Many business owners begin their business life as sole traders and as their business grows, they may decide to make the switch to a limited company structure.
There are many benefits for transitioning from a sole trader to a limited company such as tax efficiency, business credibility, limited liability of the business owner and protection of your company name. However, a limited company entails more administration and sometimes increased costs.
In this blog we will talk about the differences between sole traders and limited companies and the things you need to consider if you are looking to transition from one to the other.
Types of business structure
Small business owners have a choice of the business structure they use. The four main business structures are:
- Sole Trader.
- Limited Liability Partnership (LLP).
- Limited Company.
Deciding on the right business structure
Your decision on which business structure is right for you will be dependent on your own circumstances but some of the things that may influence your decision are:
- The type of business you run.
- The turnover, growth and potential future growth of your business.
- The level of risk you take as an individual.
- The support you have from advisors and internally to manage paperwork.
- How customers see you and your professional credibility.
What is a sole trader?
A sole trader business is controlled and owned by one individual who is self-employed. Legally there is no separation or distinction between you as the individual and the business. This is significant because if your company gets into financial trouble or accrues debts, you will be personally responsible for them. This means your personal assets such as your home and savings etc. are at risk.
Anyone can start a sole trader business without having to register at Companies House. You do, however, have to register with HMRC as being self-employed.
What is a limited company?
A limited company is owned and run by one or more shareholders or directors. A limited company has its own legal identity and different legal structure. It is the company that is liable for its debts and losses or any claims against the company, rather than you as an individual. This means that as a shareholder you limit your liability. Limited companies are registered with Companies House and there are requirements to submit accounts and Corporation Tax returns each year (more about this later in the blog).
The key differences between a sole trader and limited company
Let’s take a look at some of the key differences between being a sole trader and a limited company:
Registration: Sole traders register with HMRC as self-employed individuals. Limited Companies are registered and incorporated with Companies House. There is no registration cost for a sole trader, but you will have to pay an incorporation fee to Companies House to register your limited company.
Ownership: A sole trader is one person only that owns the entity. A limited company can be owned by multiple people who are shareholders in the company.
Legal structure: For sole traders there is no legal distinction between you and the business. A limited company is a separate legal entity to its owners. Your business name is protected if you are a registered limited company, whereas you have no protection of your business name as a sole trader.
Liability: As a sole trader you will be personally liable for any debt, losses or legal disputes for your company. A limited company limits your personal liability. The company is responsible for any debts, losses or legal disputes. Business finances and personal finances remain separate in a limited company and business assets will be held within the company. As a sole trader you will also be personally liable for business loans, and this may impact your own individual credit rating.
Employment: As a sole trader you are classed as self-employed. As an individual in a limited company, you are classed as an employee, which may give you some additional employee benefits.
Credibility & potential work: Some organisations will only do business with other businesses and won’t employ sole traders or self-employed individuals, so being a sole trader may affect credibility and the ability to do work with some companies.
Tax saving and tax planning: There is potential when running a limited company to save tax personally by using a combination of salary and dividends to pay yourself. As a self-employed individual you will pay income tax on all the profits the business makes above your tax free personal allowance. As an employee of a limited company, you have the ability to pay yourself via both salary and dividends, which depending on your income may be more tax efficient. Companies have to pay corporation tax on profits, but this can sometimes be less than some income tax bands. There are potentially other tax saving opportunities if you operate a limited company.
Claiming expenses: There are some differences and benefits between what is allowable as an expense for tax purposes for a sole trader and what’s allowable for a limited company. There are far more allowable expenses when you operate a limited company compared with being a sole trader.
Business bank account: All limited companies need to have a business bank account. As a sole trader you can use a personal bank account.
Registered office address: As a limited company you can opt to use a registered office address (this may be your accountants address) on your company details. This allows you to protect your personal address from being listed publicly.
Administration differences between sole traders and limited companies
There is more administration needed to run a limited company. This includes doing the following for a limited company:
- Sending annual accounts to Companies House by a particular date each year (depending on your company year end date).
- Completing an annual return.
- Submitting a Corporation Tax Return.
Whether you are a sole trader or limited company shareholder, you will need to submit an annual personal tax return to declare your income to HMRC for them to work out the tax you need to pay.
Whether you are a sole trader or limited company if your turnover is above £85,000 per year, then you will also need to register for VAT.
