Sole Trader vs Limited Company: Choosing the Best Option for Your Business

Sole Trader vs Limited Company: Choosing the Best Option for Your Business

Reading Time: 12 minutes

A simplified way of defining Sole Trader vs Limited Company is that a sole trader and a limited company are like deciding between a solo performance and a blockbuster movie. One’s a one-person show with all the spotlight, while the other’s a production that demands collaboration for its epic success.

If you are thinking of starting your own business, one of the first decisions you need to make is how to structure it.

There are different ways of setting up a business in the UK, but the two most common options are becoming a sole trader or registering a limited company.

Both options have pros and cons, and the best choice for you will depend on various factors, such as your income, expenses, risk appetite, growth plans, and personal preferences.

This article will explain the main differences between sole traders and limited companies and help you decide which suits your business needs better.

Below are the highlights of this article. Click on the links to navigate to specific sections.

• What is a sole trader?
• What is a limited company?
• How do sole traders and limited companies compare?
• How to Register a Business (Sole Trader vs Limited Company)
• Advantages and Disadvantages of Sole Trader and Limited Company
• How to choose the best option for your business

So, let’s dive in.

What is a sole trader?

A sole trader is someone who runs their own business as an individual. You are self-employed and work for yourself, by yourself.

Being a sole trader is like riding a unicycle on a tightrope – it’s a daring balancing act where every step forward is a testament to your skill and determination!

You don’t need to register with Companies House or pay fees to set up your business. It would be best to inform HMRC that you are self-employed and file a Self-Assessment tax return annually.

As a sole trader, you keep all the profits from your business after paying taxes and national insurance contributions (NICs). You can also deduct certain expenses from your income to reduce your tax bill.

As your business owner, you bear personal responsibility for any debts or losses it incurs.

This implies that if your business experiences financial difficulties, you may need to use your assets, such as your home or car, to pay off outstanding debts.

Furthermore, your legal protection from legal action is limited compared to a limited company.

What is a limited company?

A limited company is a type of business structure that provides legal protection and separates the business’s finances from the personal finances of its owners (also known as shareholders).

When a business is set up as a limited company, it becomes a separate legal entity, almost like its own person in the eyes of the law.

This means the company can own property, enter into contracts, and take legal action in its name. It also means the company is responsible for its debts and liabilities, not the individual owners.

To set up a limited company, register it with Companies House and pay a small fee. It would be best to choose a unique company name, appoint at least one director and shareholder, and issue shares.

In the entrepreneurial symphony, limited companies are like a full orchestra – harmoniously combining various instruments of expertise to create a masterpiece of success!”

As a limited company, you pay corporation tax on your profits, and you can distribute the remaining profits to your shareholders as dividends.

Dividends are taxed at lower rates than income tax, making a limited company more tax-efficient than a sole trader. You can also claim more expenses as a limited company than a sole trader. However, you also have more paperwork and accounting requirements as a limited company.

Let’s get into the details of Sole Trader vs Limited Company.

How do sole traders and limited companies compare?

There are several factors to consider when choosing between being a sole trader or a limited company. Here are some of the main ones:

• How to register a business
• Liability
• Tax efficiency
• IR35 Rules
• Business growth opportunities
• Perception

How to Register a Business

Starting a sole trader business is more straightforward and cost-effective than setting up a limited company. You do not have to register with Companies House or incur registration fees.

Additionally, you have fewer administrative tasks and accounting responsibilities as a sole trader. Your primary obligation is to monitor your earnings and expenses and submit a Self-Assessment tax return annually.

Register a Sole Trader

If you want to establish a sole trader business, it is required to inform HMRC that you pay taxes via Self Assessment. It is necessary to submit a tax return annually.

Furthermore, you’ll need to:

• Keep detailed business records of income and expenses
• Send a Self Assessment tax return every year
• Pay Income Tax on your profits and Class 2 and Class 4 National Insurance (you can use the HMRC’s calculator to help you budget for this)
• Register for VAT if your turnover is over £85,000.
• If you plan to establish a business in the UK, applying for a National Insurance number is necessary.

Also, If you work in the construction industry as a subcontractor or contractor, you’ll need to register with HMRC for the Construction Industry Scheme (CIS).

Register a limited company

Setting up a limited company requires additional time and financial investment. You must register with Companies House and pay a nominal fee.

Additionally, you must select a unique company name, assign directors and shareholders, allocate shares, and establish a business bank account.

Here are the things you need to register a limited company:

• Check if setting up a limited company is right for you
• Choose a company name that defines who you are, what the business does, and how you want people to see your company. 
• Open a business bank account.
• Choose directors who follow the company’s rules, keep company records, and file your accounts and Company Tax returns. Also, have a UK-registered office address; directors don’t have to live in the UK.
• Decide your shareholders or guarantors.
• Prepare documents agreeing on how to run your company
• Check the records you need to keep
• Register your company with an official address and choose a SIC code – this identifies what your company does.

You have more paperwork and accounting responsibilities as a limited company.

