The definition of a sole trader is an individually owned and operated unincorporated company which is usually regarded as the simplest method of running a business. However once set up and even after employing a couple of other staff a lot of small trading companies completely discount the benefits of changing to an incorporated limited company due to fear of the bureaucracy involved, (an increase in their NI costs and increased accountancy fees etc), without considering the advantages of going limited which goes further than purely monetary advantages and misses the fundamental point of “limited” status.
Sole Trader Advantages:
Sole Trade Disadvantages:
Ltd Company Advantages:
Ltd Company Disadvantages:
To set up as a sole trader all you need to do is notify the Inland revenue (HMRC) that you are self employed and you can start trading. Although as a sole trader or self employed person will also need to:
- Keep full accounting records and produce profit and loss accounts for the purposes of a self assessment but this will be in its simplest form, however you are still likely to require an accountant to do this for you.
Your accountant (although this is purely your choice if you are a sole trader) should also really be producing at least simple balance sheets for you so you know your liquidity, what your creditors and debtors are, (in simple terms the difference between how much you owe and what is owed to you). In any case more detailed information is normally required for any loan or mortgage applications.
- To register for VAT if you exceed the HMRC VAT thresholds and have to produce VAT returns as you would with a Limited Company.
- To operate PAYE (Pay As You Earn) and make employers National Insurance contributions and manage this paperwork if employing someone.
- Pay National Insurance Contributions but these will be Class 2 at £2.65 per week and 9% on profits between £7,605 and £42,475 plus 2% on profits over £42,475.
- The income tax you pay is normally collected as payments on account but may in fact get some cash flow benefits if you put the tax owed to one side in an interest bearing account.
- Bear in mind that as a non incorporated company (not limited) you are personally liable for any debts and bear all the legal and financial obligations.
- To set up as a limited company you will normally have to employ your accountant or an agent. This is actually quite straight forward (do not let them tell you otherwise or go to somebody else) and should only cost you a few hundred pounds as a one off fee. It’s easy to find out whether a name is already registered on Companies House.
- There should be no major change in terms of accounting work, however you will be required to produce Financial Statements filed with Companies House, the company’s annual returns, and some other Company Secretarial duties for keeping official records such as register of members. These additional compliance only services should cost you anywhere between £500 to £1,000 per annum. This can of course offset some of the tax advantages.
- There are tax advantages in setting up a limited company although these can be a bit complex so please speak with your accountant .There may also be other considerations to take into account such as the accounting treatment of expenses.
- A limited company is taxed via corporation tax on its profit and you are then able to distribute this profit to yourself as a shareholder via dividends.Dividends are taxed at 10% to the higher earnings point and above that at 32.5%. A sole trader would be taxed on the upper rate threshold at 40%. As a shareholder you receive a dividend tax credit of 10%. This dividend tax credit is explained here so if you are at the upper earnings threshold paying yourself via dividends rather than a salary is beneficial.To make it easier just remember that you are effectively paying 25% tax on dividend received e.g.
Dividend Income = £111.11 (If you’ve taken £100 the dividend income for tax purposes is gross of the tax credit- £100/90 *100)
Tax charge at 32.5% = £36.11
Less 10% tax credit = £-11.11
Tax due = £25 (or 25% of dividends received)
At the lower earning threshold for instance, (for the tax year 2012/2013), if your profits before salary were £34,370 you could take a salary of £7,488 without physically paying either employers or employees NI (although effectively you are considered to have paid the base Employer’s NI and are credited it for pension purposes -“your stamps are paid”). You would then pay 20% corporation tax on £26,882 of £5,376 and you can then distribute the remainder as a dividend of £21,506. Total net earnings are the £7,488 plus £21,506 which is £28,994 with tax paid of £5,376.As a sole trader with your profit of £34,370 you would pay National Insurance (dependant on class) say for class 4 of £2,408 and Income tax (at 20% after deducting your personal allowance of £8,105) of £5,253. Therefore tax paid is £7,661.
If your profit falls into the higher tax bracket you can chose to leave this income in the company to fund further growth and therefore not pay the additional 20% tax. As a sole trader any growth would have to be funded from your net income after 40% tax. As a limited company if you go beyond the higher rate tax limit you may have some tax advantages by redistributing the shares to your spouse.
- A limited company is a legal separate entity to its directors and shareholders and therefore you are not personally liable for its debts although you have to adhere to the Companies Act. In effect this means you must act in good faith to manage the company to maintain its financial health and security and therefore setting up a limited company cannot be seen as a carte blanche means of taking more income in the form of dividends or spending more than the company can afford.
- A limited company has a perception of gravitas and tends to be regarded as more trustworthy due to the increased statutory requirements. This may be of benefit in winning new business and achieving funding or business loans.
Note: Whether you’re a sole trader or a limited company, by keeping detailed books and records you will save on your accounting fees. Talk to your accountant to discuss the possible advantages of changing to a Limited Company.