Sole trader vs limited company: what’s best?

Contributor -

Elaine Clark

Sole trader business owner talking on phone about setting up a limited company

Should you run your business as a self-employed sole trader or turn it into a limited company? Chartered accountant Elaine Clark of explains the pros and cons of each business type

There are several key advantages of running your business as a limited company instead of remaining self-employed but the only way to be sure if it's the right business model for you is to crunch the numbers.

"I recommend that all sole traders carry out a 'tax fitness check' at least once a year, to see what your finances look like compared to if your business was a limited company," says chartered accountant Elaine Clark.

Sole trader vs limited company

The two main advantages of forming a limited company are that it offers you limited liability and it can be more tax-efficient. Limited liability basically means the debts are the company's - not yours. As a sole trader, you are personally liable for any debts. Moreover, as a limited company director, you take money out of the business through a combination of a small salary and dividends - which is usually more tax-efficient.

Crucially, you do not pay income tax on dividends up to the dividend allowance threshold of £500 (2024/25). Dividend income over the dividend allowance threshold is taxed at the rate applicable to your income tax band (8.75% basic rate, 33.75% higher rate or 39.35% for additional rate tax payers). There is no national insurance paid on any dividend income. So this means that you could pay less in tax by using a mixture of dividends and salary.

"Some think that being a limited company involves paying much higher accountancy fees, but this isn’t always the case," says Clark. There are also advantages of being a limited company when it comes to customer perception. "Not all, but some customers, possibly larger businesses, prefer to buy from companies," says Clark. "To an extent, being a private limited company might make you more credible to potential customers, partners or investors."

How to set up a limited company

You can do it yourself by completing some paperwork and filing it at Companies House with your registration fee which is just £15. However, for a small fee, a formation agency can take care of the whole process for you.

Elaine Clark has a word of caution, though - don't get sucked into buying a deluxe incorporation package. You won't need most of the added extras, she says. "Also think carefully about share capital. Avoid setting up large amounts of share capital, such as 1,000 shares at £1, because you'll have to put £1,000 into the business and that will be tied up. You can start a company with as little as one share at £1 and one director."

How to turn a limited company into a sole trader business

If your profits decrease significantly, being a sole trader might be more tax-efficient, but because you will then be liable, you need to think carefully about how much debt your sole trader business is likely to build up. You may think that being a sole trader will involve less tax admin and form-filling. To an extent it probably will, but bear in mind that you do still need to file accounts and tax returns, so you will still have legal responsibilities.

Closing a company and re-registering as a sole trader business

Make sure your company accounts and tax returns are up to date. Once these are filed, there's a formal process to follow. It's not difficult, but it will take some time – it's not quick. Assuming that the company is debt-free, you complete a DS01 form, which can be downloaded from the Companies House website. It's easy to complete and there's a £10 fee. To close a company down:

  • It must not have traded for the past three months.
  • Its name must not have changed within the past three months.
  • It must not be subject to any legal proceedings, current or proposed.
  • You must not have made a disposal for value of property or rights.

The trading name can be carried over into the new business, minus the word limited. If your company is in debt and you want to close it down, there are specific rules and you would need advice from a qualified accountant. You can set up a new sole trader business simply by calling the HMRC hotline on 0300 200 3504 or by registering online.

How to avoid paying too much tax

When it comes to setting up a business you really should seek advice from a qualified accountant. They will be able to help you decide which business structure is most tax-efficient now and in the future. Otherwise, you may well end up paying too much tax.

Written by Elaine Clark of Cheap Accounting.

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