Limited Company or Sole Trader – which is better?

by | Jan 24, 2021 | Business, Business Basics

So, you have decided you’re going into business. I can assure from my own experience that the surge of excitement of making that decision (and rightly so you should be excited) will be replaced with a barrage of questions. One of the most important ones is, “how should I set up my business?”.

At some point soon, you need to decide. Sole trader, or limited company. I have had clients join me after having made that decision, only for me to wonder “why” with a tinge of regret at their choice. There is no right or wrong answer, more that individual and business circumstances should help guide you.

In the next of my business basics series, I’m going to talk through the pros and cons of either setting up as a limited company, or a sole trader.

LLPs (Limited Liability Partnerships) are a different beast altogether. There may be reasons this is the right structure for you. But for now, I’ll keep it simple. I would always encourage you to seek professional advice that works around your circumstances before deciding. if you want an idea of the key points read on.

What will save me more tax?

Let’s not beat around the bush here. In most cases, your number one question is going to be “how do I pay the least tax”?

It really depends. Generally speaking, limited companies are more tax efficient if set up the right way and managed properly. But it is always worth considering your circumstances, both personally and professionally, to make the right decision.

Never take this decision in isolation from all the other points in this blog. It’s not all about tax.

It helps as well if you understand how you will pay yourself if you are set up one way or another.

How do I pay myself?

A sole trader is simple. Because you are the business, any profit you make is yours, but is immediately taxed and considered drawings. You will pay tax on the rates of income tax that prevail today and have your taxable allowance to work with, plus you will need to pay Class 2 and Class 4 National Insurance on your earnings.

Limited Companies operate differently. The funds you make are not yours but belong to the company. To take them out, there are a few more steps to follow. First, you should consider establishing a payroll and pay yourself a salary as an employee. After this, your business may have earned a profit, which will be taxed at the Corporation Tax rate. What’s left are known as retained earnings. Provided you don’t need this cash in the business to keep it running and you are a shareholder, you can take this out as a dividend. But again, tax is paid on dividends due. You also need to be careful you don’t pay dividends when you have insufficient retained earnings, as these are illegal.

Taking out funds without putting it through as a salary or dividend is considered a director’s loan. These loans, if they grow, can become nasty with huge tax charges and risk incurring benefits in kind. Don’t forget as well all the necessary paperwork, such as minutes and dividend vouchers needed if you take out a dividend.

As you can see, there is a lot involved with a limited company to make sure you don’t fall foul of the law and avoid unnecessarily paying extra tax.

Limited means limited liability, but with some exceptions

The phrase “limited” is short for “limited by shares”. This quite literally means your liability on business debts is limited. So, if your business were to fail and you had outstanding debts, your creditors would be limited to what is recoverable from within the business only. Critically, that means not your personal assets, such as your home or car.

Sole traders cannot enjoy this protection and for them, this remains a key risk of being a sole trader.

However, being limited doesn’t absolve directors of these liabilities completely. In certain cases, such as fraud, creditors can look through the limited company and find directors personally liable. Suppliers will undoubtedly want to see a good history of credit and trading before offering you terms, or you may be asked to provide a personal surety on certain things, such as a lease.

Going limited shouldn’t excuse business owners from ensuring they have good insurances in place for any other liabilities that are a risk to them.

Want to keep private?

Limited companies can be viewed on Companies House. You can Google a name of a company, see the director’s names and even details such as the month and year they were born.

Other details such as address are visible too, although you can find services which will give you a PO box to register the company at and service your post for a small fee.

The public can examine your accounts too. Depending on the size of your business you will have to adopt different accounting standards. FRS105 (micro entity) for small businesses only require a summarised balance sheet to be published, but other standards require a little more depth.

Sole traders are not exposed at all in this way, so if privacy is a concern for you, going limited might not be ideal.

What about banking?

Limited Companies need their own bank account, established in the name of the limited company. This is important for several reasons, such as avoiding breaching the terms of your banking facilities, or misappropriating income or expenses ‘personally’ which can have significant tax repercussions. Business bank accounts also typically charge a fee, although there are some compelling free options now available.

With sole traders, you don’t have this restriction as the business is in your name. However, you should always check the terms of your banking provider to ensure you can use the account as you intend.

As a sole trader, you should still seek to keep your business and personal banking matters separate. Dedicate an account to your business. This helps you (and your accountant) get a better grasp on how your business has performed.

Do limited companies look better?

There is a perception that limited companies are ‘bigger’, or more professional than their sole trader counterparts. This stems off the fact that generally as companies grow, they will come under the limited banner and are run with more rigor, better processes and so on. However, this is purely perception and psychology. I simply see no distinction. But potential clients may have a different opinion.

