Sole trader or limited company? What form should your business take?

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Date: 6 September 2021

An attractive man works out the best legal form for him new business

COVID-19 helped to push UK business start up figures to new heights in 2020. According to the Centre for Entrepreneurs, annual year-on-year UK business formations in 2020 rocketed by 13% to 772,002.

A key decision when starting a business is which legal structure should you choose when registering. The three most common options are sole trader, limited company and ordinary business partnership, although most people become a sole trader. Sole traders make up about 59% (3.5 million) of the total UK business population of 5.9 million. They include many freelancers, contractors and agency workers.

Ordinary business partnership members make up about 7% (405,000) of the UK business population. Basically, these are sole traders who go into business together. The UK also has about two million (34%) active private limited companies.

So, why do so many people in the UK who work for themselves operate as sole traders?

Here's what we'll cover

  • What is a sole trader?
  • How much tax do sole traders pay?
  • The key advantages of being a sole trader
  • Sole trader v limited company: what's more tax-efficient?

What is a sole trader?

Being a sole trader is the same as being self-employed. In law, you and your business are the same thing, which makes you personally responsible for your sole trader business debts. Providing you don't build up debts and your business is successful, this won't be an issue, of course.

To become a sole trader, you must register with HMRC (the UK's tax authority) for Self Assessment (SA), the system used to collect tax from sole traders. You'll then pay income tax on your profits during the tax year (20%, 40% or 45% depending on your income/earnings). You work out your profits by deducting your allowable expenses and any allowances from your income/earnings/sales.

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Sole trader NICs

Most self-employed people pay their National Insurance contributions (NICs) via Self Assessment. In the 2021/22 tax year, you will pay:

  • Class 2 NICs if your profits are £6,515 or more a year (£3.05 a week) and
  • Class 4 NICs if your profits are £9,569 or more a year (9% on profits between £9,569 and £50,270 and 2% on profits over £50,270

Declaring sole trader earnings and VAT

Sole traders aren't required to submit annual accounts to HMRC, but they must maintain accurate financial records (which can be checked) and submit details of their income and business costs in their annual SA100 tax return, which must be filed each year.

If your taxable earnings/turnover goes over £85,000 a year (the current VAT threshold) or you know they will, you must register for VAT. You'll then have to charge VAT, collect it and pay it to HMRC. This also applies to limited companies.

Need to know! The UK tax system is being fully digitised under Making Tax Digital, which means Self Assessment will be replaced for accounting periods starting on or after 6 April 2023 (although you can voluntarily start following the new rules now).

The advantages of being a sole trader

It's very quick (minutes not hours or days) and free to register online for Self Assessment, so you can start your sole trader business quickly. The tax admin is much easier when compared to a limited company, which means it can be done quicker. This reduces costs, whether you do it yourself or pay an accountant to do it for you.

The paperwork and financial record-keeping requirements when you're a sole trader are minimal; completing your SA tax return is more straightforward and any losses you make can be offset against other income.

Many customers won't care whether you're a sole trader or not, as long as your prices, products and/or services meet their expectations. In any case, you can easily change to a limited company structure later if you wish. And sole traders can employ others and their businesses can grow and prosper.

Being a sole trader can give you much more flexibility and control over your business, because you're not answerable to shareholders. You won't have to share your profits with them either! You will enjoy more privacy, too, because sole traders do not have to publish their annual accounts. The annual accounts of limited companies must be published on the Companies House website, which means anyone can view them.

Sole trader v limited company: which is more tax-efficient?

Example 1

Sole trader profit = £50,000 Net income = £38,717                                                                

Ltd co profit = £50,000 Net income = £40,109

Difference = £1,392

Example 2

Sole trader profit = £100,000 Net income = £67,752

Ltd co profit = £100,000 Net income = £69,469

Difference = £1,717

Example 3

Sole trader profit = £150,000 Net income = £91,723

Ltd co profit = £150,000 Net income = £92,057

Difference = £334

These examples assume that all profits are extracted from the business, salary up to Secondary National Insurance threshold (£8,840) is taken and the remainder paid as dividends (2021/22 rates).

Conclusion

As the above examples show, operating as a limited company can reduce your tax bill. However, if you need to pay an accountant each month to look after your tax admin and complete your annual accounts and Corporation Tax returns, in reality, any financial advantage as the director of a limited company can be minimal or non-existent.

Each year, hundreds of thousands of people in the UK who decide to work for themselves register as a sole trader and many go on to establish and grow highly successful small businesses. In many ways, being a sole trader is the easier and cheaper choice and it need not hamper your business or your ambitions.

Sponsored post. Copyright © 2021 Aiden Corcoran, personal tax senior at GoSimpleTax - tax return software that can help you manage your self assessment.

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