sole trader which, depending on your industry and circumstances, can be an important consideration
- Limited companies are also likely to be the most tax efficient way to trade
- Sole traders however are subject to fewer rules and can extract money from the business easier and with no tax implications
- Sole traders also do not have to submit accounts; there is more paperwork and legal requirements with limited companies
- Trading as a limited company may look more professional and, in some industries, is key to obtaining work, particularly if working for agencies
If you have any questions about this article or if you want to discuss your own circumstances then please don’t hesitate to get in touch and we will be delighted to help.