Sole Trader or Limited Company?
Which legal structure should I choose?
There are seven forms of legal structure or trading style you could use for your new business in the UK…
- Sole Trader
- Partnership
- Limited Liability Partnership
- Limited Company
- Public Limited Company
- Co-operative
- Franchise
…but apart from buying a franchise or starting a co-operative, they are all variations of the Sole Trader or Limited Company and once you understand these two then you can understand all the rest.
This section summarises the main differences between trading as a Sole Trader or forming your own Limited Company and at the end is some advice about how to choose.
Why use a business structure?
Your company or trading structure is a big decision. It will affect how much tax you pay and may even affect how your customers see you.
Please read this information carefully and then get professional advice from an accountant before you act on it.
How money works in a business
Starting your own business will change the way you think about income and expenses.
Historically, companies have always paid less tax than individuals for the simple reason that companies can deduct the cost of their operations from the sales income that they get. They are only taxed on the resulting profits whereas individuals are taxed on income. That’s why the rich and enterprising individuals (like you?) have turned themselves into trusts and corporations to minimise their tax bill.
Take a look at the table below which summarises the differences between having a job and owning your own business.
| As An Employee | With Your Own Business |
|---|---|
| You earn money by selling your time and labour for a fixed price | You earn money by improving your own business and the value you create contributes to your retirement plan |
| You are only employed for as long as you add more value than you cost | - |
| You are contributing to the retirement plans of the business owner | - |
| Your earnings are limited by others | Your earnings are limited only by your ability to find paying customers. |
| You pay tax. PAYE removes tax from your earnings at source. You probably work five months a year to pay this tax. You have no choice or control over the amount you pay | You can spend these earnings on your administration and operating expenses. Many of the running costs of your life and business can be counted as a business expense, for example, your salary or pension contributions |
| You can spend what’s left of your money after tax | You pay tax on whatever is left after deducting your administration and operating expenses from your earnings. If nothing is left, you pay no tax |
As you can see from the ‘With Your Own Business’ column, if you have a healthy cash flow of business expenses you can operate within the cycle of earning and spending before you go anywhere near paying taxes. Why? Because taxes are only paid on your operating profits not your sales.
This is why it is so important to consider carefully how you structure your business and also why the amount you pay yourself and the way you pay yourself will differ greatly from the bad old days when you had a job…
For example:
- Earning a lot less than minimum wages could be a good idea…
- Making a loss can be a successful way of trading…
- There are times when spending more can save you more…
The key calculation that governs your life when running a business is:
Negotiated prices minus business expenses equals profit
As a Sole Trader you pay income tax on this profit and live on the rest.
As a Ltd Company the company pays tax on this profit and the rest can be paid out to the business owner.
Let’s consider these business structures in more detail…
The Basics
The tables below enable you to compare and contrast the Sole Trader and Limited Company structures so that you can see what the differences are and what it means for you. Read through them carefully and then discuss it with your accountant.
What is it?
| Sole Trader | Limited Company |
|---|---|
| There is no legal difference between you and your business | A separate legal entity (an artificial legal person), distinct from you |
| The money you make belongs to you and is counted as your personal income | The money the company makes through trading belongs to the company |
Being a Sole Trader means there is no legal separation between you and your business. You trade on your own account so the money you make belongs to you and counts as your income.
Using a Limited Company means buying or creating a separate legal entity, like an artificial legal person. This trading vehicle owns assets and makes money. It is taxed separately from you.
What is my legal liability if something goes wrong?
| Sole Trader | Limited Company |
|---|---|
| Total. (That’s everything). No legal separation means that everything you own is at risk if your business goes wrong You can manage this risk with insurance | Limited to your investment in the business. (but Directors have other risks). This is no protection from stupidity - if you borrow against your house to start a business and the business fails, you will still lose your house |
What’s my employment status?
| Sole Trader | Limited Company |
|---|---|
| You are self-employed | You now have three roles. You are a director. You are an employee. You are an employer. Each role comes with a set of responsibilities and rights |
Sole Traders are “self-employed” but if you work for a Limited Company (even your own) then you are an employee. Watch your language here, especially when talking to a government department. Be clear on your employment status because it affects your tax and NI.
