It’s a common quandary for entrepreneurs starting a new business. Do I register as a sole trader or create a limited company? The best option will depend on the type of business you’re starting, the scale and how you want to operate on a financial level.
According to Merchant Savvy, there are 5.7 million small businesses operating in the UK in 2021 – all of which with 49 employes or less, operating as either sole traders, limited companies or partnerships.
There’s no one right answer, as each business has different needs.
It’s important to understand that your choice will affect all aspects of your business, from tax and earnings to legal responsibilities. There’s no one right answer for which option is best, as each business has different wants and needs.
We’ve put together this guide to give you a brief overview of the difference between being a sole trader and a limited company, and hopefully help you make that all important decision.
What is a sole trader?
Being a sole trader means you’re self-employed and the sole owner of the business. From a legal point of view, you and your business are the same entity. That means any debt or legal claims will be made against you as an individual, not your business.
Setting yourself up is quick, easy and free. As a sole trader you will:
- Register online and can start trading immediately.
- Need to keep records of your sales and expenses.
- Submit a self-assessment tax return each year.
- Pay Income Tax on your profits and Class 2 and Class 4 National Insurance contributions.
- Won’t need to register for VAT unless your turnover is more than £85,000 (though you can voluntarily register if you want to be able to reclaim VAT).
Note for non-UK nationals: You’ll need to apply for a National Insurance number if you’re moving to the UK to set up a business.
Find out more about setting yourself as a sole trader.
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What is a limited company?
The key difference of a limited company is that it is a separate legal entity. That means that you (and other Directors or shareholders) and your business are completely separate. Any debt or legal claims are made against the company, not you.
As part of setting up and running a limited company you will need to:
- Name the company
- Nominate at least one Company Director
- Have at least one shareholder (who can also be a director)
- Keep records about the company itself (e.g. names of directors/shareholders, results of any votes, credit/loan/mortgage agreements secured against the company)
- Keep records of all of the company’s financial activity (e.g. all money received, list of company assets, debts, stock owned by the company, goods bought and sold)
For more information, see Gov.uk’s for details about setting up a limited company.
Sole trader vs limited company – what are the differences?
There are a number of differences between being a sole trader and setting up a limited company, which have legal and financial implications. Here are the main ones that are most likely to affect you:
Tax
Limited companies tend to be the most tax efficient option, with Corporation Tax on your taxable income charged at a flat rate of 19%. As the Director of a limited company you have the option of paying yourself (and any other directors) using a combination of salary and dividends.
Tax efficiency is one of the main reasons entrepreneurs choose to set up a limited company.
By using dividends you can minimise your tax and National Insurance contributions. Company directors also have the option to defer tax by leaving any surplus income in the business bank account until a subsequent tax year.
As a sole trader you don’t have those options, you simply pay Income Tax on all your profit – charged at a varying rate of 20-45%, depending on your profits. You’ll also need to pay National Insurance contributions.
In addition, there are some tax benefits that apply to limited companies but not sole traders, such as company mobile phones, company cars and ‘rent’ for an office space (in your home or a paid office space). Read more about company tax benefits.
National insurance
National Insurance contributions also differ between sole traders and limited companies:
- Sole traders – usually pay Class 2 and Class 4 National Insurance
- Limited companies – the company pays employer’s Class 1A or 1B National Insurance on salaries and staff will pay employees’ Class 1 National Insurance on salaries.
“What do these National Insurance classes mean?”, we hear you cry. Well, numbers alert…
Class 1 National Insurance is for employees earning more than £183 a week and under State Pension age. Current rates are 12% (for income of £183 to £962 a week) and 2% (for any income over £962 a week).
Class 2 National Insurance is set at a fixed rate. For the tax year 2020/2021 this is £3.05 per week your business was operating. It’s payable if your income exceeds £6,475 per year. Therefore, a business that has been operating for the full tax year will pay £158.60 (52 x £3.05) for the year, assuming profits have exceeded the threshold.
Class 4 National Insurance is based on your level of self employment profits. You’ll be eligible to pay this once your profits exceed the lower profits limit – which for 2020/2021 is £9,500. You’ll currently be charged 9% on profits between £9,501 and £50,000, and 2% on profits over £50,000.
For a full description of National Insurance classes and current rates, check out Gov.uk.
Founder story
“I’m all for keeping things simple. In my view, if you’re just selling stuff or services to people – at a small-ish scale, then being a sole trader is probably a good call. If, however, you’re planning on selling to businesses or looking to really scale something up, then you’re likely going to want to be a limited company. That is a super simple view of it – so there are caveats, but I just wished someone had told me that at the start!”
– Eddie Whittingham, Founder
Read more
Financing
As a limited company it’s often easier to obtain funding due to the additional transparency that applies, with company details being publicly available via Companies House. As a sole trader, your access to funding or credit will depend on your individual circumstances.
One of the main disadvantages of a limited company is the cost of setting up and ongoing running costs.
Setup and running costs
One of the main disadvantages of a limited company compared to a sole trader is the cost of setting up and ongoing running costs. Registering as a sole trader is free and you may not even need an accountant to submit your annual self-assessment (although it’s often wise to use an accountant).
On the other hand, setting up a limited company will cost around £100. Due to the slightly complex nature of company accounting and taxes, you’ll most likely need to hire an accountant to work on a monthly basis. That comes at an average cost of around £50-£150 per month, depending on your business’s amount of financial activity.
As part of your record-keeping for a limited company, you’ll have to prepare annual accounts and file them with Companies House. You’ll also need to file full corporation tax accounts for HMRC. A sole trader won’t have to do either of these.
Legal
As we’ve previously mentioned, the legal definition is one of the big differences between being a sole trader or a limited company. As a company director, you have limited legal liability for debt and bills incurred by the company.
If you’re a sole trader, your personal assets are at risk if you get into financial trouble.
If you’re a sole trader, however, you’re responsible for all debt and bills of your business. That puts your personal assets at risk if you get into financial trouble. If you’re setting up as a sole trader, we recommend getting insurance to protect you against any potential legal claims.
Profits and paying yourself
One of the joys of being a sole trader is that you have constant and unlimited access to all the profits you make as a business. That means you can access your profit money whenever you like, with no limitations.
As a limited company director you’ll be paying yourself with a PAYE salary and dividends. That means you’re limited to those specified payments on a regular basis. If you want access to more money from your business you’ll need to take out a director’s loan from the company – which you may have to pay additional tax on.
Opportunities
One final point we thought worth mentioning, if you’re still on the fence, is that sole traders sometimes experience difficulty in securing work. Clients and other companies often feel more comfortable working with a registered company than dealing with a sole trader.
As a sole trader you may also be considered too small or too much of an unknown risk with regards to liability and potential legal issues. For tax reasons, many businesses will only work with limited companies as hiring sole traders comes with potential IR35 implications.
As a sole trader you can be much more nimble financially.
That said, as a sole trader you can be much more nimble financially and operate in a more flexible way. Often entrepreneurs start out as a sole trader to test the water with no commitment, and then convert to a limited company down the line.
Which option is best for me?
We’d love to be able to answer that with a few words but, as you can see from this article, it really depends on your individual business circumstances. Our top tip? Take time to thoroughly research the options and implications before making your decision.
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