If you are still considering your legal setup, the following should be of use. However, this is a big decision to make, run it by a qualified accountant unless you’re absolutely sure you know what you’re doing.
- Benefits Of Being A Sole Trader
- Benefits Of Having A Limited Company
- Setting Up A Sole Trader
- Setting Up A Limited Company
- Example Tax Savings
Benefits of being a sole trader
Flexible use of losses – many businesses are initially loss making. If you leave a highly paid job to become self employed, you can offset trading losses against previous employment income. Losses can also be offset against other income such as savings interest, dividends, or rental income. This will often lead to an immediate repayment of tax. Limited Company losses cannot be offset against personal income.
Lower tax on capital gains – if what you are looking to do is predominantly building an asset, with low regular income but a big payoff when you sell in the future, you’re likely to pay significantly less tax as an individual than if the assets are held in a Limited Company. This is due to rates of CGT (Capital Gains Tax) typically being lower than income taxes, entrepreneurs relief, and your annual exemption. Also if a Ltd Co sells an asset at a gain, it will pay corporation tax on that gain, then the sales proceeds are still within the company wrapper. Hence you’ll likely pay further personal tax when you draw those funds out.
Reduced admin burden – Limited companies must comply with the Companies Act and submit annual statutory accounts and an annual return. The accountancy fees tend to be lower for a sole trader.
Change of circumstances – if you give up on your new venture after a few months, as a sole trader there’s minimal hassle. If you setup a limited company, you will have to get it struck off.
Secrecy – as a sole trader, you only need to submit information to HMRC and (subject to them not leaving it on a train) nobody else can see it. Limited companies must file accounts with Companies House, which everyone can access. As a small company, the information disclosed is low, however there is still a public record of what you are doing.
Benefits of a limited company
Choice regarding profits – Limited Companies are taxed on their profits at corporation tax rates (typically lower than personal income tax rates). If, therefore, you have a very profitable business but do not need to withdraw all the profits, then a Limited Company may be superior. Bear in mind however that if in the future you do wish to withdraw funds from the Company, they may be taxed again.
Limited liability status – this provides some protection for you should things go bad. If the company cannot afford to pay all its debts, you will not normally be personally liable for them. NB there are strict rules regarding wrongful/fraudulent trading, and directors can be held personally liable if they have acted negligently/fraudulently.
Credibility – perhaps not as true as it used to be, but some businesses feel more comfortable trading with a Limited Company rather than a sole trader, as the perception is that it will be a more established business, and therefore more reliable. However, in recent years, huge numbers of limited companies have been created and struck off so this is not necessarily a factor anymore.
Setting up a sole trader
If you setup as a sole trader, you should inform HMRC within 3 months of starting out. At this point you will also need to start paying class 2 National Insurance Contributions (NICs). These used to be paid monthly, but are now typically bundled in with your annual personal tax liability.
You will also be liable to income tax and class 4 NICs on any profit you make. Roughly speaking, for the tax year 2021-22, the first £12k is tax & NI free (it’s actually more like £9.5k for NI and £12.5k for tax…but let’s keep it simple). The next ~£38k you will pay 20% tax and 9% NIC. Between £50k and £100k will be at 40% tax and 2% NIC. Above £100k a few other nasty things creep in like reduced personal allowance, and potentially the 45% tax rate.
In everything other than name, class 4 NICs is also tax, so to crudely simplify:
| Earnings (£’000s) | Tax & NI rate (%) |
|---|---|
| 0 – 11 | 0 |
| 11 – 46 | 29 |
| 46+ | 42 |
If you have a student loan you will also be required to make repayments in respect of this at 9% on your annual profit in excess of a certain level (£19-21k).
If you’ve got children and claim child benefit, you will also be required to repay some of this if you earn £50k-60k, all of it if you earn >£60k.
Setting up a limited company
If you setup a Limited Company, you will presumably be a director and shareholder of that company. It is important to remember that (unlike with a sole trader) the company’s money, and your money are not the same thing. Care should be taken when extracting funds from the business.
The company will pay corporation tax on its profits, 19% at time of writing.
Paying yourself (as director) a salary will reduce the company’s profits, and hence the corporation tax bill. However, it will also lead to you personally having income and suffering income tax and NIC. The company will also have to pay 13.8% employer’s NIC on your salary in excess of ~£9k.
Alternatively, you can extract funds as a dividend. Dividends are paid out of after (corporation) tax profits, but taxed on you at a lower rate. Dividends suffer 7.5% personal tax whilst in the basic rate band. Once in higher rate tax the rate is 32.5%. There is no NIC on dividends.
For a lot of small companies, the most tax efficient method of extracting funds is to take a salary up to the lower earnings limit for NICs, and dividends for everything in excess of this.
A few things to watch out for with dividends however:
Dividends can only be paid from distributable reserves (retained earnings). If your company does not have any retained earnings, you cannot pay a dividend…but you may still be able to pay yourself a salary.
Formal dividend vouchers must be drawn up, and minutes must be kept of shareholder meetings where dividends were voted and agreed. This may seem a ridiculous formality for many owner managed businesses, but if you do not do this then dividends may be taxed as salary instead.
Tax savings of limited company
The tax savings of incorporating are not what they once were. Gordon Brown created tax advantages to help small Companies. Then later decided his own rules were “unfair tax avoidance” so changed them again. However, there still are modest tax savings to be made.
Still not sure which is best for you? Give a firm of qualified accountants like us a call.
If you’ve decided to definitely go ahead with the Limited Company, there are plenty of online company formation agents who will form the company for as low as £20. They can be great, but make sure you get everything you’re going to need. Call us if you’re unsure.
