Choosing between becoming a sole trader or limited company

When you start working for yourself, one of the first big decisions will be choosing between becoming a sole trader or limited company. Picking the right option for your personal circumstances and business objectives could save you a lot of time and money.

There are positives and negatives to operating as either a sole trader, or a limited company. While it’s possible to switch at a later date, this can be expensive and time-consuming. And you’ll just have to put up with any additional costs you’ve incurred in the meantime.

  • What is a sole trader?
  • What is a limited company?
  • Other types of company structure
  • What are the advantages of becoming a sole trader?
  • What are the disadvantages for sole traders?
  • What are the advantages of becoming a limited company?
  • What are the disadvantages of becoming a limited company?
  • Making the right choice


What is a sole trader?

Sole traders (also known as sole proprietorships) are the most common examples of self-employment, with 3.2 million people working for themselves at the start of 2022 (56% of UK private sector businesses).

The main reason is that it’s simple to get started. You can simply register with HMRC and begin working, including hiring staff and taking on premises. For legal and taxation purposes, you and your business are viewed as a single entity, which makes accounting easier, and all profits after tax are yours.

But it also means you’re also personally liable for any business losses or debts. And in addition to submitting a Self Assessment tax return each year, and registering for VAT if your turnover exceeds £85,000 per year, you’ll also be subject to the new Making Tax Digital for Income Tax Self-Assessment rules in the coming years. For more details, we have a dedicated guide on how to pay yourself as a sole trader

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What is a limited company?

Setting up a limited company means that your business becomes a separate legal entity, with its own financial and legal reporting requirements. Whether you’re the sole director or not, it means you’ll have a limited liability for any losses and debts.

There are more regulations applied to limited companies, which mean you can’t just dip into business profits when you want to. And you’ll need to file more paperwork, including company accounts and corporation tax returns. This is before you also file your personal taxes and pay any amounts due on your individual income from both wages and dividends. You can find more information in our guide on how to pay yourself as a limited company director.


Other types of company structure

There are other options available when you want to become self-employed, including working for an Umbrella company as a contractor, Partnerships, Limited Liability Partnerships, Charities, or Social enterprises (including co-operatives, credit unions, and employee-owned businesses).

Broadly speaking, a partnership will be closer to operating as a sole trader alongside one or more other individuals, while a Limited Liability Partnership (LLP) is more akin to a limited company, requiring incorporation and registration with Companies House, annual accounts, and profit-sharing agreements.


What are the advantages of becoming a sole trader?

Along with being quick and easy to set up, it’s easier to manage your own accounts when you’re operating as a sole trader. At the moment, there’s minimal paperwork beyond submitting your annual Self Assessment tax return. That will change over the coming years as Making Tax Digital (MTD) rolls out, but you’ll just need to use MTD-compliant software to provide quarterly updates.

Even with the new MTD regulations, it’s still easier to operate as a sole trader. There are less administrative requirements and costs. You don’t even need separate business and personal bank accounts (although differentiating incomings and outgoings is recommended). Plus, you’re entitled to all profits, making it simple to take money from your business as and when you need it.

Another benefit to operating as a sole trader is that you retain more privacy. Unlike a limited company, you don’t need to supply company accounts and confirmation statements to Companies House, which are then made available to the public.

When you’re just starting out, losses can be used to reduce other tax due in your first year, or relief against profit from the past, even from prior employment. It’s also possible to make use of Capital Gains Tax if you sell any business assets.

In summary, the main advantages of setting up as a sole trader are:

  • Quick and easy to set up, and minimal paperwork
  • Accounting can be simpler, and you’re entitled to any profits
  • Privacy for your details and business accounts
  • No corporate tax overheads
  • Ability to use Capital Gains Tax allowances
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What are the disadvantages for sole traders?

The main downside of being self-employed as a sole trader will be the increases in tax as your income grows. For income in 2022/2023 that’s a Basic Income Tax rate of 20% on income up to £50,270, 40% on income between £50,271 and £150,000, and 45% on anything over £150,000.

You’ll need to pay both Class 2 and Class 4 National Insurance Contributions (NICs), along with registering for VAT if you have a turnover more than £85,000 over a 12-month period.

You’re also not able to leave money in your business and pay yourself more in the next tax year, as you could with a limited company.

The other big issue is that you’re subject to unlimited liability for any business debts or losses, putting your personal finances and assets at potential risk over any unpaid costs or bills. That’s less of an issue if you’re working alone with a modest number of smaller clients, but can be a big problem if you’re liable for things such as office rents, equipment costs and employees.

Some clients may see sole traders as less credible than limited companies, or even require you to have limited company status before working with them. And lenders tend to be more wary about financing for sole traders, meaning you can borrow less and face higher rates of interest.

As a sole trader, you’re also not able to protect your business name, meaning that competitors or unrelated companies can operate under a similar or identical title.

Finally, it’s more complicated for sole traders to pass on their business or sell it to new owners. As it’s not legally separate, you’ll need to organise a transfer of assets. This is also the process if you decide to become a limited company, and usually requires the help of an accountant or financial specialist to make sure it goes smoothly.

