Have you been wondering if it is better for you to run your business as a sole trader or limited company? What are the pros and cons? When is it worthwhile to form a company? We will give you guidance of the pros and cons, as well as other options, in order to decide the right business structure for you. Many people may find themselves in this position and there are a lot of questions around business start-ups because it is something new to them. It is important to make sure that you know the tax implications and your responsibility because you are about to become a business owner/company director.
Sole Trader vs Limited Company
For pure tax purposes, a limited company has a lot of advantage. In particular, if you are running a profitable business the tax advantage is quite big because the company tax is only 19%. If you are making profit as a sole trader then effectively it can be taxed as high as 40%-45%. This proves that running a limited company is better for tax purposes.
For some people being a sole trader is a better option especially if you are a bootstrapping entrepreneur. This means you are a start-up but in the meantime, you’re still keeping your day job due to your business not making enough sales. Due to it being too early so you do not have enough income to cover your living expense. For example, if you are starting a consulting business or if you are a life coach and you start your business on the side, at the beginning you may have a lot of business expenses. It is worthwhile to stay as a sole trader because at this point you are effectively making a loss in your business. If you are making a loss, you can use that loss to offset any employment income. This can help you get some tax back in order to aid some cash flow to give you some more money to invest in your business.
Even if you are not keeping your day job and just starting out your business small, the structure is not too complicated. If you are providing services, it is worthwhile to remain as a sole trader because your responsibility is less than a limited company. You only have to file a self-assessment once a year as a sole trader.
At the same time, if your business structure is not that big and you are company director you have to file your company accounts every year. This is due to a limited company being a separate entity from yourself. You have to take care of your company’s tax return as well as your tax return so it’s double the responsibility. Filing company accounts is more complicated than doing sole trader accounts. You cannot randomly draw money from the company because you might get a tax charge if you are not careful enough.
When is it Worthwhile for You to Set Up a Limited Company?
Whether you are a sole trader or a limited company, you are taxed on the profits not on the top-line revenue. If you are earning £50,000 and you spend the same amount it does not make any difference because you don’t pay tax. But if you are making £20,000 in profit then at this point you might think it’s better to set up a limited company. If you do run a limited company, you can take £10,000 as your own salary because it is under the personal tax-free threshold. This does not trigger much personal tax burden and if you are running your own salary through the payroll it is a tax-deductible expense which is a tax benefit. As a limited company, you do not have to worry about the Class 4 national insurance. As a sole trader, you are not paying your income tax and national insurance as well. You might have to pay second payment on account which means you have to pay next year’s tax in advance. Cash flow wise it might not be suitable for you. Effectively, you will save company tax and then the rest can be taken as a dividend.
At the moment, even though dividend tax has changed, it is still cheaper than a salary or your sole trader income. If you are earning within the basic rate bracket, which is currently £45,000, then the dividend tax is only 7.5% which is an advantage. If you have a profit of £45,000 then 20% of it will be taxed.
When Limited Company is the ONLY option?
If you are a start-up, for example a technology start-up and you request funding or looking for investments at this point you have to set up a limited company structure. This is because you might have to give up your equity to your investors as a sole trader you cannot attract investors. As a sole trader, the business is relying on you.
If you as a business owner resign, you are ill and cannot work, or the sole trader has died then the business will die because of that person. But if you run your limited company even if you resign, you can give your share to other people and set up other people as the director so that the business can continue.
If you are looking for investors, you have to have a limited company structure. You will be able to set up a share structure for the investors, you will have A share and the investors could have B share. They will have different rights and you will have decision voting rights.
Should You Get an Accountant to Set Up the Limited Company?
It is important to consider that a limited company is more complicated and most people start looking for an accountant to help. You have to keep your books in a more comprehensive way as well as there being a double-burden. This is mainly due to filing accounts, filing the company tax and personal tax. You would need to find a professional to do it to make sure it is compliant and to keep the peace of mind. Even if you are confident to do it yourself, the time is also the cost so all of these elements need to be considered.
If you are confident and have the knowledge yourself then you can do it yourself. However, the benefits of using an accountant are:
- They will give you extra reassurance.
- They will be able to take care of what is essential to you. Especially for your start-up, the accountant will make sure you understand what you are doing and what are the critical deadlines.
There are other structures apart from a sole trader and limited company. For example, there is a partnership or even a limited liability partnership. If you are a small business, it is more effective for you to be a sole trader as things are simple but it will not stop you from being a limited company in the future.
Please note that this is not a replacement of tailored professional advice. For personalised and confidential review of your taxes and tax saving opportunities, please contact the author of this article.