Sole Trader vs Limited Company

The pros and cons for your small business

When you start out in your own business, it’s common to be a one-person operation. You’re in charge of your accounts, your marketing and everything that relates to the service you’re providing. So, does that mean that going into business is the same as being a sole trader? Or do you need to set up as a limited company?

In this article, we take a look at what it means to be a sole trader or a limited company. We’ll show you some of the positives and negatives of each approach so that you can make the best decision for you.

Sole trader

A sole trader is someone who is formally recognised by HMRC as being in business for themselves. It’s common for such people to refer to themselves as self-employed or as freelancers, but the official term is ‘sole trader’.

When you register with HMRC as a sole trader, you must agree to keep appropriate financial records and pay all taxes due. This means tracking eligible expenses, issuing invoices for all work done and submitting self-assessment returns that confirm your taxable income.

Unlike being a traditional employee of another organisation, where tax is usually deducted at source through the Pay As You Earn (PAYE) scheme, sole traders use self-assessment to calculate their tax burden and pay this to HMRC twice a year.

In addition to these tax payments, sole traders usually need to pay Class 2 and Class 4 National Insurance Contributions (NICs). The amounts are calculated automatically when you submit your self-assessment form online. You can find out more about this on the government’s Self-employed NI rates page.

Pros of a sole trader

  • It’s easier to set up as a sole trader: there’s less paperwork (although you still have to complete an annual tax return) and you don’t need to register with Companies House.
  • You have a greater level of privacy than limited companies: if you set up a limited company, some of your personal details will be published in the records of Companies House. However, you’ll need to put some information out into the public domain if you’re to market your business effectively.

Cons of a sole trader

  • You have full liability if your business gets into debt: it’s possible to protect yourself from such things through the likes of professional indemnity insurance and payment protection insurance, but keep in mind that liability for your sole-trader business ultimately lies with you.
  • You may be at a disadvantage when bidding for big contracts: even if you’re providing exactly the service a client is looking for, internal policies may rule you out because you’re a sole trader and they’ve decided to work only with limited companies. It’s useful to understand who your ideal clients are and what matters to them.
  • You may not be eligible to claim tax reliefs: you have to be within the charge of corporation tax to be eligible to claim Research & Development tax reliefs and the creative industries tax reliefs. Therefore you have to be a limited company in order to claim these reliefs.

Limited company

A limited company has its own legal identity and is structured as a business with shareholders and directors. A limited company can be run by just one person, but the setup is more involved than being a sole trader.

For limited companies run by an individual, the person in question becomes the director of the company as well as its only shareholder. That person then takes their remuneration in the form of either a salary or dividends (or a mix of both) from the earnings of the business. How to remunerate yourself can be complex, but we can help to remove the complication.

To set up a limited company, you need to register with Companies House. That means your full name, address and month and year of birth will be published for all to see. The same is true for all directors in the UK, even for those who serve as directors in not-for-profit organisations.

When registering as a limited company, you agree to file an annual confirmation statement and annual company accounts each year. Both these documents will be on public record.

Pros of a limited company

  • They may feel more trustworthy to some clients: a limited company can give the impression of a greater sense of permanence and financial success.
  • Limited liability: financial liabilities are placed on the company rather than on the individual(s) running the company. Generally, that means your personal assets aren’t at risk if you run a limited company.
  • They can be more profitable: limited companies pay corporation tax rather than personal income tax. You also have far more flexibility in terms of how you remunerate yourself, affording you more tax planning opportunities.
  • You have the potential to save more than sole traders: as a limited company, you can can take advantage of a greater range of tax-deductible items. Those who plan for gradual growth sometimes start a business as a sole trader and then switch to becoming a limited company.
  • Greater protection over your name: setting up with Companies House means your business will be the only one allowed to register and use the name you’ve chosen. Note that you may still need to apply for a registered trademark, if that’s relevant to your business.

Cons of a limited company

  • More paperwork: It takes more effort to set up a limited company, and the ongoing reporting requirements are more onerous. An annual confirmation statement and annual company accounts must be filed for all limited companies. It’s advisable for limited companies to engage an accountant to keep their finances in order.

Whether you register as a sole trader or a limited company, you also need to consider the separate question of whether to register for VAT. VAT registration is compulsory if your business’ annual turnover exceeds the VAT threshold, currently set at £85,000 per year.

We’re happy to talk through your options when setting up your business so that you can make the best decision for your needs. Get in touch on 01903 234094 to discuss further.

A version of this blog originally appeared on the website of one of our MHA association member firms, Henderson Loggie.