How does the money work in this legal structure?
| Sole Trader | Limited Company |
|---|---|
| Remember that the money you earn is yours… | Remember that the money you earn belongs to your company… |
| Because the money is yours, you record it on your tax return: (Sales minus Expenses = Profit or Loss) | You could: * Pay yourself a salary. * Claim your expenses. * Have your company contribute to your pension plan. * Share profits with the business owners in the form of a dividend. |
| This profit is your income and you will pay income tax on this profit | You may pay income tax on your salary. Your company will pay corporation tax on any profits |
| (This ought to worry you) |
Sole Traders account for their business on their Self Assessment Tax Return using the Self Employment pages.
- You enter your sales (business turnover)
- You then list your expenses under various categories
- Your sales minus your business expenses then becomes your trading profit. Because you are trading as an individual, this counts as your personal income
With a Limited Company the money does not even belong to you. All the invoices have been in the company name and it holds the money. So, how do you get your hands on it? You have four basic options…
- The company can make employer’s contributions to a pension plan for you - you get the money later. Remember this is a business expense for your company
- The company can pay you a salary - again, this is a business expense
- You should claim reimbursement of expenses because everything the company pays for reduces the need to pay salary (and potentially income tax)
- If profitable, the board of directors (usually you!) can pay a dividend to shareholders (usually you!)
That’s great but how is this money taxed?
| Sole Trader | Limited Company | |||
|---|---|---|---|---|
| Income Tax | Income Tax | Corporation Tax | ||
| First | £7,475 | 0% | - | - |
| Next | £35,000 | 20% | You choose your salary and therefore your income tax | First £300,000 of profits taxed at 20% |
| Next | £107,525 | 40% | - | - |
| Over | £150,000 | 50% | - | - |
| Tax is due in January and July | Tax due nine months after year end | |||
You can see that as a Sole Trader you are going to be paying income tax on your net profits. So unless your income and expenses are evenly balanced, any profit above £7,475 will mean between 20p and 50p of each £ of profit going to the Revenue. If you already have other income that you pay tax on then your Sole Trader profits will be added on top of this, running the risk of pushing you into a higher tax bracket.
With a Limited Company, you choose your salary so you choose how much income tax you pay. Keeping your salary low however means that the company profits will be higher and your company will pay Corporation Tax on any profit it makes.
You can see from the figures that a profitable Sole Trader will pay more tax than a profitable Limited Company once profits go above £42,475. Below that figure you need to consider the impact of National Insurance (see later). That’s why a widely used structure for small companies is to pay a small salary and take the rest out as dividends. Companies also pay tax less frequently than Sole Traders.
Thankfully, in 2011, Corporation tax rates have fallen back to 20% making them the same as the income tax rate which applies to Sole Trader profits. Previously there were a number of deliberate, and somewhat spiteful, attempts by the Treasury to increase the tax on people who are enterprising enough to turn themselves into a Limited Company. This kind of “Personal Service Company” still looks attractive if:
- Your work is a contract for services and will not be caught by IR35
- You claim every possible business expense that you can
- You minimise salary as low as possible and reward your shareholders with dividends
- You look very closely at paying employer’s contributions to your pension plans as these are a business expense and act to lower your profits. This is particularly helpful near retirement as a useful percentage of the pension pot can be drawn as tax free cash
In general, dividends attract a lower income tax rate than salaried income and they are free of National Insurance which makes them a very effective way of sharing the profits of a successful company.
