The process of changing from a sole trader to a limited company is seen by many business owners as entering the ‘big leagues’ and graduating to become a ‘proper’ business. But what does it actually mean to go from being a sole trader to a setting up a limited company, and why do it? Let’s take a look.
Why change from a sole trader to a limited company?
Many businesses start off as sole traders because it’s the most simple form of business to set up. If you just want to get out there and start plying your trade in whatever field you’ve chosen, it’s the most straightforward route from A to B. Some businesses stay this way their whole lives, and for some business owners, it’s enough to allow them to achieve their aims. But for businesses who want to make that next step, employ more staff and invest more money into their venture, it often makes sense to convert to a limited company instead.
Basically, setting up a limited company means that your company becomes a legal entity that’s separate from you. As a sole trader, you ARE your business, which isn’t an ideal position to be in when you’re talking about an enterprise that’s worth tens of thousands of pounds and is responsible for people’s lives. There are advantages to changing to a limited company, including giving you more legal protection if something goes wrong, making your business more tax-efficient, protecting your businesses’ name and identity in law and adding a gloss of prestige to your venture that you get from having LTD after your name.
When is the right time to change?
It’s not always obvious when it’s the right time to make the change from sole trader to limited company, but there are a couple of rules of thumb that you can use. One of the big advantages of being a sole trader is simplicity, and many young businesses that are just starting out find that the ease of the rules they have to follow, and the easier accounting and tax regulations in place, are a great help. If your earnings are still fairly low and you don’t have any (or many) staff, it can be a good idea to stay this way for longer. However, there comes a point where the advantages of simplicity are outweighed by the disadvantages, and you get to a position in which it would be advantageous to make the transition. This usually happens when you end up paying significantly more tax as a sole trader than you would as a limited company, typically when your profits sit around the £30,000 per year mark, or when your legal liabilities are more than you could comfortably afford to pay if something went wrong.
This transition brings with it another set of issues, most notably the paperwork involved in dealing with the transition and your new accounting responsibilities. While you may have been able to handle this yourself as a sole trader, it’s almost certainly now the work of an accountant or business administrator. As a result, if the difference in the amount you’ll save is marginal, it’s always best to err on the side of caution and remain a sole trader until there is a real advantage to transitioning. Otherwise, you could easily find yourself drowning in paperwork, and the associated costs, while feeling little benefit. If you’ve timed it right, the cost of taking on help should be more than covered by the savings you’ll make by being more tax efficient. This is also a good opportunity to make your business more diverse and to take advantage of the greater opportunities afforded to limited companies, such as taking on new investors as shareholders or directors.
What do I have to change to become a limited company?
Becoming a limited company is more than just a technical change to your tax code, it’s a totally different way of thinking about your business, so there are a few things you need to do differently. Some of these are fairly minor, while some can have big legal and financial implications, so it’s good to make sure you’ve done your research!
One of the biggest changes is in the type of tax you’ll pay. When you’re a sole trader you pay tax as if the money your business earns is your personal income, so you have to pay self assessment income tax and National Insurance like any other person. As mentioned earlier, becoming a limited company means creating a separate legal entity to you, which means you’ll pay corporation tax on your revenue rather than self assessment. This can mean a significant drop in combined taxes from up to 47% to as little as 19%, but don’t forget you’ll still have to pay income tax on any salary you draw from your company as before.
Consider IR35 responsibilities
IR35 is a piece of UK tax legislation brought in to tackle the problem of disguised employment, which is a kind of tax avoidance. In this scam a company sets up separate limited companies for all their employees, usually family members, allowing them to pay corporation tax instead of income tax and avoid paying National Insurance by paying out dividends to themselves instead of drawing a salary. For any contract you take on as a limited company, you’ll have to check whether it’s subject to IR35 rules or not, and whether you’re complying with them. If you break the rules, you can be subject to large fines.
Changes to your income
When you own a limited company you become a director and shareholder rather than an employee, which means you can be paid in a combination of a salary and dividends, which don’t attract National Insurance payments. Your salary is also classed as an allowable expense, for which your company can receive tax relief. This can be complicated, which is why it’s a good idea to consult an accountant to help keep your business and personal tax affairs separate, and make sure what you’re doing is both legal and tax efficient.
Business banking
While even sole traders should try to separate their personal and business accounts, for limited company directors it’s imperative. For a start, you won’t be held personally liable if there are claims against your business, so your personal money shouldn’t be anywhere near your business accounts to keep it safe. You’ll also be taxed separately on your personal income from your business income, so the ability to demonstrate which is which in a legally sound manner is the best way to avoid unfortunate tax and legal penalties should your accounts be investigated.
Becoming a director
Forming a limited company usually means becoming a company director, which means you’ll be subject to the rules and regulations that this comes with. You’ll have to file separate taxes, comply with several personal and professional guidelines, file different accounts, pay yourself differently, and a whole host of other things. This is a whole new world for most business owners, and it can all get very confusing, so it’s a good idea to get a professional accountant involved to help you out with all the twists and turns. This will protect you from any legal or financial penalties, and make sure your business is running as efficiently as possible.