There are pros and cons to structuring your business as either a sole trader or a limited company, depending on your circumstances. It’s no small decision, and one that will influence the way you run your business for the foreseeable future.
There are several key differences between the two legal structures. To help you make an informed decision, we have outlined the advantages and disadvantages of both.
Differences between a sole trader and limited company
A sole trader is the sole individual that is responsible for the business and, legally speaking, there is no difference between them and the business.
Therefore, if you are operating as a sole trader, you earn and own what the business earns and owns. You also owe what the business owes to creditors.
The director of a limited company, on the other hand, enjoys limited liability from the business – legally speaking, they are two separate entities.
Contrary to popular belief, the distinction between the structures is not necessarily to do with the business size. A company can have a small number of employees (just the director, in some cases), and a sole trader can employ as many people as they wish.
Sole trader pros and cons
There are several advantages to running a business as a sole trader.
In some ways, it can be considered as the simpler option. There is less paperwork, fewer registrations and only one tax return to do a year – your self-assessment tax return.
It is also completely free to set up a business as a sole trader, while there are fees to set up a limited company.
However, because sole traders pay income tax on their profits, they may end up paying more in tax than companies, especially if they are doing well.
That is because, as you will know, income is taxed in three different bands – 20%, 40% and 45% – while corporate profits are taxed by corporation tax at just 19% as of the 2021/22 tax year.
Furthermore, because a sole trader and their business are one and the same in the eyes of the law, your personal assets may be at risk if things do not go well. In a worst case scenario, you could face bankruptcy.
Limited companies pros and cons
While the personal assets of a sole trader may be at risk, this is less of a concern for directors of limited liability companies because of their legal nature.
And, as mentioned, companies also pay less tax on their profits than sole traders. Directors will have to extract that profit as personal payment, however, which will face a tax charge.
If you stay below the Class 2 National Insurance band, you will pay no National Insurance or income tax. You can then top up your payments with dividends, which are taxed at a lower rate than regular income.
This strategy allows many company directors to pay less on their tax bill than sole traders, even if you take corporation tax into account.
However, there are considerable costs associated with incorporating a business and running it as a limited company, so you will only feel the tax advantages if you are earning a sizeable profit.
Furthermore, you will have extra responsibilities that could become time-consuming – such as a corporation tax return on top of your self-assessment tax return, statutory records and dealings with Companies House.
Tell us about your business to find out whether incorporation is a good move for your business.