Be careful…
The most widely used structure for smaller businesses making decent profits is to be a Limited Company, paying a small salary, claiming expenses and taking the rest as dividends. Please use an accountant to help you with this. A wise accountant can help you set this up properly to minimise your tax bill. This becomes even clearer when we turn to look at…
National Insurance (the hidden tax)
| Sole Trader | Limited Company | |
|---|---|---|
| Remember - NI is really income tax | ||
| Class 2 = £2.50 a week | Employees NI | Employers NI |
| Class 4 = 9% of all profits above £7,225 | 12% of salary between £7,228 and £42,484 | 13.8% of all salary above £7,072 |
| Class 4 = 2% of all profits above £42,475 | Then 2% of the rest | - |
| (Yes, that’s income tax AND national insurance on your profits) | You choose your salary so you choose your NI bill | |
Sole Traders pay…
A fixed weekly charge then face a further NI charge on their profits ON TOP OF the income tax they have paid. This means that when your profits go above £7,475, you will pay a combined income and national insurance tax of 29p in the pound then 42p and 52p at the higher rate.
It’s important that you put this money aside every time you make a sale so that you have it ready to pay the tax demands in January and July each year. A good rule of thumb is to put aside 25% of each sale because this allows for the deduction of expenses and will probably leave some left over. It’s always better to have spare money than be looking for money to pay a tax demand you haven’t planned for.
If you are going to be self employed it is also a very good idea to pay your Class 2 contributions because they entitle you to a handy range of state benefits.
If your Limited Company pays you…
…a big salary then you have BOTH an employer’s and employee’s NI contribution to make. This is a disaster as your tax bill would be 20% + 12% + 13.8% (45.8%) at the lower rate and 40% + 2% + 13.8% (55.8%) for a higher rate salary. At salary above £150k your marginal tax will be 50% + 2% + 13.8% (65.8%).
You can minimise your NI bill by keeping your salary small. Remember, the dividends you receive do not attract an NI charge but any salary you pay to yourself and others does! This is a good reason to think very carefully before employing someone else - not only will you have to deduct their tax and NI but you will have to pay the “employment tax” (Employer’s National Insurance) which is 13.8% of whatever they earn.
The obvious move here is to pay dividends instead of salary and to counter that there is now a slightly higher tax rate on large dividend payments. Get advice.
Build your NI record without paying contributions
One interesting quirk of the NI and Income tax system is that if you pay yourself more than the lower earnings limit (£102 a week) but less than the primary threshold (£139 a week) then your NI contributions are credited to you although you pay no deductions. This means that if for some reason you did want to keep your salary very low you would still maintain an NI record for things like state pension. Please confirm the current position with your accountant.
Use your accountant to help you plan the right balance of salary and dividends so that you minimise your tax bill.
Which NI Contributions pay for which benefits?
- Class 1 national insurance contributions count towards contribution-based Jobseeker’s Allowance, Incapacity Benefit, Bereavement Benefits, Retirement Pension and Maternity Allowance
- Class 2 contributions count towards the same benefits as Class 1, but Class 2 will not always count towards contribution-based Jobseeker’s Allowance
- Class 3 (voluntary contributions) count towards bereavement benefits and Retirement Pension
- Class 4 contributions do not count towards any benefits. However, you still have to pay these if you are self-employed and have profits over a certain level (see above)
Tax Table
Here is a simplified tax table for the financial year ended 5th April 2012. You can always get the most up to date version of the table from the downloads page.
Tax Effect Of Your Legal Structure - Year End 5th April 2012
| Rates | Employed | Sole Trader | Ltd Co - salary | Ltd Co - dividends |
|---|---|---|---|---|
| Income Tax on rising profit / salary | ||||
| 0 - £7,475 | 0% | 0% | 0% | 0% |
| £7,476 to £42,475 | 20% | 20% | 20% | - |
| £42,476 to £100,000 | 40% | 40% | 40% | |
| £100,000 to £150,000 | 40% + gradual loss of personal allowance | 40% + gradual loss of personal allowance | 40% + gradual loss of personal allowance | |
| above £150,000 | 50% and no personal allowance | 50% and no personal allowance | 50% and no personal allowance | |
| National Insurance | ||||
| Class 1 Employees £7,228 - £42,484 | 12% then 2% | - | 12% then 2% | - |
| Class 1 Employers > £7,072 | - | - | 13.8% | - |
| Class 2 fixed | - | £2.50 week | - | - |
| Class 4 £7,225 - £42,475 | - | 9% then 2% | - | - |
| Corporation Tax - on profits | ||||
| £0 - £300k | - | - | - | 20% |
| £300k - £1.5m | - | - | - | Marginal relief |
| > £1.5m | - | - | - | 26% |
| Other | - | - | Employers NI is a business expense but still ‘money out’ | Dividends free of NI and attract a reduced income tax charge at higher rates (get advice) |
This table is a summary of the tax position and does not constitute financial advice. Please consult an accountant before making any decisions based on this information. These rates only apply in the tax year ended 5th April 2012.