Liability

As a sole trader, you are not considered separate from your business in the eyes of the law. This means that any debts or losses incurred by your business are your responsibility.

There are situations when you may have to use your assets, such as your home or car, to pay off debts. You also have less protection from legal action than a limited company.

As a limited company, you are not personally liable for any debts or losses incurred by your business. In financial difficulty, you stand to lose only the money you have invested in or lent to the company.

Your assets are typically protected from creditors or legal action (unless you have offered personal guarantees). Furthermore, limited companies tend to provide more legal protection than sole traders.

Tax efficiency

Being a sole trader means paying income tax and NICs on your profits after deducting certain expenses.

The income tax rates for 2022/23 are:

Band	Taxable income 22/23	Tax rate
Personal Income tax	Up to £12,570	0%
Basic rate	£12,571 to £50,270	20%
Higher rate	£50,271 to 125,140	40%
Additional rate	Over £125,140	45%

If you have employees, the amount of Income Tax you deduct depends on their tax code and how much of their taxable income is above their Personal Allowance.

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Being a limited company means paying corporation tax on your profits after deducting certain expenses.

If your company earns a profit of over £250,000, you will be subject to the main Corporation Tax rate of 25%. On the other hand, if your company earns a profit of £50,000 or less, you will be required to pay the ‘small profits rate,’ which is 19%.

You may be entitled to ‘marginal relief’ if your profits are between £50,000 and £250,000.

If your company has short accounting periods or multiple “associated companies,” the profit thresholds for paying £50,000 or £250,000 in taxes will be proportionately reduced.

You can also claim more expenses as a limited company than a sole trader, such as salaries, pensions, travel, equipment, and training.

Check out the Tax Deduction Cheat Sheet For Small Business

It’s essential to be cautious about the IR35 rules designed to prevent tax evasion by contractors who provide services through intermediaries.

If found guilty of breaking the rules, you may have to pay income tax and NICs on your earnings as if you were an employee.

IR35 rules

It is a tax legislation that aims to prevent tax avoidance by contractors who provide services to clients through intermediaries, such as their own limited companies. IR35 affects how contractors pay income tax and national insurance contributions (NICs) on their income.

For a Sole Trader, IR35 does not apply, but it does apply to limited companies. Sole traders are self-employed individuals who do not trade through a limited company and are, therefore, unaffected by IR35.

Limited companies are separate legal entities that have their finances and liabilities. Therefore, they are affected by IR35 if they provide services to clients similar to those of an employee.

IR35 can significantly impact limited companies, potentially leading to increased tax liabilities and National Insurance contributions (NICs) if they fall under its scope.

In such cases, the company’s status may be reclassified as if its directors and shareholders were their clients’ employees rather than operating as self-employed contractors.

As a result, the company’s tax efficiency and profitability may be adversely affected, as it loses some of the tax advantages associated with self-employment.

Business Growth Opportunities

Sole traders and limited companies have various business growth opportunities to explore, each with unique considerations and strategies.

Raising Finance

As a Sole trader, you may find it more challenging to raise significant capital, as you are personally liable for any debts incurred by the business. You might need to rely on personal savings, bank loans, or alternative financing options.

Limited companies often have an advantage in this aspect. You can raise finance by issuing shares to investors, obtaining loans, or seeking venture capital funding.

Investors and lenders are typically more inclined to invest with your limited company due to the clear legal structure and limited liability protection it offers.

Hiring Staff

Sole traders can hire staff but must consider employment regulations and tax obligations. Often, sole traders start by hiring freelancers or contractors before moving to full-time employees as their business grows.

As a limited company, you usually have a more straightforward process for hiring staff. Your company can hire employees and establish formal employment contracts as a separate legal entity. This structure may attract talented professionals seeking stable job opportunities.

Expanding into New Markets

Sole traders and limited companies can explore new markets and expand their business reach. It might involve diversifying products or services, targeting new customer segments, or entering international markets.

Limited companies may have a slightly easier time expanding due to their perceived credibility and financial stability, which can open doors for potential partnerships and collaborations.

Selling or Exiting the Business

Sole traders may face challenges when deciding to exit a business as they are the sole owners of their companies. Exiting might involve selling assets or client lists or passing the business to a successor.

Limited companies may have more flexibility when selling or exiting the business. Since they are separate legal entities, transferring ownership or selling shares to interested parties can be easier.

Regardless of the business structure, sole traders and limited companies can benefit from strategic planning, market research, and adapting to changing business landscapes.

Perception

As a sole trader…

You operate your business as an individual without forming a separate legal entity. While this setup offers simplicity and flexibility, it has some potential downsides.

One significant drawback is the perception that your business is less professional or trustworthy than a Limited Company.

When dealing with clients or customers of significantly larger organizations, they might prefer to work with a limited company due to the added layers of legal protection and the perception of being more established and credible.

Limited companies have distinct legal identities and are subject to specific regulations, which can provide potential clients with stability and security.

This perception could impact your ability to win contracts or tenders, particularly with organizations with stricter criteria, and may prioritize working with more formalized business structures.