In summary, the main disadvantages of setting up as a sole trader are:

  • Potentially higher tax liabilities with less options to defer income
  • Unlimited liability for debts or losses, risking personal finances and assets
  • No protection if you’re trading under a business name
  • Some clients may see sole traders as less credible
  • Securing finance can be more difficult
  • Selling or transferring your business is more complicated


What are the advantages of becoming a limited company?

The main reason most people would give for becoming a limited company is that you’re not held personally liable for any debts. While this is true in most cases, you may still be asked to give a personal guarantee if the business is accessing loans or other financial products, and it doesn’t remove the need for relevant insurance.

Another major benefit is that there are more tax efficiencies available as a limited company, particularly if your profits are above certain thresholds. From 2023, profits under £50,000 incur a Corporation Tax rate of 19%, with percentages rising up to a main rate of 25% for profits of £250,00 and above. But as a director and shareholder, you’re able to choose the best combination of salary and dividends for your individual circumstances.

You can also choose to potentially leave profits in your business if you prefer, rather than incurring additional tax in a financial year. And Director Loans are available if money is needed at short notice, although they will need to be paid back promptly to avoid any personal tax implications.

While the allowable expenses are only slightly wider than those for sole traders, you’re able to claim them back from your business, rather than having to pay them from your personal income and profits. There are also more potential options for tax relief and deductions available for limited companies, such as Research and Development incentives in qualifying industries.

As part of setting up a limited company, your business name will be registered with Companies House preventing others from choosing an identical title. This provides some legal protection, although the use of trading names can still cause confusion unless you also apply for relevant trademarks.

You’re also likely to be seen as a more credible and professional business, and be given greater access to financial products due to the legal status and tax benefits available. It’s also potentially easier to bring in other people as directors and shareholders, or to transfer and sell your business in the future.

In summary, the main advantages of setting up as a limited company are:

  • No personal liability for business debts (unless you sign any personal guarantees)
  • Potential for personal tax efficiencies using salaries and dividends
  • Offers the option to leave profits in the business rather than taxable income
  • More opportunities for tax relief and funding
  • Some protection for your registered company name
  • Greater credibility in some industries
  • Easier to sell and transfer your business, or bring in additional shareholders


What are the disadvantages of becoming a limited company?

It’s more difficult and time-consuming to meet the administrative and tax requirements of a limited company. This can often necessitate an accountant or other support on a regular basis, as you’ll need to file accounts to Companies House and HMRC, follow PAYE (Pay As You Earn) procedures, and also file a Confirmation Statement to Companies House each year.

If you’re issuing dividends, this requires a director’s meeting, and issuing a dividend voucher. And your company can’t pay out more in dividends than the available profits from current and previous financial years.

Even if you’re a sole director, you’ll still be classed as an employee which requires payroll to be reported to HMRC in real time. And you’ll obviously also have to file your personal tax returns in addition to the business. If you take any director’s loans, they will incur tax for you and potentially also your business.

Ongoing changes to tax rates mean that the tax savings from operating as a limited company are lower compared to working as a sole trader than in the past, so it’s worth speaking with an accountant or specialist financial advisor to check which option is best for your personal circumstances now, and in the future.

Whilst your personal financial risk might be more limited, you’re still legally responsible for the business. This includes safeguarding company assets and ceasing trading if you know the company can’t survive.  This can lead to fines, prosecution and disqualification for up to 15 years. And can prevent you from certain occupations including working as a solicitor, barrister or accountant.

By submitting details of your business, including the names and addresses of directors, this information is available to the public via Companies House and other services. Your accounts will also be visible, allowing anyone to see if your company is doing well or struggling.

Operating as a limited company also makes it more likely that you can fall ‘inside IR35’, where you’re deemed to be working as a disguised employee by HMRC. Given the potential costs, it’s worth investing in IR35 Contract Reviews, with a discount available to IPSE members.

In summary, the main disadvantages of setting up as a limited company are:

  • More tax and admin responsibilities and overheads
  • Lower savings for smaller self-employed businesses than previously available
  • Limitations on withdrawing profits as salary, dividends and director’s loans
  • Legal responsibilities as a company director, including putting the business before personal interests
  • Public records of business details and accounts


Making the right choice

Choosing to become a sole trader or limited company is a decision which depends a lot on your personal circumstances, and your plans for the business. Investing in some specialist advice when you’re starting out can save you time and money over the first few years of self-employment.

In very general terms, if you’re intending to work part or full-time as a small business with a modest client portfolio and income, then becoming a sole trader may be the most suitable. Although you’ll typically pay more tax, managing your own accounts and admin can offset some of that cost.

If your business is growing quickly, or you’re planning to expand in the near future, then the benefits of a limited company will probably outweigh the increased complexity and costs of the additional responsibilities. Outsourcing the work to an accountant will lower the burden, although company directors will remain legally responsible for all aspects of the business, so it’s important to check and double check all paperwork.

Whichever option you choose, it’s always possible to incorporate a company having previously operated as a sole trader, which is relatively common, or to wind up your existing business and move in the opposite direction (which is more unusual).

Self-employment provides you with the freedom to choose exactly what kind of business you want to run, and the freedom to change it to suit your current circumstances or future ambitions.

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