Notes for the tax table:
NI - 12% between primary threshold (£139 a week) and upper earnings limit (£817 a week). This means that you start paying NI earlier than income tax. 2% above upper earnings limit.
Sole Trader - income tax and NI are charged on profits not sales. Use expenses wisely to reduce declared profits. 9% between lower profits limit (£7,225) and upper profits limit (£42,475). 2% above upper profits limit.
Ltd Company - taking a salary means paying Employers NI as well as Employees NI so the most common structure is “small salary, big dividends”. Employers NI is deductible as a business expense. You still have to pay it but the cost will reduce your profits liable to Corporation Tax.
Personal Allowance Once salary rises above £100,000, the personal allowance reduces by £1 for every £2 of income above the £100,000 limit until it disappears completely at £113,950. You’ll then pay 20% on the first £42,475 and 40% on the rest. Couple this with new 50% tax rate at £150k and the uncapped Employers NI contribution and you can see why any entrepreneur earning a large salary from their business is in urgent need of good quality tax advice.
Please note that this is a vastly simplified table to show the principles involved. It does highlight the danger of using salary as a reward in your own Limited Company. What makes it so ineffective is the Employer’s National Insurance, which is really a surcharge on employing people - even yourself. It may be wise to pay some NI so that your pension and benefits record are up to date but keep it to a minimum. The most common structure for a Limited Company is ‘small salary, big dividend’ You can see how important it is to take professional advice from an accountant who knows about small businesses.
If you’ve had a big redundancy payment, here’s a tax tip
The power of making a loss
If you have received a redundancy payment in the same tax year that you want to start your business then using the Sole Trader structure to make a loss could be useful for tax planning.
| Sole Trader | Limited Company |
|---|---|
| Your losses can be set against other personal income. Consider creating a loss to offset the tax paid on your redundancy payment | A loss just carries forward into next years accounts |
| (if this sounds attractive or useful, please take professional advice about your situation from an accountant) | A loss means that you can’t pay dividends unless you have retained profits from earlier years |
How does this work?
Luce Smorels is being made redundant at the end of December. Her package is generous and although some of it is tax free her company deducts 40% income tax from the rest. She knows that the tax year does not end until the following 5th April so she makes up her mind to earn nothing else in those three months. This might result in a tax refund. Her accountant recommends that she goes one step further and starts as a Sole Trader so that she can pay all her start-up costs and expenses before 5th April. She makes sure that she doesn’t receive any income before the new tax year. The result of all this is that she makes a “loss” and this is offset against the income tax already paid. To her delight, the Revenue then refund most of the 40% tax that was deducted from her excess redundancy, just as her accountant promised. Speak to an accountant if this is similar to your situation.
How do I actually, officially, register a new business?
How to register as a Sole Trader
It’s easy. Ring 0845 010 9000, the HMRC help-line for the newly self-employed. Only ring when you are ready to go and you must tell them within three months of starting trading (your first sale). It’s a good idea to talk to your accountant before you do this.
How to register a Limited Company
This is harder because someone has to buy or create a brand new legal entity. There are three main approaches you can take:
- DIY - use the forms from Companies House. This appears to be the easiest way but is actually quite slow and hard. Not recommended.
- Formation Agent - there are many reputable company formation agents who will run the set up process at Companies House for you. Takes about a week. Only use this approach if your affairs are very simple.
- Use an Accountant - this is by far the best way (although the most expensive) because it gives you a chance to talk through all the relevant issues before forming a company. Here is the list of things to consider when you are creating a new company:
- Share splits - who owns what proportion of the company?
