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Setting up a business is very exciting, but something that is often overlooked is the structure in which your business should operate. There are a few different business structures with pros and cons to each. Today we’ll explore the most common two - operating as a sole trader vs a limited company.
Sole trader.
What is a sole trader?
A sole trader runs their business as an individual. There is no distinction legally between the business and the owner. Everything belongs to the owner, whether that’s profit, business assets or business liabilities. As a sole trader, you will get to keep all the profits of the business and you will need to pay tax on profits personally.
The Pros.
Easy to set up.
Sole trader businesses are very easy to set up. All you need to do is choose your business name and register as self employed with HMRC - voila!
More privacy.
Sole traders are not legally required to prepare and publish annual accounts, meaning all information relating to your earnings and how the business is doing is totally private.
Lower admin costs.
Registering as a sole trader won’t cost you a penny. Furthermore, there is much less work involved in operating as a sole trader, meaning that you’ll also have the benefit of lower accountancy fees.
The Cons.
Higher risk.
There is no separate legal distinction between a sole trader and their business - they are considered to be the same entity in law. As a result sole traders are personally liable for everything to do with the business, including any debts, which could leave personal assets on the line in the event of financial difficulty.
Not always tax efficient.
When you reach a certain level of profit, being a sole trader actually becomes quite tax inefficient. Sole traders pay tax at higher rates (starting from 20%), than that of a limited company owner who is able to extract their earnings from the company as a dividend (more on this below).
A sole trader also has to pay Class 2 and Class 4 national insurance on their profits.
Accounting records still need to be top notch.
Running a business as a sole trader isn't as casual as it may seem. Accounting records still need to be up to date and in line with HMRC's standards, and they must be kept for a certain amount of time.
Limited Company.
What is a limited company?
A limited company is a company that is limited by shares. Limited companies are considered a separate entity in law, which gives distinction between the company and the owner(s). They are private (i.e. their shares are not publicly available for sale) and there can be one or more owners (referred to as 'shareholders').
The Pros.
Less risk.
Because there is a legal distinction between the company and the owner(s), limited company owners get to enjoy the benefit of limited liability. This means that the owners of the company are not personally responsible for the business or its debts, keeping your personal assets, like your home, safe if the business got into trouble.
Lower tax rates.
The tax rates that apply to the profits of a limited company are between 19-25%, which is quite a saving compared to the rates of tax that a sole trader is liable to pay, which ranges from 20-45%.
More tax-deductible expenses.
Limited company owners typically take their earnings in a mixture of a salary and dividends. A salary paid to the directors can be deducted from profits to reduce the company's tax bill, as opposed to sole traders, who pay tax on all their profits, regardless of the amount they physically paid themselves.
Increased personal remuneration.
Limited company owners are able to pay themselves from the business in the form of a dividend. The tax rates for dividends are significantly less, starting from just 8.75%, with the first £1K being tax-free altogether, compared to the income tax rates which sole traders pay (starting from 20%).
There is also no national insurance owed on dividends.
The Cons.
Less privacy.
Limited companies are legally required to prepare and submit accounts to Companies House on an annual basis. These accounts will be available for anybody to see on Companies House. In addition to this, names and correspondence addresses of the directors are also available publicly on Companies House.
More work involved.
There are a lot more legal filings involved in running a limited company - from annual accounts to company secretarial documents, corporation tax returns, etc. However, if you hire a good accountant to do this for you, you won't notice the extra admin.
Higher accountancy costs.
A higher amount of work involved in maintaining a limited company does of course bring about higher accountancy costs. The good news is that more often than not, the benefit of hiring an accountant far outweighs the cost, as we know our way around the tax system and can use our skills and expertise to save you even more money.
So... what will it be?
There is no doubt that you'll be grateful for setting up as a limited company if the business faces financial difficulty. Operating as a limited company also provides more tax benefits as explored above, and can look more reputable to potential stakeholders.
However, you must compare the benefits to the additional costs you will incur in hiring an accountant or, if you plan on doing the work yourself, the time lost.
If you're still unsure, our team can help you decide by putting together a no-obligation quote and a set of calculations based on your circumstances to compare the tax savings between the two structures.
*Information is correct at the date this blog was published.