Setting up a new business can be a daunting task. There are various legal and financial factors to think about, although one of the first major decisions that you need to make is whether you want to operate as a sole trader or form a limited company.
There are over two million limited companies in the UK, with around 3.5 million sole traders. There are various differences between these company forms, which is why you may be unable to decide what you should register as. You may also be a sole trader already and trying to decide whether you want to change to a limited company instead.
Choosing one business model over the other could have long-term ramifications for your business, which is why it's a good idea to with up both options before you fully commit.
In this article, we'll take a look at the main differences between sole traders and limited companies, including the tax requirements, pros and cons and how you can change from one to the other.
Sole traders are different from limited companies because they are run by self-employed individuals and therefore they are personally liable for the running and finances of the company. However, limited companies are separate entities and can have multiple shareholders and directors who aren't directly linked to the finances.
This means that sole traders are responsible for business debts as well as personal debts, whilst shareholders and directors are only responsible for the money that they put into the business. Sole traders can have their personal assets seized in compensation for business expenses, which isn't the case for a limited company because they are a separate legal entity.
Continue reading to find out more about sole traders and limited companies, including how you can register as one and the legal obligations that each type of company is required to follow.
What is a sole trader?
A sole trader is a self-employed individual who runs their own business. They are treated as one entity with their company, which means that they are personally liable and can lose personal assets if the company loses money. However, this means that a sole trader can keep all of the company's profits once the tax has been paid on them.
Self-employed individuals need to register as sole traders if they earn more than £1,000 in a tax year. Sole traders must also register for VAT if their income exceeds £85,000 in a tax year.
Self-employed individuals may also need to register as a sole trader to claim financial aid such as tax-free child care. It is the responsibility of the individual to keep a record of everything that they sell through their company, as well as business expenses. Sole traders must send HMRC a Self Assessment every year, as well as pay Income Tax and National Insurance on their profits.
Sole traders aren't required to legally register the name of their company, although there are some limitations to the type of the name that they can use. For example, sole traders can't operate under names that are offensive, have the same name as an existing trademark or contain 'limited' or 'ltd' in the name. Companies are also unable to name their business with a title that has a suggested connection between the government or local authorities.
What is a limited company?
A limited company is a business entity that is its own legal identity. This means that there is limited liability to the shareholders and directors as they are only responsible for the money that they have invested themselves. This remains the same, no matter how many owners, directors and shareholders the limited company may have.
Most limited companies operate on a shares basis. This means that the company is divided between multiple people in the form of shares, which have monetary value and voting rights attached. Shareholders are usually able to vote on important decisions made within the company, such as the hiring of directors. Limited companies can keep any business profits they make after the tax has been paid.
Some limited companies use guarantors and are usually not-for-profit. As with 'limited by shares' companies, these 'limited by guarantee' companies have a business structure that means the finances are entirely separate from the personal finances of the guarantors. This type of limited company will invest any profit that it makes back into the business.
You must appoint a director for your limited company, although you don't have to have a company secretary. Directors are responsible for keeping the company records, filing accounts and reporting charges. They also have to pay Corporation Tax on any profits that the company has made in the tax year.
What are the pros and cons of being a sole trader?
Sole traders are self-employed individuals who own and run their own companies. This means that they have complete control over their business and aren't required to consult partners or shareholders before they make a decision. They are also able to retain all of the company's profits after paying tax.
Another advantage for sole traders is that they have little paperwork in comparison to limited companies and are only required to submit a Self Assessment tax return and pay Income Tax rather than pay Corporation Tax.
However, there are some disadvantages to operating as a sole trader. As the business and self-employed individual are considered one entity, they are financially responsible for all debts that the company may accrue. This means that sole traders may have to sell their personal assets, such as their houses, to pay off their debts.
Sole traders can also appear less legitimate to potential customers or trading partners as they don't receive the same legal protection that limited companies do. In the same way, the name of a sole trader's company isn't protected because it isn't registered and therefore the name can be used by another company.
Although sole trading businesses are relatively easy to set up, they can be hard to expand and find investors for. For this reason, most businesses choose to become limited companies once they reach a certain growth point.
What are the pros and cons of having a limited company?