- Registered Office - where will this be?
- Company Secretarial - who will fulfil this function for your business?
- Bookkeeping - agree a system with your accountant which makes this easier for both of you
- Payroll - who will register a PAYE scheme and administer your payroll?
- Financial Year - do you want to adjust the length of your first financial year so that you align future years with the calendar year or tax year?
- VAT - who will do the company VAT returns?
Please see Do I need an accountant?
What to do before you register
Here are three common sense checks that you should make before setting up either type of business:
- Check the list of limited companies at Companies House to see whether the name you want is already taken. Your name must be at least two characters different from any other name on the database
- Check Yell to see whether Yellow Pages have any other business listed with the name you want to use
- Do a domain name search to see whether there is a web address free in the name you want to use
At this early stage you want to make sure that you are able to have a professional sounding trading name that is not being used by a close competitor. A decent business will have…
- A simple memorable name
- The same name as a website using either .co.uk or .com
- Be able to send and receive email using that address
You could spend the next 10+ years saying this name. Pick something easy to say and easy to spell. I use Namesco for all my domains and their service is very good.
Which records should I keep and for how long?
| Sole Trader | Limited Company |
|---|---|
|
Every receipt Delivery notes from suppliers Invoices and bills you pay Copies of invoices you issue Bank statements (reconciled) Chequebook stubs Credit card statements and slips Your mileage records and a diary/record of your work | |
| See bookkeeping briefing note for some useful advice | |
| Keep for 6 years | Keep for 6 years |
| Your records are private | Your accounts are available at Companies House |
How easy is it to sell this type of business?
| Sole Trader | Limited Company |
|---|---|
| Hard to sell | Easier |
| Unless there is something tangible that someone will pay for it’s quite hard to separate your business and personal items | Provided there is something to sell |
| Remember that you can split ownership between many shareholders. Think about relatives and children who could become shareholders and receive dividends |
What happens if I die?
| Sole Trader | Limited Company |
|---|---|
| Your business ends when you die | A Limited Company exists forever |
| (unless there is something to sell) | (until someone shuts it down) |
| So, make a will…make sure you know who gets what when you are no longer around |
So, how do I choose which structure to use?
Consider the Sole Trader structure if…
- You want a low risk easy way of setting up in business. One quick phone call to the Revenue and you are away. All you need is to be organised with keeping receipts and copies of all your business paperwork. You can do the accounts yourself if you really want to and all you need is a separate bank or building society account. Use a separate credit card too.
- You want to use the losses in this type of business to help your personal tax position.
- It’s a part-time, casual or interim business that is only ever going to be you - no employees.
Terry Bull is a successful electrician. He has been a Sole Trader for ages because his first accountant recommended it and it was what all his mates did. Business is growing and his new accountant says that he’d pay less tax as a Limited Company. He sets up the company and then ‘sells’ all his tools and equipment to the new company. This is useful way of taking some expenses out before tax AND his accountant arranges a ‘goodwill’ payment for the Sole Trader business as well.
Consider setting up a Limited Company if:
- You are already a Sole Trader making profits that put you near the upper income tax bracket.
- You know this business is going to grow and be your main source of income.
- You have other income, perhaps a pension, that means you pay a lot of income tax already so the Sole Trader structure is not suitable
- Your customers expect to deal with a professional business.
- You are happy to pay an accountant to take care of the paperwork requirements for Companies House.
- It will be useful to use the structure of shareholders and employees for tax planning. For example “employing” a spouse or children so you can pay them a basic salary to use up their personal allowance and / or selling them shares in your business you can pay them dividends - possibly to fund education.
Catherine Wheel runs a small consultancy business. Her husband ‘Squeaky’ stays at home at the moment with their school age children. She sets up a Limited Company with herself as sole director and her husband as the company secretary. She pays herself a salary of £7,475 so using up her personal allowance. She pays her husband the same. This means that she has earned enough to pay a small NI contribution but no income tax. The salaries are company expenses and are taken out of the business before corporation tax. Her accountant recommends splitting the shares 75% / 25% so she is able to pay dividends (free of NI) to make up the rest of the income they need. They record each decision properly with board meeting minutes and dividend certificates to comply with the Companies Act. As the children get older she plans to employ them on a casual basis and later as directors of the business, using the salary to fund their education. They may also “buy” shares in the business so they can receive dividends.