The added administration can add to the cost of running a limited company. However, these additional costs can often be offset by tax savings you gain.
You should seek professional advice to both ensure you submit all the right paperwork to Companies House and HMRC, but also to ensure that you maximise your company tax savings or personal tax relief for yourself and other company directors. A good accountant such as dns accountants will make sure you never miss a tax deadline or filing deadline or incur penalties.
What tax do I pay as a sole trader vs limited company?
Companies pay Corporation Tax on profits (currently 19%, rising to 25% in 2023). Personal tax you pay will be dependent on the level of income that you take from the company. However, if you seek professional advice, you can structure your personal earnings by taking a combination of salary and dividends, which is generally more tax efficient for individuals.
When running a limited company, you can leave money in the company i.e., in your business bank account to help with future development of the company. As a sole trader you will be taxed on all profits made in a year, whether you draw them personally from the business or not.
There are generally less options available for tax planning for sole traders, which often results in a higher tax bill as a sole trader. Read more here about the tax you may pay as a sole trader or limited company.
Will I earn more money as a limited company or sole trader?
This will depend on your individual circumstances. Running your business as a limited company can provide the potential for greater profitability because of tax planning opportunities available. Sole traders will pay 20%-45% in income tax on all profits. However, limited companies currently only pay 19% corporation tax (rising to 25% in 2023), so they tend to be more tax efficient. Limited companies also qualify for a wider range of tax relief and allowances and tax deductible expenses.
How do I change from sole trader to limited company?
There are some steps you need to take if you want to change over from a sole trader to limited company.
- You need to form your limited company and complete forms for Companies House. Company formation can be handled for you by an accountant such as dns.
- You will need to contact HMRC and notify them of the change to your company structure.
- You will need to de-register as self-employed in order to stop paying self-employed class 2 National Insurance contributions.
- Advise your accountant of the changes, so they can help and support you with the transition and offer you the right advice.
- You may need to open a business bank account, if you don’t have one already, this ensures you keep your personal finances separate from your business account.
- On business letters, order forms and websites, you must show: the company’s registered number and its registered office address once your limited company is formed and you begin trading.
Your company name
If you didn’t form a limited company (to protect its name) when you began as a sole trader, then you will need to check with Companies House if the company name is available. Choosing a company name can be hard, especially if you have built up a reputation under a name you used whilst self-employed and that name isn’t available at Companies House. You can use the Companies House availability checker online.
When you’ve found a name that is available, you need to legally form the company with Companies House. You can form your limited company online. Our company formation service will take the hassle away and will register your new limited company with companies house.
What happens if I want to switch back from a limited company to a sole trader?
There may be reasons in the future that you may want to switch back to being a sole trader (if your income significantly decreases for example). It is possible to switch from running your business as a limited company to running it as a sole trader, but there are a number of things you need to do to change from a limited company back to a sole trader. This can be referred to as “winding up” but how you do this will be dependent on your business’s financial position.
Before you proceed to “strike off” your company (i.e. getting Companies House to remove your company from its register), you will need to undertake some administrative tasks first such as:
- Pay off any outstanding business debts with your suppliers and chase unpaid invoices due to your company from customers.
- Complete a final corporation tax return.
- File a final VAT return (if your company is VAT registered) and cancel your VAT registration. If you wish to remain VAT registered as a sole trader, you can apply to change status.
- Pay any employees their final salary and if decide how much to pay yourself for your final director’s salary and dividend (seek profession advice from your accountant to make sure you are doing this as tax-efficiently as possible).
- Shut down your PAYE scheme. If you will continue to have employees as a sole trader, you cannot transfer your PAYE scheme over and must start a new PAYE scheme instead.
- Close down your business bank account (as this will be in your limited company name).
When it comes to making the decision to switch from a sole trader to a limited company, you need to think carefully about the advantages and disadvantages of making the switch. In most cases, running a limited company can provide better tax efficiency and many people pay less tax when running a limited company. Having your business finances separate by using a business bank account and limiting your personal liability should your company run into trouble, and you have company debts are also huge benefits of running a limited company. Always seek professional advice before making the switch.
If you need any help or advice on transitioning from a sole trader to a limited company, company formation or tax planning, then please contact dns on 03300 886 686 or email us on firstname.lastname@example.org.
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