Sole Trader or Limited Company? What’s best for me?

Jun 20, 2021

business woman thinking

When starting your own business, you must decide whether to register as a sole trader or form a limited company through which you can deliver your services.

It’s a question that virtually all of the 4.5 million people in the UK who work for themselves asked themselves before taking the plunge. It’s also one that necessitates making a well-informed choice.

We decided to compare and contrast these two popular business forms in order to help you understand the differences between a sole trader and a limited company, and so arm you with the information you need to make the best decision.

What is a sole trader?

A sole trader is the business’s only proprietor, as the title implies. Because sole trader businesses aren’t incorporated, they can get up and running quickly. It also has the advantage of reducing reporting requirements.

Because a sole trader is not a separate legal entity like a limited company, they are effectively the business. This means you are individually liable for any debts or overheads you incur while trading – often known as “unlimited liability.”

Read our guide to ‘What is a Sole Trader Business’ to discover more about being a sole trader. Check out ‘How to Become a Sole Trader’ to find the process of becomong a sole trader.


What is a limited company?

A limited company is an incorporated firm that exists independently of its owners. As a result, the company’s shareholders are not personally accountable for the company’s obligations – this sort of business is referred to as having “limited liability.”

Although forming and operating a limited company is slightly more complicated than functioning as a sole trader, it does provide more tax planning alternatives.


Tax differences between sole trader and limited companies

When deciding whether to operate as a sole trader or as a limited company, the amount and type of tax you must pay is likely to come into play. We’ll now look at the taxation of both structures:

Sole trader tax responsibilities:

  • Income tax on the profits of the business via the annual Self-Assessment Tax Return
  • Class 2 and class 4 National Insurance contributions
  • VAT (businesses must register for VAT if they turn over £85,000 or more in one year or they expect to exceed this amount in a 30 day period, but you can register before out of choice)

Limited company tax responsibilities:

  • Income tax via the Self-Assessment Tax Return
  • Corporation tax (a 19% tax on the profits achieved by your business)
  • VAT (businesses must register for VAT if they turn over £85,000 or more in one year or they expect to exceed this amount in a 30 day period, but you can register before out of choice)
  • Your company’s annual accounts and confirmation statement must be filed with Companies House
  • PAYE for employees and directors paid a salary from the business
  • Regular payroll reporting to HMRC

Business expenses

A number of expenses incurred while conducting a business can be claimed by sole traders and limited company owners. You can lower your tax bill by claiming tax relief on these items, whether you pay it personally or through your limited company.

While the costs you can claim as a sole trader or a limited company are generally the same, there is one significant distinction. A sole trader will cover these costs out of their own pocket, but in limited companies, the costs are paid by the company rather than the individual. However, depending on what the owner pays for individually (i.e. from their personal bank account), they may be able to claim it back from the company.

There are a plethora of permitted company charges, ranging from marketing to website costs, accounting fees, and office rent. The majority of expenses can only be deducted if they are incurred “wholly and exclusively” as a result of trading. Others, such as home internet expenses or your mobile phone contract, may require you to run a sum to claim a portion of the bill as an expense since it serves a ‘dual purpose,’ as defined by HMRC.


Sole trader vs limited company pensions

Contributing to a pension is not only a sensible method to save for retirement, but it also helps you save money on taxes. Limited company owners have more options than sole traders, who can only contribute to a personal pension because their business isn’t established.  These businesses’ owners can set up a workplace pension scheme in addition to a personal pension and make payments in a more tax-efficient manner.


Paying yourself as a sole trader or limited company

Sole traders can pay themselves whenever they want during the year and it will have no effect on the amount of tax they owe. This is because income earned as a sole trader is yours (not the company’s), so there is no way to pay it to yourself in a tax-efficient manner.

Limited company owners, on the other hand, may opt to remove money from their business at specific times to maximise tax efficiency. For example, if a contractor’s income is approaching the higher tax bracket, they may decide to reduce the amount they take from their firm until the following tax year, when everything resets to zero.

Most people use a combination of salary and dividends to pay themselves through a limited company, allowing them to operate in a tax-efficient but compliant manner.


Selling your business

If a sole trader sells their business, they will have to pay Capital Gains Tax (CGT) if the earnings exceeds the CGT level of £12,300 for the 2020/2021 tax year. If you earn less than £50,000 per year, you will be taxed at a rate of 10%. If you earn more than this, you’ll have to pay CGT at a rate of 20%.

If limited company owners sell shares in the company and take some of the profits for themselves, things can get a little more complicated. They will be required to pay CGT (on money obtained personally) as well as Corporation Tax on any profit made by the company when selling shares in this scenario.

To learn more about Capital Gains Tax, which is a tax on profit earned when you sell an asset that has increased in value, visit the government’s website.


Employment status for sole traders and limited companies

Employment status, whether you want to work as a limited company or as a sole trader, can be a minefield.

This is exacerbated by the fact that employment law recognises three legal statuses (employee, worker, and self-employed), whereas tax law recognises only two (employed and self-employed).

Whatever structure you use, it’s critical for both you and your customer to understand the responsibilities that have been assigned to you.

You do not receive employment rights from a client while you are classified as self-employed, and you are still responsible for paying your own taxes. If you’re in a deemed employment relationship, your client should add you to their payroll and withhold PAYE tax and national insurance from your income, as well as pay employers’ national insurance.  If you are classified as a worker, you will be entitled to some employment benefits such as the National Minimum Wage and holiday pay.

You must consider IR35 legislation and off-payroll reforms while working through your own limited company. If your assignment is determined to be one of “disguised employment,” you will fall under IR35, which means you are “employed for tax reasons” and will be taxed as an employee.  Contractors working within IR35, on the other hand, will not be offered employment rights in return, which is a major source of contention.

So which is best? Sole trader or limited company?

It’s not as if one is superior than the other. Whether you run your business as a sole trader or as a limited company should come down to personal preference – and possibly the industry you work in, your growth ambitions, and even your tax strategy, if you’re thinking that far ahead.

Whatever path you choose, feel confident that it is not a decision you must make on your alone. Please contact one of our friendly accountants if you would like expert, no-obligation assistance to help you better grasp the ins and outs of being a sole trader or limited company.