Think about the kind of clients you want to work for and what you are selling. I would suspect a window cleaner working around the village would have a lot less concern than a business tendering for a multi-million-pound contract. If you were offering that tender, would you rather it goes to XYZ Limited, or Joe Bloggs?

I have heard of examples of customers refusing to work with businesses who aren’t limited for their own reasons, so make sure you don’t unnecessarily lose out.

What if I am after investment?

A limited company is set up perfectly to introduce more investors and partners into the business, through issuing equity via shares. Being a sole trader means you don’t have this option.

Remember though, if financing is a requirement, debt such as a bank loan could work, and this isn’t so prescriptive.

How much would an accountant charge?

How you are structured directly impacts the amount of work and care your accountant needs to provide.

A sole trader will have one main tax return due the 31st of January (online) each year to declare their income and expenses.

A limited company has its own tax return – a corporation tax return – due 9 months and one day after the accounting period ends.

On top of that, company accounts are required.

And, if the director is in receipt of dividends, they will need to complete a self assessment as well to declare that income.

Because of all this, accountants will charge more for servicing a limited company. But this should not be the main reason for making this decision, as the increase in costs could be offset by potential savings in tax, or fit your circumstances better.

What if I am employed as well as self-employed?

Much like how we started, you may be employed and self-employed.

Again, it is circumstantial but consider whether you need the income from your self employment whilst employed. If your main job is paying the bills and you don’t need the funds from your business, it may be worthwhile going limited. The reason being is that these funds can be kept in your company and should you be profitable, you are only going to pay 19% tax. As a sole trader, profits are taxed fully as income. This becomes an issue if you are a higher rate payer, where rates are 40% + NI or even more if you are an additional rate payer.

If you do need those funds to make ends meet, then they will be subject to dividends or payroll and you need to look at the tax picture as above.

Can I go from Sole Trader to Limited?

A common question and the short answer is yes. You can incorporate a limited company, transfer assets across and inform HMRC and other stakeholders of your change.

It does create additional work but might be an option if you are testing your waters, particularly with a small business.

And the other way round?

Again yes, but it’s more difficult. You need to shut the company down and that alone is an extensive process, depending how you do it.

What about VAT?

A common misunderstanding is that VAT is a factor here. People have said to me a few times that you need to set up a limited company if you need / intend to register for VAT. That simply is not true. If your turnover reaches £85,000 (at the time of writing) or higher, you need to register for VAT, regardless if you’re a sole trader or a limited company.

A famous example I regularly mention is Sports Direct’s Mike Ashley. Whatever your take on him, an interesting fact was that little was known of him despite his high street presence. At one point he had over 100 stores, yet he was trading as a sole trader! VAT certainly didn’t stop him trading this way.

Could circumstances change?

A lot of this is based on what is known today. But tax evolves and that in turn could make being a sole trader or a limited company better or worse for you.

The only option here is to continue evaluating the landscape, the rules and what it means for you and your business. If you need to change, don’t be afraid to do it, if it’s worthwhile. This is particularly important in this current climate. The government is providing an unprecedented amount of support to individuals and businesses related to COVID-19 and they will need to recoup that tax somehow.

A good accountant will keep you informed proactively, so if something is coming down the road that isn’t right for you, they will let you know so you can act.

So, which is better then?

Is a limited company worth it? Or should you go down the sole trader route? There is no generally better way, but there is a right answer for you.

Think about the below and what matters the most. Critically, it’s not all about tax, but do make sure you are not losing out excessively if you go one particular way.

  • Will you need to limit your liability? – if you’re going to take on a lot of debt, need credit terms or maybe a sizeable lease this could be very important. Think about risks to you and your family here if you don’t do this.
  • Are you going after big contracts? – For right or wrong, limited companies will most likely be better received versus sole trader counterparts for bigger contracts.
  • Do you intend (for now) to live off the profits of your business? – Sole traders are taxed immediately on their profits. Limited companies can allow reserves to build up and suffer corporation tax, meaning a lower effective tax rate.
  • Will you seek investment one day? – With a limited company, you have an avenue to offer shares to investors and have more ways to bring in funds to grow your business. Loans are another option though.
  • Can you handle the extra rules and paperwork? – Limited companies are significantly more complex. You need to be happy you understand the rules and regulations, so you don’t land in hot water, or appoint a good accountant by your side.
  • Is privacy important? – Limited companies are visible on Companies House. If you want privacy, sole trader could be a better choice.

Need some guidance in setting up your business? Get in touch today and we’ll help you understand what works best for you.

Ready to start the journey?

To get help with your accounts and start freeing up your time to focus on growth, talk to the Mayflower team today.

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