Many businesses choose to get incorporated to become a limited company because the business will then become a separate entity from the shareholders and directors and therefore will have separate financial responsibility. Limited companies are also more tax-efficient, as what they pay in Corporate Tax tends to be lower than what sole traders pay in Income Tax. They are able to qualify for more tax-deductible expenses too, such as office furniture, as well as drawing dividends out of the business that aren't subject to National Insurance.
Investors are more attracted to limited companies because they are officially registered with the Companies House, which is an executive agency that acts as the UK's registrar of companies. This means that the company and investors have more legal protection than self-employed individuals. Limited companies, therefore, have more funding opportunities and credibility too.
One of the downsides to limited companies is that they can be complex to set up and run because there is a lot of paperwork involved, including registration and annual fees that need to be paid to Companies House, tax and company accounts that need to be filed with HMRC and PAYE processes.
Due to the accounts that are filed with Companies House, limited companies also have less privacy than sole traders because the accounts and documents are part of the public record, which means that anyone can access them.
What are the tax differences between sole traders and limited companies?
Limited companies and sole traders pay different taxes because self-employed individuals operate as one entity and therefore pay Income Tax, whereas limited companies are separate from the directors and shareholders and pay Corporation Tax.
There is a tax difference between what sole traders pay compared to what limited companies pay. In most instances, sole traders pay between 20% to 45% in Income Tax, whereas limited companies are only required to pay 19% of their profits in Corporation Tax. The percentage for Corporation Tax can change with each new financial year, although the amount has stayed the same for the past five years.
Corporation Tax is a direct tax that a business must pay on their profits to HMRC. Income tax, which is what sole traders pay, is the amount of tax that is paid on income that reaches above the Personal Allowance bracket, which is currently set at £12,570. The tax percentage is also based on the tax band that an individual falls into, of which there are four - Personal Allowance, Basic rate, Higher rate and Additional rate.
Limited companies are required to pay tax on additional profits, such as trading profits, investments and the sale of assets. Sole traders have a number of tax exemptions, such as savings interest and dividends if they own shares in another company. The first £1,000 that they earn as a sole trader is also tax-free, as it counts as a 'trading allowance'.
How do I register a limited company?
You can register for a limited company by applying to Companies House, which also registers you for Corporation Tax. After doing so, you will be sent a certificate of incorporation, which will confirm that your company legally exists, along with a company registration number and the date that the company was formed.
To apply for company incorporation, you will need three pieces of personal information from yourself and the guarantors or shareholders. This includes information such as your mother's maiden name, the town of your birth and national insurance number. The registration will cost £12, after which your company should become fully incorporated within 24 hours.
The application can be done online, via post, through an agent or through third-party software. The application must be completed within three months of conducting business if the company fits the previously mentioned criteria.
Can I change from a sole trader to a limited company?
It is possible to change from a sole trader and apply for your business to become a limited company. Circumstances within the company may have changed, such as the addition of shareholders or the need for growth. In this instance, you can register with Companies House so that your sole trader's business can become registered as a limited company. This also means that the company's name will be registered and cannot be used by another trading company.
Sole traders can take the same steps that a company can take when beginning to trade for the first time. Unlike sole trading companies, you will need to decide on at least one guarantor or director who can be a shareholder within the company. You should also identify individuals who have significant control within the company (PSC), such as those that have over 25% of the company's shares. This individual should be named on the company's records, as they have the right to install or remove directors and have significant voting rights within the company.
Sole traders have more flexibility than limited companies because they are not officially registered and aren't influenced by the decisions of multiple shareholders or directors. This also means that sole traders have more privacy because the company accounts aren't available to the public. However, sole traders may have difficulty expanding their business and finding investors because the company isn't registered with Companies House and doesn't have the same legal protection that limited companies do. For example, a limited company's name is registered and protected, whereas a sole trader could find that their name is used by another company.
Limited companies pay less tax than sole traders do, as Corporation tax is capped at 19%, whereas Income Tax can range between 20% and 45%. The tax amount that a sole trader has to pay is based on the tax band that their income falls into. Self-employed individuals have a Personal Allowance of £12,570, which means that any income below this is tax-free.