A wise old accountant once suggested
- Run as a Sole Trader while you are making a loss, then switch to Limited Company to shelter your profits
- Register for VAT early to claim for your set up costs
- When you move to a Limited Company sell all your Sole Trader assets and equipment to the new company
Action
- Go and see at least three accountants and run through this section with them. A decent accountant will give new clients the first hour free of charge
- Book yourself on a free Inland Revenue workshop
- Find your local Business Link and have a free meeting with an adviser to talk through your options
- Check the list of limited companies on the Companies House website to see whether the name you want is already taken. Your name must be at least two characters different from any other name on the database
- Check Yell.com to see whether Yellow Pages have any other business listed with the name you want to use
- Do a domain name search at Names to see whether there is a web address free in the name you want to use
- When you have the above information do the following:
- Create a simple memorable name for your new business.
- Make sure you own the same website name using either .co.uk or .com.
- Check that you can send and receive email using that address.
- Set up your email signature file so it looks professional
- Decide which structure to use and either register as Self Employed or get an accountant to set up the Limited Company for you.
- Start your basic bookkeeping system
Checklist for your Legal Structure
Registration as a Sole Trader / self employed
- I have contacted HMRC and registered as self employed
- I am now paying Class 2 National Insurance Contributions to safeguard my benefits
- Legal requirements for documents - Sole Trader
- My letters, orders and receipts show
- My name
- My trading name
- My business address
- VAT number if applicable
Creating a new Limited Company
- I have found an accountant to create the company for me
- We agreed on the registered office address
- We agreed registration and admin of a payroll scheme for employees (PAYE)
- We agreed company secretarial responsibilities and who will maintain the statutory records
- We discussed preferred method of bookkeeping
- We agreed suitable share splits for my circumstances
- We discussed the date of registration and the financial year end of the company
- I have signed the form to give HMRC authority to communicate directly with my accountant
- I now have the company registration certificate
- Legal requirements for documents - Limited Company
- My letters now carry my company name, registered office and registration number
- My web pages carry name of company, registered office, registration number and VAT number where appropriate
Beware the spectre of “Income Shifting”
If you have worked through these sections you’ve probably realised that it is very tax efficient to employ your spouse or children especially if they have unused tax allowances. It means that you can reduce both profits and your family income tax bill by being efficient about who gets paid what.
This perfectly normal practice is increasingly being painted by HMRC as an abuse of the tax system. Here are their actual words on the subject:
“The Government firmly believes it is unfair that some individuals can arrange their affairs to gain a tax advantage by shifting part of their income to another person who is subject to a lower rate of tax. The Government has considered the responses received to the recent consultation and believes that a further period of consultation will ensure that legislation in this area provides clarity and certainty for businesses and their advisers. The Government now intends to introduce legislation through Finance Bill 2009 and will not enact legislation effective from 6 April 2008.” (Budget Press Notes 2008)
Their initial proposal was that you would need to keep detailed records, time-sheets etc. of your spouse or children’s actual contribution and a tax inspector could decide whether this justified their salary arrangements or not. This was rightly greeted with hoots of derision as being both unreasonable and unworkable for many family firms that work all hours just to stay in business.
In the end, they backed down because of the credit crunch. It hasn’t gone away totally though. At the heart of it is a naked attempt to make you keep your profits high so that more tax can be taken. The key things to remember are:
- Make sure you have got an employment contract in place for everyone you employ that spells out what their job is and is worded in a way that helps you
- Make sure you have thought through and claimed every area of legitimate expenses that you can
- Keep accurate records of business meetings and other work that gets done.
- If you are trading as a company, discuss with your accountant the right balance of share ownership between you and your family
- Keep your eye on the press and media for future developments
