How to decide whether to be a sole trader or limited company

Whether you're about to launch a shiny new business, or you've been going for a while and are thinking about the next steps, you might be coming up against the age old question of whether you should trade as a sole trader or limited company. You start speaking to other people in your industry, turn to Facebook groups, or even family who have never run a business. What to do, what to do? So here I am with the definitive answer once and for all.

Not really, sorry to disappoint. It's another of those areas where it really depends on your circumstances and aims for the business. While I’d love to be able to tell you what to do, I don’t even get the privilege of that with my dog. But what I can do is tell you the main things to think about.

Do you need to be a Secret Squirrel?

One consideration is how private you want or need your financial affairs to be. As a sole trader no one sees your tax returns unless you show them. They go off to HMRC and no one is any the wiser as to the numbers side of your business.

It’s very different as a limited company. The company’s tax returns aren’t public, but the accounts are. Anyone can go to the Companies House website and have a look at the filed accounts, as well as other information such as who is a director and their address. One way round the address issue is to use a virtual office for both the company’s registered office and the director’s service address. There are lots of options around but I’ve used Registered Address happily for the last 7 years (my affiliate code, 729EJXL, will get you 20% off).

Time for the tax talk

The next thing to think about is how your business fits with the rest of your life. Is it your main source of income? A side venture while you build up to leave your dreaded 9-5 job? Maybe you’re also a landlord and have money coming in from property. This is important because of the different ways in which sole traders and limited companies are taxed. I wouldn’t recommend making big business decisions purely based on how tax efficient something is, but let’s face it, it plays a big part.

For sole traders, there’s no difference in the eyes of HMRC between you and your business, even if you trade under a business name rather than using your own. This means that the business’s profit (sales minus your expenses) is considered to be your income, regardless of whether you’ve actually withdrawn that money from the business. So if your business makes £20,000 profit but you don’t touch the money as you have a salary from a full-time job and want to keep the money in the business for the future, you’re still going to be taxed on that £20k. The benefit, however, is that you can use your personal tax-free allowance (currently £12,570 for most people). So if your only income comes from your business and you make £10k profit, you won’t pay any tax as it’s less than your personal allowance amount.

If you have multiple businesses as a sole trader then you also need to think about the combined total of these with regard to the VAT threshold, as they’re counted as one rather than as individual businesses. In this case, it's the person, not the business, that registers for VAT. If combined your sales are more than £85,000 then all of the businesses will fall under VAT, which could have a big impact.

A limited company is a completely separate legal entity to you. This is particularly useful if things go wrong as your personal liability for debts will be limited, which wouldn't be the case as a sole trader. Even if you are the only shareholder and director, the company’s money is not yours. The company is taxed on its profits, and unlike a sole trader, there’s no tax-free allowance. You as an individual would then be taxed only on the income you take from the company, with your personal tax-free allowance coming in to play.

Someone with other income, particularly if that uses up most or all of their personal tax-free allowance, may benefit from a tax point of view of being able to control how much additional income they are taxed on. In this case, a limited company is likely to be a more attractive option.

Show me the money

As well as the tax side of taking money out of the business, there’s also the practical admin side. As long as there’s money in the bank, sole traders don’t need to give much thought to taking money out and can dip in whenever they want.

I mentioned earlier that as a director of a limited company the company’s money is not yours. This comes crashing home when it comes to taking money out of the company. For most people, income will be a mix of salary and dividends, although the exact mix depends on personal circumstances. In order to take a salary above £6,396 per year, the company must register as an employer and run payroll, even if it’s just for you. Your salary would be classed as a business expense, and so would reduce the company’s profit and therefore reduce the amount of corporation tax it pays.

Dividends can only be paid to a company’s shareholders and can only be paid if there are reserves in the business. This generally means that the company must be making a profit. Dividends aren’t a business expense, so don’t reduce profit.

Some people find the idea of salary and/or dividends too restrictive. They want to be able to withdraw money as and when throughout the month, without the extra burden of running payroll or needing to closely monitor the company’s reserves.

Obligations

There’s no denying that operating as a sole trader is much more straightforward than running a limited company. Other than submitting a self assessment tax return to HMRC once a year, there’s not really much expected of you.

Limited companies come with much more paperwork. There’s the corporation tax return, annual accounts that must be in a certain format, and a confirmation statement outlining who has control over the company. If you’re taking a salary then you’ll have payroll obligations to meet, and dividend paperwork to prepare when you pay dividends. This is in addition to your own personal tax return if needed.

In practical terms this means that while most people can manage the admin side of being a sole trader themselves, bringing in external support becomes much more important as a limited company. This comes at a cost and accountancy fees are higher for limited companies than for sole traders.

What else?

There are other things to consider too, such as how potential clients will view your business. For reasons known only to them, some businesses prefer to work with limited companies. This is particularly true if you’re wanting to work with large businesses, local government, or education establishments.

It's worth nothing that this isn’t a decision that you’re committed to forever. You may well decide to start as a sole trader, for ease, and then over time decide to move to a limited company. Yes there’ll be a whole load of admin involved and I definitely wouldn’t recommend flitting back and forth between the two, but it’s perfectly possible to change later.

The choice of sole trader vs limited company is never as simple as it first looks. If you’re not sure what’s best for you, book a Power Hour, where we can look at your personal circumstances in more detail.