How to decide between working as a sole trader or limited company

So, you’ve finally decided to take the plunge and make a go of running your own business – congratulations! It’s an exciting time, but if you find yourself also feeling just a bit overwhelmed, then this sole trader vs limited company guide will explain what you need to know to help you make a decision easier. One of the first decisions you’ll have to make when starting your own business is whether you want to operate as a sole trader or a limited company. Gov.uk reported that at the start of 2023, there were roughly 3.1 million businesses operating as “sole proprietorships” (sole traders) and 2.1 million businesses trading as limited companies. Although it seems that working as a sole trader is the most popular choice, there are advantages and disadvantages to both being a sole trader and limited company which we weigh up below.

What is a sole trader?

A sole trader, also known as a sole proprietorship, is the most basic type of business structure. It is simply you running a business as yourself, an individual. Your status is defined as being self-employed. All the money you earn is yours to do with as you like. Any expenses and/or debts incurred will have to be paid for through your own personal finances.

What is a limited company?

A limited company is a formal business structure that is its own separate legal entity, distinct from its owners (the shareholders) and managers (the directors). You can be both the shareholder and the director of your own limited company, but the company itself still holds its own assets, takes on its own debts, has its own earnings and tax liability. On a practical level this means that – unlike a sole trader, you’re not free to simply withdraw funds from the company whenever you would like for your personal use but must instead follow formal procedures. Also, unlike sole traders, limited companies are subject to more legal requirements which become the director’s responsibility to fulfil.

What is the difference between a sole trader and limited company?

The main difference between a sole trader and a limited company is the protection of limited liability for the shareholders of a limited company. What this means is that shareholders of a company are only responsible for a company’s debts up to the value of their shares in the company. In comparison, a sole trader’s debts are personally held which means that, if you go into debt in the course of running your business, your personal assets such as house and car could be legally seized to pay off those debts. Limited liability prevents this from happening to shareholders unless the business failings are due to their own gross misconduct.

What are the advantages of a sole trader?

Possibly one of the main reasons why a majority of registered businesses choose to operate as sole trader status is the ease and simplicity. Some of the advantages to operating as a sole trader include:

• Being able to start your business straight away
• No fees to pay when you register your business as you do not need to register with Companies House
• You only file one self-assessment tax return a year which covers your business and yourself so there are far less administrative responsibilities
• You have complete control over your business with no formal rules to follow
• You have more privacy as information on your business does not have to be published publicly on Companies House
• Accounting costs are often lower as most businesses run as a sole trader are relatively small, and this structure is best suited for early-stage businesses just starting out
• It is fast and easy to close the business down as a sole trader

What are the disadvantages of being a sole trader?

Despite the many conveniences, there are also limitations which some will see as disadvantages to operating as a sole trader, such as:

• Unlimited liability, which means that you are liable to personally cover any debts or losses of your business
• Increased difficulty when it comes to securing finance for your business, as many banks and lenders will not be willing to lend large sums of money to sole traders
• Customer perception can be harder to change as many people will take the view that sole traders are less credible than limited companies and therefore may prefer to work or purchase from limited companies instead
• Similarly, many businesses will often only work with limited companies, so you could be missing out on potential business as a result of operating as a sole trader
• There are fewer opportunities to reduce your tax liability using efficient tax
• strategies because the entirety of earnings made will be subject to income tax
• There are many generous tax-advantageous schemes offered by the government such as SEIS, EIS, R&D tax credits and EMI share schemes which are only available to limited companies, so you are restricted in your ability to access these

What are the advantages of a limited company?

Although not as simple as starting a new business as a sole trader, many people choose this option for the benefits and advantages of operating as a limited company including:

• You are protected by limited liability which means that only money you choose to put into the company, and money that is made by the company, is at risk of loss
• Limited companies often benefit from the reputation of being less risky to work with or buy from than sole traders as many customers feel there are more reliable recourses if they are dissatisfied with a product or service, so you may be able to grow your business faster and easier than as a sole trader
• Your company name is legally protected and cannot be used by another business
• You have increased chances of securing finance from investors and lenders as a limited company compared to sole traders
• As a shareholder of your limited company, you are entitled to receive dividends. This enables you to make use of the annual £500 dividend allowance as well as personal allowance. In addition, dividends are taxed at a lower rate than income tax.
• There are increased tax planning opportunities including re-investing profits into the business to reduce corporation tax, making family members shareholders to issue dividends to, and reducing National Insurance contributions by paying less salary and more dividends.
• You can access a tax-free loan from a limited company so long as you comply with the director’s loan rules.

