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Should I Register as a Sole Trader or Limited Company?

The legal status you choose for your business has major implications for tax, earnings and even survivability. Should you be a sole trader or a limited company—and how to reach that decision?

When you set up as a freelancer, you need to decide the structure of your business. What works for one company might not be best for another, so it’s crucial that you consider the pros and cons of each option and practice due diligence in order to make an informed decision.

Read on to find out if you should register as a sole trader or limited company.

Sole trader vs. limited company: what’s the difference?

When you’re starting out as a small business owner, it’s important to understand the implications of your company’s legal status.

What is a sole trader?

As a freelancer, you may feel that you are your business. Registering as a sole trader would turn this feeling into a legal standpoint.

A sole trader is a self-employed individual with full ownership of their business. The business does not have a separate legal identity from that of the owner, so a sole trader accepts full liability for their business.

As a sole trader, you keep all your profits after tax. You do not pay corporation tax or take a salary, because your profits are your salary, and you are taxed on them accordingly. You can follow your finances as a sole trader far more easily if you set up a sole trader bank account, for more information read our guide to sole trader bank accounts.

Because there is no legal distinction between a sole trader business and the owner, you are responsible if you run into financial difficulties. On the flipside, however, a sole trader business is very easy to set up and requires little admin to maintain.

What is a limited company?

A limited company is legally distinct from the identity of its owner, so it can have more than one owner (or director). Each owner has limited liability for the business, meaning their personal finances are not implicated if the company struggles financially.

If you register a limited company, you create an independent entity that you work for—even if you founded it. You do not take the profits as your wages; the profits belong to the company. You may pay yourself a salary, but you may also choose to be paid in dividends, which are paid only if the company makes a profit. Alternatively, you might choose to be paid a split of salary plus dividends.

Setting up a limited company is more complicated than registering as a sole trader, and involves a fee. Running a limited company is more work, but it entails potentially greater flexibility, which we’ll explore in a moment. Some companies work only with individuals who operate as limited companies (not sole traders), and registering as a limited company protects your personal assets against company debts.

Should I set up as a sole trader or a limited company?

Both business models involve pros and cons, so let’s examine these in depth with regard to different aspects of your business.

Tax

Limited companies are registered with Companies House, which means they are required to pay corporation tax. Sole traders do not have this obligation, but must pay income tax at the standard rate and contribute National Insurance on all profits.

A sole trader’s business expenses are tax-deductible, meaning only profits are taxed at your income level. This form of taxation may prove efficient for small businesses with low income, but less so for higher-earning sole traders.

If your sole trader business starts to generate greater revenue, it may be more tax-efficient to register as a limited company and pay yourself a split of salary and dividends. Just remember that you would then have full liability for your business and therefore be accountable for any penalties or fines for late returns or paperwork errors.

There are rules about using a company where you are effectively providing a service that is effectively the same as being employed. "IR35" is a serious consideration for many freelancers and you should investigate how it may apply to your activities.

However, the flexibility created by using a company has other real benefits, For example, if your business is going to require ongoing investment then this allows you to leave profits in the company to invest without having been personally taxed on them.

Earnings

Sole traders retain all their profits after tax, and these are paid via self-assessment. Earnings are therefore entirely dependent on performance. With a limited company, however, you have the option to split take-home income between salary and dividends.

The earnings from a limited company may also come in the form of dividends, subject to performance. In 2017, former Chancellor of the Exchequer Philip Hammond decreased tax-free allowance on dividends from £5,000 to £2,000, meaning directors of limited companies faced a reduction in tax-free earnings from these additional sources of income.

The amount you pay in tax beyond your overall tax-free allowance and your £2,000 tax-free dividend allowance will depend on your tax bracket.

And remember, there are different business bank accounts available depending on how you set up your company—and making the most of your business bank account can take time and research.

Responsibility

Being a sole trader entails less admin than setting up as a limited company, but it involves greater personal risk, as there is no legal distinction between your assets and those of your company. If you run up debts as a sole trader, creditors have the right to claim your personal assets to balance their books. And if a client or customer sues you or takes you to court, as a sole trader you would probably be liable for legal costs.

Because the owner of a limited company has limited liability, they are unlikely to be held accountable for lawsuits or debts. And whilst a sole trader could become bankrupt should their enterprise fail, the owner of a limited company cannot, as their assets are protected even if the company goes into liquidation.

Clearly, this does not protect you from acting responsibly and as a Director, you have specific legal obligations to your company.

For these reasons, sole traders would be advised to seek public liability or professional indemnity insurance to protect themselves against litigation. These policies can be costly, which may factor in to your decision about how to set up your company.

Ultimately, how you set up your company depends on your business goals. Self-employed individuals and small enterprises may prefer the control over earnings and administrative simplicity of sole trading, whilst those with ambitions of developing a larger company may feel drawn to the security provided by limited company status.

It is worth considering how long you expect your business to continue. If you stop trading as a sole trader then limited actions are necessary. However, as a limited company is a separate legal entity it continues to exist and you will continue to have obligations to maintain. Winding up a limited company has to be completed in a specific way and can itself take time.

How to register your business

When it comes to declaring your small business’s legal status, there are very different routes taken depending on whether you wish to classify as a sole trader or as a limited company.

Registering as a sole trader

Setting up a sole trader business is straightforward. You need to register for self-assessment with HMRC, after which you need to wait up to 10 days for an activation code. You therefore need to set up well in advance of when you wish to submit your tax return.

Registering as a limited company

To set up a limited company, you will need to register with Companies House and provide a company address, which must be a physical address in the UK (although you may use a PO Box address).

You will need to register for corporation tax within three months of having registered as a limited company. Then you will need to begin filing your corporate tax returns, as well as your self-assessment returns.

If you register as a limited company then you will be required to have a business name, and will need to register a company name with Companies House.

Setting up as a limited company can be tricky and time-consuming, so you may wish to seek advice from an accountant or solicitor.

It’s the first step—but the implications are significant

For small businesses and self-employed individuals, the status of sole trader offers some financial benefits but also poses risks. Limited company status, on the other hand, protects owners from said risks, but entails more admin and time and costs spent on accounting.

The pros and cons can be difficult to weigh up, so consult friends and colleagues who have gone through the process and make sure to conduct thorough research. Just remember, what was right for one business might not be right for you, so crunch the numbers—and don’t be afraid to seek professional advice.

Written by Nic Redfern

    Published on 04-06-2020

Finance Director at KnowYourMoney.co.uk and business adviser to SME's Nic is spokesperson for small and growing businesses with a strong understanding of the financial needs of business

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