Sole Trader vs Limited Company: Which is Right for You?

Welcome to our easy-to-understand guide on sole trader vs limited company. We know that choosing the right business structure can be a bit of a head-scratcher, but don’t worry, we’re here to help! This guide will walk you through the key differences between operating as a sole trader vs a limited company. We’ll cover the pros and cons, the legal and financial implications, and everything in between. So, whether you’re just starting out or considering a change in your business structure, this guide is your friendly companion to help you make an informed decision. Let’s dive in!

What is a Sole Trader?

A sole trader, or sole proprietor as it’s sometimes called, is a type of business structure where one individual owns and runs the entire business. It’s the simplest form of business structure and is pretty popular among small businesses and self-employed folks. The owner, who is the sole trader, has total control over the business and can make all decisions. But keep in mind, they also take on all the risks and responsibilities. So, if the business gets into debt, the owner is personally liable. It’s like being the captain of your own ship, with all the freedom and challenges that come with it!

Advantages of being a Sole Trader:

Complete Control: As a sole trader, you have complete control over your business. You make all the decisions and can change the direction of your business whenever you want.
Easy to Set Up: Setting up as a sole trader is straightforward. There’s less paperwork and legal formalities compared to setting up a limited company.
Keep All Profits: You get to keep all the profits after tax, which can be a big incentive if your business is successful.
Privacy: Sole traders have more privacy as their accounts are not made public, unlike limited companies

Disadvantages of being a Sole Trader:

Unlimited Liability: If your business runs into financial trouble, you’re personally responsible for all the debts. This could mean selling personal assets to cover the debts.
Difficult to Raise Finance: It can be harder to raise money as a sole trader. Banks and investors may see you as a higher risk compared to a limited company.
Pressure: The success of your business rests solely on your shoulders. This can be stressful and demanding.
Lack of Continuity: If you decide to stop trading or if you pass away, the business doesn’t continue. This can be a disadvantage if you want your business to carry on in the future.

What is a Limited Company?

A limited company, in simple terms, is a type of business structure where the liability of the shareholders is limited to the amount they’ve invested in the company. This means, if the company runs into any financial trouble, the personal assets of the shareholders are protected. They are only responsible for the company’s debts up to the value of their shares. Setting up as a limited company is a popular choice for many businesses because it offers that extra layer of financial security.

Advantages of being a Limited Company:

Limited Liability: Your personal assets are distinct from your business assets, offering protection in the event of financial difficulties.
Build Trust with Clients: Clients often prefer to conduct business with companies rather than individuals, which can provide a competitive advantage.
Easier Access to Funding: Limited companies often find it easier to secure funding from banks or investors compared to sole traders. The structure offers a clearer separation between business and personal finances, making lenders feel more comfortable.

Disadvantages of being a Limited Company:

Maintaining Accurate Records & Annual Filings: Running a limited company comes with a heightened responsibility for accurate financial record-keeping. Detailed accounting practices are crucial to meet legal requirements.
Limited Flexibility in Profit Distribution: Profit distribution in a limited company typically occurs through dividends, which are subject to personal income tax for shareholders.

The Key Differences: Sole Trader Vs Limited Company

Both sole trader and limited company structures have their pros and cons. It’s important to consider your personal circumstances, your business goals, and your risk tolerance when deciding which structure is right for you. Consulting with a business advisor or accountant can also help you make an informed decision.

Personal Liability

When we say you’re personally liable, it means that your personal finances and assets are at risk. If your business can’t pay its debts, your personal assets, such as your house, car, or savings, may be used to cover these debts. This is a significant risk and one that you should be fully aware of before deciding to operate as a sole trader.

A limited company is a separate legal entity from its owners. This means that the company’s finances are separate from the personal finances of the owner. This structure provides a level of protection for the owners’ personal assets, so even if your company faces financial difficulties, your personal assets are generally safe. It’s like a protective bubble around your personal belongings. However, remember that this protection doesn’t apply if you’ve given personal guarantees for business loans or if you’re found to be trading irresponsibly.

