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One of the first things you need to think about when starting a business is whether to run it as a sole trader or a limited company. Regardless of the size of your business, it needs a legal structure. But whatever structure you ultimately choose will impact on almost every aspect of the operation, from how much tax you’ll pay to what happens if your business faces difficulties.

In 2019, there were 3.5 million sole traders and two million limited companies actively trading in the UK. But what is right for one business may not be right for yours. So, whether you are just in the throes of launching a new venture or already a sole trader and considering incorporating your business and setting up a limited company, you must weigh up all the pros and cons to decide what’s right for you.

In this article, we’ll explore the advantages and disadvantages of being either a sole trader or a limited company to help you understand which business model best serves your company’s needs as it grows.

What is a sole trader?

A sole trader is self-employed with full ownership of their business. They can keep any profits earned after tax. The business does not have a separate legal identity from that of its owner; therefore, a sole trader takes the full liability of their business and any losses it makes. You can start operating as a sole trader immediately, but you must register for self-assessment within three months of establishing your business.

Advantages

  • Quick, easy and free to set up
  • Relatively little paperwork involved
  • Minimal red tape
  • Greater privacy than a limited company

Disadvantages

  • Unlimited personal liability
  • You can lose personal assets should the business struggle or get into debt
  • It may not be easy to raise finance, which can limit expansion opportunities
  • Tax rates can be high once you reach a certain level of earnings

What is a limited company?

A limited company has a separate legal identity, distinct from its owner or manager This makes it easier for the business to secure investment and loans. All businesses assets, profits and liabilities belong to the company itself, and the shareholders are not solely responsible for debts incurred by the company. Shareholders only risk losing what they have invested in the company and the cost of their shares. In the UK, a limited company must be incorporated at Companies House, file annual accounts and Confirmation Statements with Companies House, and submit tax returns and statutory accounts to the HMRC.

Advantages

  • Legally separate from its business owner so offers limited liability
  • No risk to personal assets — you only lose what you invest in the company
  • Easier to secure finance
  • Once your company name is registered, no-one else can use it
  • More tax-efficient — you pay corporation tax on profits rather than income tax
  • Increases trust and credibility among customers, investors and competitors

Disadvantages

  • Costly and time-consuming responsibilities involved, such as filing an annual company tax return and annual accounts
  • Information about your business is publicly available on Companies House, including company earnings and directors’ salaries
  • You must pay a fee to incorporate with Companies House

Self-employed sole trader vs limited company

As we’ve already explored, the different business structures of operating as a sole trader or a limited company have their own advantages and disadvantages. Deciding which is right for you and your business is an important decision that can have consequences long into the future. Here we will look at some of the key differences between running a limited company and working as a sole trader.

Responsibilities and personal liability

As a sole trader, you can expect to have complete control over your business. There are also fewer administrative tasks to deal with. However, there is more personal risk involved with running this business structure. In the UK, there is no legal difference between the assets that belong to you personally and those of your company’s. This means that if your business faced difficulties and you accrue debts, creditors are legally entitled to make claims against your personal assets — including your own property — to clear the debt. Furthermore, if a customer decides to take you to court, you could find yourself liable to pay the legal costs.

If you are running a limited company, you will have limited liability. This means that it’s unlikely you will be held liable for any legal action or debts incurred by the business. If the business fails, a sole trader can be made bankrupt; however, owners of a limited company cannot be forced into bankruptcy. Their personal assets remain protected even as the company enters liquidation. Due to this, sole traders must take out public liability insurance to give themselves a degree of protection should something go wrong. Policies such as these can be costly, so it is best to factor in these expenses into your decision-making. You may need to weigh up the increased risk and insurance costs you accrue with being a sole trader against the simplicity it offers.

Earning potential

Being self-employed, you will get to keep all the earnings you make from your business aside from that which you pay in tax through HMRC’s self-assessment process. Your earnings will depend on your business’s performance from the previous year. This means that while you may look forward to large profits, there’s also the possibility that you may not make sufficient money to pay yourself a good income.

Meanwhile, if you own a limited company, your earnings will take the form of a salary taxed at standard PAYE rates. Depending on the performance of your business, you may also earn additional income through dividends and bonuses.

Tax implications

As limited companies are registered with Companies House, they are required to pay corporation tax. The corporation tax rate is typically lower for larger companies than for sole traders, making it more tax-efficient for businesses with big profits and high turnovers.

For sole traders, however, they are not legally required to pay corporation tax. Instead, they must pay income tax at the standard rate and make National Insurance contributions on all their profits. As business expenses are tax-deductible, only a sole trader’s profits are taxed.

This type of taxation is extremely efficient for small businesses with lower incomes. But for higher earners, especially those earning £25,000 or more, they are not always as efficient. Therefore, if your earnings reach the next bracket, you may find a more tax-efficient solution would be to register as a limited company and pay yourself a salary.

When it comes to the dreaded business paperwork, sole traders must register as self-employed with HMRC and submit a self-assessment tax return. The tax obligations of a sole trader are generally less complicated than those of a limited company. However, as they have full liability, a sole trader can be held accountable for any penalties or fines resulting from a paperwork error or the submission of a late return.

Changing the legal structure of your business

If you decide to benefit from the greater tax efficiencies and security of operating as a limited company, you may wish to switch from a sole trader to a limited company. You can either choose to do this yourself or use a company formation agent like Uniwide Formations. To change your business’s legal structure, you will need to inform HMRC, as the change will have a bearing on how much tax you must pay. You will also have to register your company with Companies House and set up a dedicated business bank account for your new limited company. You should also inform your suppliers, customers, service providers, lenders, insurers and landlord.

While it is more unusual to change from a limited company to a sole trader, it is possible. The process will involve a formal winding-up procedure, such as:

  • Preparing the final company accounts and submitting them to Companies House and HMRC
  • Settling all outstanding tax payments
  • Transferring out any remaining money from the company’s bank account
  • Transferring any assets held in the company’s name
  • Arranging for any outstanding contracts to be changed or new ones drawn up in the name of the new company
  • Submitting a formal request for the business to be dissolved by applying to Companies House
  • Informing directors, suppliers, creditors and employees of the intent to dissolve the company

Once your application to dissolve the company is accepted by Companies House, the company will be dissolved and removed from the company register within three months.

Which option is right for you?

There are many financial advantages to running a business as a sole trader, especially for those smaller businesses or self-employed tradespeople. However, a sole trader business also has an increased level of risk. A limited company provides a degree of protection for its owners by giving them limited liability. This can, however, mean a lot more administrative, financial and legal duties for the directors.

When it comes down to choosing between being a sole trader or a limited company, knowing the right business structure to pick will depend on what suits your situation and the sort of company you want to run. You can always start as a sole trader, and later on, when the time is right and your business is growing well, switch to a limited company if you wish. Whatever you decide to do, it’s a good idea to discuss your business plans and circumstances with a business adviser or accountant before going ahead.

If you decide to run your business as a limited company, Uniwide Formations can act on your behalf to make the process as smooth as possible. We know each business is different, so we offer a range of company formation packages to incorporate your company or register a partnership. To find out more about our services and how we can help your business contact us today.

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