One of the first big decisions most entrepreneurs face when starting their own business is deciding whether to register as a sole trader or a limited company. The legal structure of your new business will affect how much tax you pay, so it is an important decision to make.
There are advantages and disadvantages of any type of business structure; so determining which one is best for you, depends on your specific circumstances. In this article, we will explain the differences between the two business structures to help you choose between operating as a sole trader or limited company.
What is the difference between a sole trader and a limited company?
By operating as a limited company, you and the business are two separate legal entities. Conversely, if you decide to operate as a sole trader, you and the business are one legal entity.
The legal structure of your business impacts your obligations as a business owner including reporting requirements, how the business pays tax and even how you pay yourself.
Who is liable for business debts as a sole trader versus a company?
If you are a sole trader, there is no legal distinction between you and the business so you are personally liable for what happens legally and financially. As a sole trader, you have unlimited liability; therefore, you risk losing your personal assets if the business encounters financial or legal challenges.
Some industries are riskier than others, such as those with higher start-up costs, or businesses which take up-front larger sums of money before getting paid by the client. As a result, these industries could be better suited to operating as a limited company.
Business owners can protect their personal possessions by taking advantage of the limited liability when operating as a company. This offers greater protection to the directors and shareholders in the business, with any debts being the company’s liability, and not your own.
Paying yourself as a sole trader versus a limited company.
As a sole trader, you pay income tax and national insurance at the appropriate rates based on your profits. However, if you operate as a limited company, the business’ profits are subject to corporation tax (between 19% to 26.5%). Therefore, if you make a profit of £50,271 or more as a sole trader, it may be worth incorporating your business to become more tax efficient to avoid paying the higher rate of income tax, currently 40%.
To extract money as a shareholder and director of your own company, there are certain methods you can utilise. To ensure you are paying yourself in a tax efficient manner, you can pay yourself a small salary and declare dividends from post-tax profits.
It is important to seek professional advice when extracting funds from a limited company. Get in touch with our tax saving experts. We can help you determine the most tax efficient way of remunerating yourself and explain the tax implications of each option available to you.
Tax efficiency for business owners.
How you pay yourself as a sole trader or limited company determines how tax efficient you are. As we mentioned earlier, sole traders pay income tax and national insurance on their profits – even if they do not extract all the profits from the business.
Conversely, profits in a limited company are subject to corporation tax. After paying corporation tax, the remaining profits stay in the company as “retained earnings” until they are distributed to shareholders.
Operating as a limited company allows you to take advantage of your personal allowance and national insurance thresholds by taking a small director’s salary, which serves as a tax deductible expense to reduce the corporation tax liability.
You can then declare dividends from retained earnings to make up the remainder of your personal income. Although dividends are subject to income tax, dividend tax rates are much lower than standard income tax rates. Company shareholders must report their dividends on their self-assessment tax return.
Does business structure affect my privacy?
Unlike limited companies, sole traders are not required to make information available to the public. Limited companies are required to submit their annual accounts to Companies House and this information is published on their online register.
Your full name and address is also visible on Companies House. So if you are a side hustler and don’t want your boss to find out, this is something to keep in mind. To avoid your home address from appearing on Companies House, you can purchase a registered office address to protect your private residence.
Reporting obligations and deadlines for sole traders and limited companies.
Whether you are a sole trader or limited company, you must maintain sound financial records. Bookkeeping is the back bone to any successful business. Having bullet proof financial records reduces the risk of accounting headaches at the end of the year and ensures that HMRC inquiries are easier to deal with.
Sole traders must report their earnings to HMRC by completing a self-assessment tax return each year (6 April to 5 April). You must submit your tax return and pay any outstanding liability to HMRC by 31 January following the end of the tax year. I.e. for the 2023-24 tax year, you must file your tax return by 31 January 2025.
Operating as a limited company results in more administrative tasks. Companies must submit an annual confirmation statement and accounts to Companies House. They also have to file a corporation tax return (CT600) and annual accounts to HMRC.
The deadlines for submitting their accounts to Companies House is 9 months after the company’s year end. Payments for corporation tax must be made within 9 months and a day after the year end.
Registering your new business
Sole traders register their business by signing up for self-assessment with HMRC. The deadline for a sole trader to register for self-assessment is 5 October after the end of the tax year. I.e. for the 2023-24 tax year, you must register by 5 October 2024.
Setting up your business as a limited company is a very different process. You will need to register the business with Companies House, which will automatically enroll the business for corporation tax. There is more admin required when incorporating your business, such as appointing directors and shareholders. Companies House also charge £50 to register a limited company.
Choosing the best structure for your new business
There are a few points to consider when deciding how you want to setup your business:
- Is your profit going to be over £50,270? It could be more tax efficient to register your business as a limited company to avoid paying higher rate income tax.
- Is this a high risk business? You should consider incorporating if you will be dealing with the public on a regular basis or dealing with large transactions.
- Do you have other forms of income? This may affect the most tax efficient way of setting up your business.
It is important to remember that everyone’s financial circumstances are unique so it is worth seeking professional advice before registering your business. Feel free to reach out to our tax saving experts who can help you determine the best option for you.
In conclusion
Deciding between operating as a sole trader or forming a limited company depends on various factors, including the nature of your business, level of profit, potential risks and growth aspirations. While being a sole trader offers simplicity and direct control, a limited company provides liability protection and potential tax advantages.
Seeking professional advice to discuss your specific circumstances is advisable. Reach out to our tax saving experts who can help you determine the best structure for maximum tax efficiency.
By understanding the benefits and drawbacks of each structure, you can choose the path that best aligns with your business vision and long-term goals.