If you plan to set up a new business entity in the UK in the near future, it is essential to understand each type of trading vehicle. Of all of the main entity types, including partnerships, limited partnerships, limited companies, limited liability partnerships, and charities, sole trader businesses are widely considered to be the simplest, with little in the way of overheads and paperwork, but this comes with corresponding disadvantages such as increased personal liability. As such, it is imperative to weigh up the relative advantages and disadvantages of each vehicle type and select one that most closely aligns with your needs. It is also important to remember that if you later decide that the type of business you initially registered is now no longer suitable, you may be able to switch to a more favourable structure. In this article, we will explain what is meant by ‘sole trader’, the advantages and disadvantages of a sole trader, and how you can easily switch from a sole trader structure to a limited company.
What is a sole trader?
As a sole trader, you are self-employed and responsible for running and making decisions relating to your business personally. As such, there is no legal separation between the business entity and the person who owns the business; as a sole trader, you are the business. You will also own any of the assets of the business. Many people choose a sole trader business structure for their small business due to the lack of legal obligations, ease of establishment, and overall simplicity. Contrary to what many believe, as a sole trader, you don’t have to run your business alone; you can employ staff on a part-time or full-time basis as with other types of business.
Advantages of a sole trader
There are several distinct advantages of operating a business using a sole trader model, as follows:
Ease of establishment
Setting up a sole trader business is extremely straightforward. There are no formation formalities, and you will just need to inform HMRC that you intend to pay your tax through Self-Assessment as a self-employed person. In addition, there are no costs when registering as a sole trader.
No business constitution is required
Unlike other business types, there is no need for a sole trader business to draft constitutional documents when setting up the business.
No filing requirements
Once you are set up as a sole trader and operating, you will not need to complete annual business filings (e.g. confirmation statements and annual accounts). You will, however, need to complete an annual Self Assessment return to HMRC to confirm your tax liabilities.
No director’s duties
Because you are not a company, you will not be subject to the Companies Act 2006. This means you will not be bound by the duties of directors; these include acting within the company’s constitution, promoting the success of the company, exercising reasonable care, skill and diligence, and avoiding conflicts of interest.
As a sole trader, you have the flexibility to switch to a different business structure in the future; e.g. to a limited company. This is made easier as there is no administrative overhead to cease a sole trader entity.
Greater business control
For many sole traders, there is a considerable advantage in knowing that they have the final say over decisions that affect their business. They exercise full control over the business and are not accountable to shareholders or directors.
Reap the full financial rewards
Another key benefit of a sole trader is that you alone keep the profits of the business. Profits do not need to be shared with other directors and shareholders.
As a sole trader, you will only need to prepare and submit an annual self-assessment form to HMRC. This is now completed online and can be automated with modern online accounting systems. You may also need to collect and pay VAT, depending on your annual turnover. You will not, however, need to deal with corporation tax or file annual accounts (or micro annual accounts) with Companies House.
Financial privacy and confidentiality
Another substantial benefit of being a sole trader is that you can operate with complete privacy and confidentiality when it comes to your finances. This is because, unlike with other business types, there is no requirement for your finances to be made available publicly; rather, these can be kept private and confidential.
Disadvantages of a sole trader
While there are several distinct advantages of operating as a sole trader business, there are also disadvantages of a sole trader to be aware of, as follows:
Perhaps the biggest disadvantage of this business model is that a sole trader is personally liable, without limit, for all the debts and other liabilities of the business. This includes any costs such as tax owing, office rent, and money owed to suppliers. As such, as a sole trader, your personal assets, including your property, are always at risk.
Perceived lack of prestige and credibility
While this is not a problem for many, it is important to understand that sole trader businesses can be perceived with less prestige and credibility by prospective customers, lenders, external partners, and service providers. This may be due to perceptions of lack of scale, infrastructure, financial capital, long-term sustainability, or robust operational procedures. This may not pose an issue depending on the nature of your business and the type of dealings you have with other businesses and individuals. On the other hand, you may operate in a business sector in which it is expected that business-to-business relationships are between limited companies.
Less tax efficient
As a sole trader, you will be liable for all of the tax owed by the business. You will also need to pay any income tax owed in the same financial year in which profits are made within the business. If profits are high, it is highly likely that a sole trader will end up paying more tax than a limited company would in the same position. This is because, as an employed limited company owner, it is possible to receive more take-home pay by drawing dividends from the business account and paying tax at an overall lower rate. In addition, you cannot benefit from tax efficiency by leaving profits in your business and then paying these to yourself in a subsequent next tax year, as is possible with a limited company.
Limited access to finance and capital
As a sole trader, it is also likely that you will experience fewer options when seeking finance and capital compared to a limited company. Where it is possible to secure finance, it may be at a higher rate or come with less favourable terms than a limited company.
Lack of business continuity
Those operating as a self-employed sole trader may find that they may struggle financially if they are unable to work. For this reason, it is important to consider what would happen if the business cannot operate due to illness, accident, or even in the event of death.
Poor work-life balance
Linked to the above disadvantage, one of the issues with sole traders is that there may be no one else to share the workload with. This can make it hard to take holidays, get away from the office, spend time with the family, or just relax. That said, there is nothing to stop you from employing staff to assist you in achieving a reasonable work-life balance.
Limited business name protection
And finally, when it comes to the disadvantages of a sole trader, it is important to consider that a sole trader business has little in the way of protection when it comes to their business name. As such, there is nothing to stop another business from using the same name. While there may be some protection available to a sole trader where another person or entity is ‘passing off’ their goods and services as those of the sole trader, this can be costly and difficult to prove.
How can I switch from a sole trader to a limited company?
On the balance of the advantages and disadvantages of a sole trader outlined above, if you decide to switch to a limited company model, you can do so relatively easily. A company formation specialist such as Uniwide can undertake this quickly and efficiently while explaining all of the tasks you will need to complete as the owner and director of a limited company. The steps involved in switching from a sole trader to a limited company are as follows:
- Register your new limited company with Companies House
- Advise HMRC you are no longer operating as a sole trader
- Transfer the assets of the sole trader business to the new limited company
- Set up a business bank account for your in your new limited company
- Inform customers, suppliers, and anyone else you deal with that you have changed to a limited company
- Register with HMRC for Corporation Tax
As with all aspects of business, it is important to make sound and informed decisions both for now and in anticipation of the future. If you expect your business to grow rapidly in the coming years, even with the flexibility and simplicity afforded by a sole trader structure, it may be preferable to start as you mean to go on and set up a limited company from day one. If, on the other hand, you have a small business that you intend to keep on a limited scale and you wish to retain ownership and control, a sole trader may be for you.
Uniwide Formations specialises in the registration of limited companies and LLPs. As professional business service providers, we offer a wide range of related services and can advise you on all aspects of company and LLP formations and filing.