Limited Company vs Sole Trader
Navigating the intricate landscape of self-employment is no easy feat, especially for contractors. Amidst the myriad of regulations, one term stands out prominently: Limited Companies. But how does a limited company compare to operating as a sole trader?
In this comprehensive guide, we delve deep into the heart of limited companies. Whether you’re an aspiring contractor or a seasoned veteran seeking clarity, this guide aims to empower you with the knowledge to make informed decisions.
What is a Sole Trader?
A sole trader is a self-employed individual who is the sole owner of their business. There are no shareholders to pay dividends to or directors to help manage the day-to-day operations.
As a sole trader, there is no distinction between yourself and the business; you are considered the same entity. You have absolute control over how the business is run and are entitled to keep 100% of the profits.
Due to the lack of a separate legal identity, you are personally responsible for the business’s financial obligations. If you do not pay your debts, the creditors you owe money to can take action against you directly.
Self-Employed vs Sole Trader
The definition of ‘self-employed’ can be a little complicated.
As a rule of thumb, you count as self-employed if you’re responsible for the success or failure of your business, you decide how and when you work, you pay tax through self-assessment, and you don’t get sick pay or holiday pay.
Therefore, while all sole traders are self-employed, not all self-employed are sole traders. A limited company contractor, for example, would also be considered self-employed.
Limited Company vs Sole Trader
There are seven key differences between a limited company and a sole trader.
i) Liability
A limited company is legally separate from its shareholders. Unless there is serious wrongdoing, you cannot be held personally liable for the losses incurred by the business.
For a sole trader, there is no distinction between business and individual. You hold personal responsibility for the businesses’ debts and may have to sell off personal assets to meet those debts should something go wrong.
ii) Registration
To incorporate a limited company, you must register with Companies House, supplying personal details and specific documents such as the Articles of Association. Although it is a relatively simple process, some prospective business owners can find it daunting.
There is no ‘registering’ as a sole trader. Your only obligation is to tell HMRC you will pay tax through self-assessment.
iii) Taxes
Limited company tax responsibilities include VAT and corporation tax on revenue earned. As the business owner, you pay income tax, dividend tax and Class 1 National Insurance contributions. The amounts owed are dependent on the split of salary and dividends.
As a sole trader, you are liable for VAT in the same way a limited company is, although you pay no corporation tax. All the businesses’ profits are subject to income tax and classes 2 and 4 National Insurance contributions.
iv) Reporting
Limited companies have recurring reporting obligations, including annual accounts and a confirmation statement containing company information. Directors of the limited company must also file self-assessment tax returns.
Sole traders have no reporting obligations beyond filing self-assessment tax returns. Both limited companies and sole traders are required to keep robust business records.
v) Take Home Pay
Most limited company owners pay themselves a tax-efficient combination of salary and dividends. They may also choose to defer tax by leaving profits in the business to withdraw later. Tax efficiency is one of the main reasons many people (including contractors) decide to set up a limited company.
Sole traders do not have an option to minimise their tax or National Insurance liabilities, nor can they defer tax by leaving profits in the business. Tax is owed during the period the income is received; there is no efficient way of paying yourself.
vi) Expenses
The expenses you can legitimately claim as a sole trader or limited company are similar. The difference is that the limited company will incur the costs while a sole trader will pay them out of pocket. Both offset relevant tax liabilities.
vii) Available Opportunities
A limited company structure can provide a professional image, opening yourself up to business opportunities that may not be available to sole traders.
Which Is Right For You?
When deciding which business structure to use, you need to evaluate three key factors:
i) Liability
To what extent do you need to be protected from liability? Does your business lend itself to potential risk, and if so, can you personally afford it?
A hairdresser, for example, is less likely to incur potential liability than a data security expert who works with a client’s confidential financial information.
ii) Future Needs
A sole trader’s business will be legally dissolved upon the owner’s retirement or death, while a limited company will continue its operation. Shares can be distributed to existing or new shareholders depending upon the owner’s wishes.
A self-employed tradesperson may not need to consider their business after retirement, but a construction company certainly would.
iii) Administration
When considering whether to incorporate your business, you must ensure you have the time and ability to meet the stringent reporting requirements that HMRC requires.
If you find these aspects challenging or are pressed for time, you can always hire an accountant; however, they often come with substantial costs.
Why Contractors Don't Work As Sole Traders
Most contractors work through limited (or umbrella) companies as they don’t have a choice. Many clients and agencies refuse to work with sole traders due to issues caused by the tax legislation.
See our IR35 and Sole Traders guide for further information.