Shared Responsibility

As a sole trader, you are responsbile for all decisions within the business – it is your sole responsibility. In a limited company, the responsibility for the business decisions is shared among the directors. This can take some of the pressure off compared to being a sole trader, where all decisions rest on your shoulders.

The UK Tax Year

The UK tax year for both sole traders and limited companies runs from the 6th of April to the 5th of April the following year. However, the way they report their taxes differs.

Sole traders need to submit a Self Assessment tax return by the 31st of January following the end of the tax year. On the other hand, limited companies operate slightly differently. They report their corporation tax based on their own ‘Accounting Period’, which is typically the 12 months from when they started trading. But don’t worry, HMRC will let you know when you need to pay your taxes. It’s always a good idea to keep on top of these dates to avoid any late penalties.

Difference in Taxes

A main difference in sole traders vs limited companies lies in how they’re taxed. A sole trader is taxed through the Self Assessment system, paying Income Tax and National Insurance on their profits. A limited company pays Corporation Tax on its profits, and any salary or dividends drawn by its directors are subject to Income Tax and National Insurance. The rates and thresholds for these taxes are different, which can make a big difference to your take-home pay. It’s always a good idea to chat with an accountant to figure out what’s best for your specific situation.

National Insurance Contributions

Both sole traders and limited companies are required to pay National Insurance contributions, but the rates and thresholds vary. Sole traders pay Class 2 and Class 4 National Insurance, while limited companies pay Class 1 National Insurance on salaries paid to directors and employees.

Tax Relief for Limited Companies

Limited companies can claim certain expenses as tax relief, reducing their Corporation Tax bill and, depending on your situation, can make you more tax efficient than being a sole trader. Some tax relief examples can include business costs like office rent, staff salaries, and business travel.

Financial Record Keeping

As a sole trader, you should keep a record of:

All sales and income
All business expenses
VAT records if you’re registered for VAT
Records about your personal income

These records will help you fill in your Self Assessment tax return accurately. Every year, you’re required to submit a Self Assessment tax return to HMRC. This is where you report your business income and expenses, and calculate your profit. Based on this profit, you’ll pay income tax and National Insurance.

Starting a limited company in the UK comes with more complex financial reporting obligations. You’ll need to prepare and file annual financial statements with Companies House and submit a Corporation Tax return to HMRC.

Every year, limited companies must prepare financial statements that include:

A balance sheet that shows the value of everything the company owns, owes and is owed on the last day of the financial year
A profit and loss account that shows the company’s sales, running costs and the profit or loss it has made over the financial year
Notes about the accounts
A director’s report (unless you’re a ‘micro-entity’)

These financial statements must be filed with Companies House.

In addition to the financial statements, limited companies must also submit a Corporation Tax return to HMRC. This is where you report your company’s profits and calculate how much Corporation Tax you owe.

Is it better to be a sole trader or a limited company?

The choice between being a sole trader or a limited company really depends on your individual circumstances and business goals. If you’re looking for simplicity and full control, being a sole trader could be the way to go. You get to make all the decisions and any profits are yours alone. However, being a limited company can offer more financial security as your personal assets are separate from your business assets. It can also give your business a more professional image and may even open up more funding opportunities. So, there’s no definitive answer – it’s all about what works best for you and your business!

Can I Change From a Sole Trader to a Limited Company?

Yes, you can absolutely change from a sole trader to a limited company if you initially decide to setup as a sole trader. There will be some administrative steps involved, such as registering the limited company with Companies House and potentially notifying HMRC of the change. It’s important to consider both the advantages (limited liability, increased credibility) and disadvantages (increased paperwork, double taxation) of a limited company before making the switch. Consulting with an accountant or legal advisor can help you determine if a limited company is the right choice for your business and ensure a smooth transition.

Sole Trader Vs Limited Company