What are the disadvantages of a limited company?

On the other hand, for many it can seem that there are much greater burdens and disadvantages to operating as a limited company such as:

• You need to register your company with Companies House before you can start your business, and this also attracts a fee to pay
• There are certain rules to follow when naming your company and you cannot use a name if someone has already registered their business with the name you want to use
• You have less privacy as your personal details and company details need to be publicly published and annually updated on Companies House
• Withdrawing money from the company for your own personal use is not as easy to do as if you were a sole trader
• Limited companies have much more legal obligations to comply with, including filing a company tax return, annual accounts and confirmation statement which also means there are more deadlines to be aware of
• Accounting can become much more complex depending on your business and therefore could mean increased costs of using an accountant
• It can be difficult and expensive to close down a limited company if you no longer want to run the business as this structure

What taxes do sole traders pay?

For sole traders, taxes are relatively simple and straightforward. You will only need to pay income tax and make NI contributions. This may be required up to twice a year. Once at the self-assessment deadline date (31^st January) and a second time by the payments on account deadline date (31^st July). 

Sole traders can choose to be VAT registered if they wish to, and it only becomes mandatory if they reach an annual turnover of £90,000. If you voluntarily register for VAT, then you’ll need to make quarterly VAT payments.

Sole traders can also hire employees. If that is the case where you will be employing someone to work for you, then bear in mind that you may have to pay Employer’s NI on their income and any benefits they might receive unless they are earning under the secondary threshold, are under the age of 21, or are an apprentice under the age of 25.

What taxes do limited companies pay?

Limited companies are subject to corporation tax as opposed to income tax. This is due to be paid once a year, but, unlike the self-assessment deadline, there is no fixed date for all companies. Instead, your company must pay within 9 months and 1 day after the day of its financial year end date. 

As with sole traders, limited companies can choose to become VAT registered where their turnover is below £90,000 but must become VAT registered once at or over this threshold. Again, they must pay that VAT bill quarterly.

Limited companies must also pay employer’s NI where they have any employees. However, unlike sole traders, you may be surprised to find that you will have to pay this even when you are the only person working in your company! This is because if you pay yourself a director’s salary through payroll then you are regarded as an employee.

What’s more, should you be paying yourself a director’s salary, then you will personally be liable for income tax and your own NI contributions. This may lead you to feel like you are paying tax twice because your company has to pay corporation tax on its profits, and then you have to pay income tax on the salary you receive from your company. However, you should remember that salaries are tax-deductible which means it reduces your taxable profits before corporation tax is calculated.

You can also choose to pay yourself dividends where your company has sufficient profits to do so. Unlike salaries, dividends are not tax-deductible and must be paid from your company’s profits after corporation tax has been paid. Paying yourself dividends does mean you have to pay dividend tax which you declare through your self-assessment tax return, but it is taxed at a lower rate than income tax on salaries.

Depending on where your company is based, you may be subject to business rates. This is where your company operates from anywhere other than a residential home, for example, an office or a shop. Business rates are the equivalent of council tax on residential properties, but there are a range of business rates relief schemes and grants available that can help you reduce this.

Which is more tax efficient – sole trader or limited company?

Explaining which option between being a sole trader and limited company is more tax-efficient is not straightforward. This is because factors such as whether you are the only director and employee of the company and how much you want to pay yourself in salary and dividends will alter the outcome. Overall, however, operating as a limited company will offer far great flexibility and options to reduce corporation tax through tax reliefs as well as extract funds from the business.

Nevertheless, since we have gone over the types of taxes you have to pay as a sole trader vs limited company above, we will also go over the different tax rates to give you a better idea of the difference. You’ll see from the below, that in most instances, both dividends and corporation tax are charged at lower rates than income tax. This is why it can be more tax efficient to operate as a limited company.

Income Tax

Tax Rate Band	Income Threshold	Income Tax Rate
Nil (personal allowance)	£12,570	0%
Basic rate	£12,571 – £50,270	20%
Higher rate	£50,271 – £125,140	40%
Additional rate	£125,141+	45%

Dividend Tax

Tax Rate Band	Income Threshold	Dividend Tax Rate
Nil (dividend allowance)	£500	0%
Basic rate	£12,571 – £50,270	8.75%
Higher rate	£50,271 – £125,140	33.75%
Additional rate	£125,141+	39.35%

Corporation Tax

Tax Rate	Profits Threshold	Corporation Tax Rate
Small Profits Rate	£50,000	19%
Marginal Rate	£50,001 – £250,000	26.5% (effective %)
Main rate	£250,001+	25%

At what point is it better to become a limited company?

