Should you do business as a sole trader or a limited company?
Running your own business gives you unprecedented independence, but it also brings on financial and tax-related challenges you must face strategically. The most frequently asked question is whether you should conduct your business as a sole trader or a limited company?
Who is a sole trader?
Do you know that sole traders account for 56% of small businesses in the UK (source)?
When you function as a sole trader your business is not a separate legal entity. You are the sole owner of your business. You provide products and services in your personal capacity. For example, if you provide tax consulting services as an individual and charge money for that, you are a sole trader.
Is being self-employed the same as being a sole trader? Many of the characters overlap but there is a subtle difference. When you are self-employed, it means you are not working under someone else’s employment. If you do plumbing jobs as Peter and get money for that as Peter, you are self-employed. People simply call Peter when they need someone to take care of their plumbing. You pay your taxes, if any, as an individual plumber.
What if you promote your services as “Ace Plumbing Services”? Although you are the only person providing the services, when people need your services, they contact “Ace Plumbing Services”. Unless mentioned otherwise, you are a sole trader, and you pay your taxes as a sole trader.
You can hire people as a sole trader. But you are personally responsible for profit and loss. All the liabilities belong to you. You are accountable for all the losses and debts you make as a sole trader.
The main advantages of being a sole trader:
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Easier to set up
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The income or profits immediately become available to you.
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You have immediate access to cash.
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Less paperwork is required to set up.
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You make all the decisions.
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Greater flexibility.
What is a limited company?
A private limited company is the most common form of UK company incorporation. You need to register your company with Companies House. The company is an individual in its own right. It functions as a separate entity from you. It has a unique identity through its own company registration number.
Once you are a limited company, you are governed by the Companies Act and its provisions.
The big difference from being a sole trader and a Limited Company is that despite you handling everything, your business exists as a separate entity. You draw a salary as a manager or a director or a service provider to your business and you get a dividend when your company makes profit.
Advantages of having a limited company:
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Minimum personal liability.
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A professional status that helps attract more clients.
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Tax benefits and better tax planning – as a sole trader you may pay 20%-45% income tax but as a limited company, you pay 19% corporate tax.
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Concrete income and dividends.
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Greater and better investment and learning opportunities.
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Better protection for the company name.
What is better for you: being a sole trader or having a limited company?
Both – being a sole trader or having a limited company – have their pros and cons. As mentioned above, it is easier to start your business as a sole trader. You can start it, like, right now. If you want to offer your services as a hairdresser and you have got the skills and experience, you can immediately start providing hairdressing services in the neighbourhood and charge money for that.
Suppose you take a loan from the bank to buy equipment and a small shop to run your hairdressing business. The business doesn’t do well – maybe it’s Covid-19 or people are just not interested in getting their hair done – and you’re unable to pay back your debt. If you are a sole trader, you are responsible and the bank can take an action against you and even seize your personal properties such as your house, your car, or other belongings.
All the income is taxable. The money that you are getting as a sole trader comes into your account and since it comes into your account, all of it is taken as income and hence, taxed. This makes it difficult to grow your business beyond a point.
As a sole trader, you work on your own. There may be some associations and groups that provide support to sole traders exclusively, but there is no formal support system as is the case with a limited company.
There is a reason why there are more limited companies in the UK than sole traders. Registering a limited company gives you a sense of formality. It gives you credibility. People have more trust in a company that goes by a brand name. They will call “Ace Plumbing Services Ltd” with greater confidence than plain Peter.
Having a limited company means your business is run under the provisions of the Companies Act, which makes you official, and liable to penalties if you don’t adhere to the provisions. Your business address is registered. You may have an official website. Different laws, including accessibility, inclusion, and diversity, are applicable to your business.
One of the biggest benefits of running your business through a limited company is that your business is a separate identity and you are protected against liabilities and unsolvable debts.
Coming back to the hairdressing example. You are providing hairdressing services as a limited company, and you take a loan from the bank. This time, you haven’t directly taken the loan, it’s your company, “Complete Makeover Hair Salon Ltd” that has taken the loan, and it is the responsibility of your company to pay it back with interest.
As a shareholder you get a dividend when your company makes profit, and you don’t get a dividend when it makes a loss.
As a director or as a manager, you draw a salary from the company. This is an expense to the company and hence tax-deductible. If you can have multiple members of your family, they will all be drawing a salary, which will again add to the expenses of the company, and hence, more tax-deductible.
As mentioned above, as a sole trader, you may end up paying 20%-45% tax whereas as a limited company, you pay 19% corporate tax and that too, when all the expenses have been deducted.
Conclusion
There are multiple benefits of incorporating your business as a limited company. It exists as a separate identity. Despite the initial paperwork, the operations are quite methodical compared to working as a sole trader. Since you are running your business under the Companies Act, there are many benefits and provisions available to you that are not available to sole traders. The accounting practises are better and more organised. Greater and better loan facilities are available to limited companies.
The best thing is, you can have your family members as employees and shareholders, and they can draw salaries and dividends whenever you make a profit. They may have to pay income tax, but it is far less than the tax that you pay as a sole trader.
The process is a bit complicated and for that, it is advised that you talk to an experienced accountant. For more advice please BBKS Accountants today.