They might have procurement policies that require their suppliers to be Limited Companies to mitigate risks and ensure compliance with specific standards.

As a limited company…

You benefit from the advantages of being a separate legal entity, which can significantly impact how clients and customers perceive your business.

This formal business structure often leads to a higher level of professionalism and credibility in the eyes of potential clients, giving you an edge over competitors who operate as sole traders or partnerships.

This perception of trustworthiness can be particularly crucial when dealing with larger organizations or government entities.

Clients are more likely to prefer working with businesses they perceive as stable and reliable, and being a limited company can help you meet their expectations.

Advantages and Disadvantages of Sole Trader and Limited Company

Advantages of a Sole Trader

• Easy to Run and Set up: You don’t have to register with Companies House, and there’s no minimum share capital required.
• Complete control: As a sole trader, you have full authority over your business, which includes making essential decisions, recruiting and terminating employees, and handling financial matters.
• Tax benefits: You can be eligible for tax deductions on your business expenses, which can be used to reduce your income tax liability.

Disadvantages of a Sole Trader

• Unlimited liability: The sole trader is personally liable for the business’s debts. This means that if the company goes bankrupt, the sole trader could lose their personal assets, such as their home or car.
• Limited access to finance: Banks and other lenders may be reluctant to lend money to sole traders, as they are personally liable for the business’s debts.
• Limited growth potential: It can be challenging to obtain financing and expand the business due to the constraints of relying solely on personal resources.

Advantages of Limited Company

• Limited liability: As a limited company shareholder, your personal assets are safeguarded from the business’s debts in case of bankruptcy. This implies that you are not liable for the company’s financial obligations.
• Access to finance: Limited companies have a higher chance of obtaining financing than sole traders because they are perceived as less risky.
• Growth potential: Limited Companies have the potential to grow at a faster pace than sole traders because they can raise finance and bring in new shareholders.

Disadvantages of Limited Company

• More complex to set up and run: Establishing a limited company involves a more complicated legal procedure and fulfillment of continuous compliance obligations.
• Higher taxes: When it comes to taxes, limited companies pay a higher rate of Corporation Tax on their profits compared to the income tax paid by sole traders.
• Less flexibility: Limited company shareholders have less flexibility compared to sole traders, as the company’s constitution binds them.

How to choose the best option for your business

Determining whether to operate as a sole trader or a limited company is subjective. Your choice should be based on your situation, inclinations, and objectives for your business.

Here are some questions you may want to ask yourself:

• How much income do I expect to earn from my business?
• How much risk am I willing to take on?
• How much paperwork and accounting am I comfortable with?
• How do I want to pay myself and save for retirement?
• How do I want to present myself to my clients or customers?
• How do I plan to grow my business in the future?

If you’re wondering whether to become a sole trader, here’s a helpful tip: It may be more fitting for you if:

• You have low or irregular income from your business
• You have low or manageable expenses and debts
• You value simplicity and flexibility over protection and structure
• You don’t mind paying higher taxes on higher profits
• You don’t need to impress large clients or investors

Alternatively, establishing a limited company might be a better option for you if:

• You have a high or steady income from your business
• You have increased or unpredictable expenses and debts
• You value protection and structure over simplicity and flexibility
• You want to save tax on higher profits
• You want to impress large clients or investors

Although there are general guidelines, it’s essential to remember that each situation is unique, and there may be exceptions. And would be best to consult an accountant or business advisor before making a final decision.

Wrapping up…

Deciding whether to become a sole trader or establish a limited company is a crucial decision that can significantly impact your business. Each option has advantages and disadvantages; the most suitable choice depends on multiple factors.

We hope that the article has been helpful and informative. If you have any questions or feedback, consult with an expert before taking any necessary actions.

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Frequently Asked Questions

How do I register my limited company?

• Check if setting up a limited company is right for you.
• Choose a company name that defines who you are, what the business does, and how you want people to see your business. 
• Open a business bank account.
• Choose directors who follow the company’s rules, keep company records, and file your accounts and Company Tax returns. Also, have a UK-registered office address; directors don’t have to live in the UK.
• Check out the HRMC website for details.

What’s the cost of registering a limited company?

The registration method and speed determine the price of registering a limited company in the UK. Companies House’s official website states that you can register a company online for £12 if you fulfill specific requirements, such as having a standard company structure and articles of association. Online registration typically takes 24 hours. Alternatively, you can register by post using form IN01, which costs £40 for the regular service (8 to 10 days) or £100 for the same-day service.

What’s the cost of registering a sole trader business?

The cost of registering a sole trader business can vary depending on the method and location of registration. To use a business name other than your legal name, you’ll need to perform a name search or reservation, which can cost between £12 and £40, depending on the service provider and processing speed. You’ll also need a business registration certificate to prove your registration as a sole trader, which can cost between £20 and £220, again depending on the service provider and processing speed. Finally, suppose you plan on hiring employees or opening a business bank account. In that case, you’ll need to apply for an Employer Identification Number (EIN), which is free if you apply online through the IRS website or may have a fee if you apply by mail or phone through a service provider.