Over the years, the UK government has been seemingly aligning the taxes between sole traders and limited companies. This can be seen in the increase of the corporation tax rate for companies with profits over £50,000, as well as the decrease in dividend allowance, and the cuts to NI.

Whereas once before, it was normally more advantageous to operate as a limited company the more you earned, this is no longer straightforwardly the case and depends on multiple factors. Nevertheless, for most business owners, choosing to operate as a limited company over a sole trader does not simply come down to taxes alone, but often and importantly because of the limited liability protection.

As a general guideline, we would recommend that it becomes beneficial to operate as a limited company when you begin to earn profits of over £50,000. This is because as a sole trader your earnings would be fully subject to income tax. When you are a higher or additional rate income taxpayer this is more tax than you would be pay in corporation tax as a limited company.  It is important to note that operating as a limited company will not necessarily guarantee that you’ll receive higher take-home earnings than that of a sole trader (as remember, you will need to pay corporation tax first on company profits and then income tax on any salary and/or dividends you extract from your business), but it does allow for greater strategic flexibility which could allow you retain more of your profits.

How to get set up as sole trader

If you have decided to become a self-employed sole trader, then you must register for self-assessment with HMRC to do this. The easiest way is to register online. The online portal will ask you to check whether you need to do a self-assessment first. Simply follow these steps to confirm that you do. Once you have completed the check it will let you know that you need to register for both self-assessment and Class 2 NI if you are becoming a sole trader. You will need to create a Government Gateway user ID and password (unless you already have an account for other tax matters) and add both of these to your account.

You must register as a sole trader by the 5^th October in the second year of your trading. This means that if you begin work as a sole trader on 1 June 2023, you must register as self-employed with HMRC by 5 October 2024. Failing to do so could lead to fines. For further details and instructions, visit our guide on registering as self-employed.

How to register your business as a limited company

If you have decided to become a limited company, there are a couple more steps to get set up because you need to register with both HMRC and Companies House. We have provided a comprehensive step by step guide that will allow you to set up a limited company yourself as well as explain the different options of who you can choose to help you if you would prefer. Unlike working as a sole trader, you will need to be fully registered first before you can start running your business as a limited company. You will also have to make more decisions right from the beginning such as a business name and any other shareholder you may want other than yourself (such as family members or spouse).

Can I switch from a sole trader to limited company?

You can switch from a sole trader to a limited company at any time. There are no restrictions, limits, or threshold requirements to meet in order to become a limited company so you can switch whenever you wish. Most people choose to become a limited company when they see significant business growth or have proactive plans to invest in achieving business growth.

To switch, you will need to register a new company so you can follow the advice in the section above. An important step you must not miss out however, is to tell HMRC that you wish to de-register yourself as self-employed. You must instead let them know that you are becoming a director of a limited company. You can do this by logging into your portal with your Government Gateway ID. Bear in mind that you may still need to complete a final personal tax return to settle any tax and NI you may owe during working as a sole trader.

Can I switch from a limited company to a sole trader?

Yes, you can also switch from being a limited company to a sole trader, but there are more steps involved and can take more time. How you go about doing this is dependent on whether the company is solvent or insolvent. To be solvent means to be able to pay off any outstanding company debts and liabilities, such as salaries and taxes. Whereas to be insolvent means that there are insufficient funds in the business account to do so.

If you are solvent, you have two options to shut down your limited company. We have a guide on the taxes you need to pay when you wind up a limited company that explains both the informal strike-off route and members’ voluntary liquidation route. This guide also provides advice on which option may be more suitable depending on your individual circumstances.

On the other hand, if the company is insolvent then you must go down the Creditor’s Voluntary Liquidation path. We explain this process in our guest post about switching from being a limited company to sole trader.

Once you have taken the necessary steps to close down your limited company, you will then need to register as self-employed with HMRC to work as a sole trader.

Get help and support from an accountant as a small business owner

If you are still deciding whether to run your business as a sole trader or limited company, then why not speak to our friendly team of expert accountants who can help you go over the pros and cons for your individual situation and goals? Once we’ve helped you choose, we can easily support you as far down the line as you need from getting you registered for your annual self assessment tax return (you’ll need to do this whether you’re a sole trade or a limited company director), help you with your bookkeeping, or file a company tax return. Get in touch to start your own business today.