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Choosing between starting a business as a sole trader or a limited company will impact what happens to your profits, how you pay taxes and your earnings. What works for one company might not work for another, so consider the pros and cons of each option before you make a decision.
Sole trader vs. limited company: what’s the difference?
The main difference between sole traders and limited companies is in their legal status.
If you are a sole trader, you and your business are the same entity.
However, if you found a limited company you are setting up a brand new legal entity.
This impacts how your business pays taxes, how liable you are for business debts, how complicated it is to start your business, how you get paid for your work and much more besides.
What is a sole trader?
As a freelancer, you may feel that you are your business. Registering as a sole trader would turn this feeling into a legal standpoint.
A sole trader is a self-employed individual with full ownership of their business. The business does not have a separate legal identity from the owner, so a sole trader accepts full liability for their business.
As a sole trader, you keep all your profits after tax. You do not pay corporation tax or take a salary because your profits are your salary, and you are taxed on them through self-assessment. You are personally responsible if your business runs into financial difficulties. You can open a sole trader bank account to keep track of your business finances separately from your personal accounts.
What is a limited company?
A limited company is legally distinct from the identity of its owner and can have more than one owner (or director). Each owner has limited liability for the business, meaning their personal finances are not implicated if the company struggles financially.
You do not take the profits as wages as those profits belong to the company. Instead, you may pay yourself a salary, or choose to be paid in dividends, which are paid only if the company makes a profit. Alternatively, you might choose to be paid a split of salary plus dividends.
Should I set up as a sole trader or a limited company?
Both business models involve pros and cons, so let’s examine these in depth with regard to different aspects of your business.
Sole trader vs limited company tax
Your decision about whether to conduct your business as a limited company or sole trader will impact the tax you pay.
- Corporation Tax: Limited companies must pay corporation tax on profits derived from doing business, investments and gains made on sold assets.
- Income Tax: Sole traders must pay income tax at the standard rate and National Insurance on all profits.
If you’re a freelancer or contractor, you may be affected by off-payroll working rules, also called IR35. It is important to investigate how this may impact you from a tax perspective before setting up your freelancer business.
» MORE: What is IR35?
Sole trader vs limited company earnings
Sole traders retain all profits after tax, which is paid via your self-assessment tax return.
With a limited company, you can take a salary, dividends or split take-home income between the two. If you take a salary from your limited company, you need to register it as a PAYE employer and ensure income tax and National Insurance contributions are correctly deducted from your salary.Limited company directors can also be paid in dividends, which are a share of any profits.
Responsibilities of sole traders and limited company directors
Being a sole trader can involve greater personal risk, as there is no legal distinction between your assets and those of your company.
This means creditors may have the right to claim your personal assets to pay off debts your business has incurred.
The owner of a limited company has limited liability and may not be held accountable for the company’s debts in the same way. While a sole trader could become bankrupt should their enterprise fail, the owner of a limited company will usually not, as their personal assets may be protected if the company goes into liquidation.
However, limited liability does not protect you against acting irresponsibly and, as a director, you have specific legal obligations to your company. If you do not comply with these obligations and your company enters liquidation, you could still be held personally liable for its debts.
» MORE: Can my personal finances be affected by business insolvency?
Winding up as a sole trader vs limited company
It is also worth considering how long you expect your business to continue. If you stop trading as a sole trader, fewer actions are necessary. You must inform HM Revenue & Customs (HMRC) that you are stopping and send a final tax return.
Winding up a limited company has to be completed in a specific way depending on whether the company is solvent or insolvent. You will need to inform HMRC that you’ve stopped being an employer (if applicable), submit a final Company Tax Return and pay any corporation tax due. More information can be found on Gov.uk.
» MORE: How is being self-employed different to being a sole trader?
How to register your business
Registering as a sole trader
Setting up a sole trader business is straightforward. You need to register for a self-assessment tax return with HMRC, after which you need to wait up to 15 days for your Unique Taxpayer Reference (UTR). It is a good idea to set up your business well in advance of when you are required to submit your tax return.
Registering as a limited company
To set up a limited company, you need to register with Companies House.
You can register for Corporation Tax when you register with Companies House, or separately register for corporation tax within three months of when you started trading. You must then begin filing your Company Tax Returns each year.
If you register as a limited company, you will be required to have a business name and register a company name with Companies House.
Setting up a business as a sole trader or a limited company can be tricky and time-consuming. You may wish to seek advice from an accountant or financial adviser.
Sole trader pros and cons
Pros
- Simplicity: With no legal distinction between yourself and your business, operating as a sole trader keeps things simple. There is less paperwork and you get to keep any profits!
- Control: Sole traders have full control over their business.
- Privacy: While some information about limited companies will be published by Companies House and be part of the public domain, sole traders have relative privacy.
- Tax benefits: While limited companies are often seen as more tax efficient, businesses with small profits might be better off as sole traders.
Cons
- Liability: Sole traders are fully liable for any losses or debts incurred by their business.
- Professionalism: Clients may consider a limited company to be a more impressive and reliable business partner.
- Funding options: It can be harder to access funding, with lenders often favouring limited companies and other business structures.
Limited company pros and cons
Pros
- Tax benefits: It may be more tax efficient to run your business as a limited company, as the corporation tax paid on profits is lower than the income tax paid by sole traders. You can also choose to take income as a salary, dividends or a mix of the two.
- Limited liability: You will not generally be held personally liable for debts. This can protect your personal finances.
- Easier funding: Limited companies might find it easier to secure business loans than sole traders, while you can also raise money by selling shares in the business to investors.
Cons
- Complexity: Running a limited company will mean more paperwork, as you will have to produce a confirmation statement, accounts and a company tax return.
- Legal obligations: Limited company directors must fulfil certain legal obligations, such as maintaining accurate company records, or they could face fines, prosecution or disqualification from being a director.
Sole trader vs limited company – frequently asked questions
Sole traders can choose to become a limited company. You will need to form your new limited company, ensure you have a business bank account and transfer your business (including any assets) to the limited company.
You will also need to inform HMRC of the change, de-register as self-employed and register for corporation tax and PAYE. Needless to say, this can be a complicated process and you may need the help of an accountant
You can also switch from being a limited company to a sole trader.
If you are a sole trader, any profits made by the business after tax are automatically yours because you and the business are one legal entity. You can pay yourself whatever wage you like, as the funds already belong to you.
You might want to pay yourself all the profit your business makes, but it is a good idea to keep some funds aside for operating costs or reinvestment, as well as future tax bills.
A separate sole trader business bank account and good accounting software might help make your life easier.
Traditionally, limited companies are thought of as more tax efficient, but some businesses can pay less tax as sole traders due to certain allowances.
For example, a sole trader with profits of below £1,000 can take advantage of the trading allowance and will not face any income tax. This is one of many ways for sole traders or self-employed workers to reduce their tax bill.
» MORE: How to change a business account from sole trader to limited company
Dive even deeper
How to Set Up as a Sole Trader
by Kristina Fox
Sole Trader vs. Self-Employed: What’s the Difference?
by Jeff Salway