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.
Small business owners have a choice of the business structure they use. The four main business structures are:
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:
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.
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).
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.
There is more administration needed to run a limited company. This includes doing the following for a limited company:
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.
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.
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.
There are some steps you need to take if you want to change over from a sole trader to limited company.
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.
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:
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 0330 088 6686 or email us on enquiry@dnsaccountants.co.uk.
Any questions? Schedule a call with one of our experts.
Sumit Agarwal Sumit Agarwal (ACMA ACA India), the Managing partner of dns accountants is a highly respected accountant with expertise in helping owner-managed businesses.
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