This is the opening chapter and is the longest and most complex... After you've made this decision, everything becomes easy.
Should I be a Sole Trader or a Limited Company?
Depending on your circumstances, one may be more appropriate than the other.
A sole trader pays income tax at their marginal tax rate, plus class 2 and 4 National Insurance contributions. An LTD pays 19% corporation tax on profits, and you would pay out a mix of dividends and salary taxed at your marginal tax rate.
Here’s what you need know to make a sensible comparison related to your situation.
Due to the complex interplay of income tax, dividend tax, corporation tax, dividend allowances, personal tax allowances, and national insurance contributions, the structure that leaves most cash in your pocket varies depending on profit level.
Figure 1 - Comparison of take-home pay from a LTD and from a Sole Trade in the most tax efficient way for both. Note, this assumes you pay out 100% of the profit, which is rarely the optimal approach.
In the scenario where you extract all available profit, then for profit up to £200k it is beneficial to be a Limited Company, and beyond that sole trader is preferable. However, at these higher profit levels your tax rate is much higher and most will instead take the option to re-invest profit for growth, something you have greater flexibility to do as an LTD.
However, this misses an important point: with a Limited Company, you have control over how much profit to extract and will keep pay in the tax efficient region, using the remainder to grow the business.
Tax and differences in cashflow
LTDs pay tax at 19% on profit each financial year, whereas sole traders pay the individual’s marginal tax rate on income, i.e. 20%, 40%, or 45% depending on which tax band you are in, plus national insurance contributions, each personal tax year.
This difference means that for all but the lowest profit levels, a Limited Company will have a smaller tax bill than a Sole Trader and hence more cash available for fuelling growth (note, in the Limited Company scenario you will still pay personal taxes on your dividend income and salary, but in most scenarios this will lead to a lower overall tax bill).
Available cash is crucial to being able to fuel growth, and this one of the key reasons that higher profit business tend to have or move to a Limited structure sooner or later.
For a Limited Company, you will pay yourself a mix of dividends (from available profit) and salary. You decide what level to set this at, and generally, you will take account of your personal tax situation to optimise when and how much you pay.
For a Sole Trade, the income is yours to keep – there is nothing further to do. Whatever income you make in each personal tax year is taxed at your marginal income, i.e. if you already have a regular job which puts you in the 40% tax bracket, then your income from the sole trade will be taxed at this level (and higher if it pushes you into the next tax bracket).
In the case of things not working out, and your business having debts to pay, with a limited company you are not personally liable (except in the case of fraud). The worst-case scenario is that you lose whatever capital you invested in the business, whereas if sued as a sole trader, creditors/claimants may come after your personal assets/home.
This is subjective and is usually the least important consideration. In general, a Limited company is perceived as more professional, and there are some suppliers/vendors who elect to only deal with Limited companies, on the basis that they are likely to be more professional counterparts.
Timing of filings
As a Sole Trader, your personal tax year ends on the 5th April each year. If you start selling as a Sole Trader in for example, February, then you will have to do a full annual filing / pay the full year accounting fee, even if you were only active for only two months of that year.
As a Limited Company, the filing period is one year from when the business starts trading. If you open the business, but do not start trading for a number of months, it is possible to file dormant accounts (trivial) and change the accounting period accordingly. Pre-trade expenses such as website building will not prevent you being able to do this.
How do I close it down if it doesn’t work?
If you’re a Sole Trader, you simply cease trading. If you have made less than £1,000 in the personal tax year (6th April to 5th April) then the requirement to file a Sole Trader Self Assessment does not apply.
If on the other hand, you make more than £1,000, i.e. exceeding the annual trading income allowance, you must complete a Self Assessment; prepare an income statement, and file accounts with HMRC, and pay tax on the trading income.
If you are a Limited Company, if your business ceases trading, you need to file a strike-off notice. You are obliged to file your final accounts to HMRC and Companies House and pay corporation tax if you made a profit.
Record keeping / bookkeeping
For a Sole Trader, you will not produce a balance sheet at year end. If additionally, you are not above the Making Tax Digital threshold / VAT registered, i.e. making more than £85k revenue per year, your bookkeeping requirements are slightly lower than they would be for the equivalent Limited Company.
In this scenario, you have the option of not using bookkeeping software like Xero and Receipt Bank (£37+ VAT per month) and saving this licence cost. Instead you track costs in a spreadsheet (we can provide a template to make this easier) and at the end of the year we will get your sales data for you (at our discretion – e.g. Amazon, Etsy, Shopify, eBay, almost always no problem – anything else we may ask you to retrieve and process this data).
In general, we try to steer people towards the bookkeeping service as it will save you time which you can use to help you grow. However, if the cost saving this represents from saved software costs (£37+VAT) and our bookkeeping fee (see pricing table), outweighs the time-savings at the earlier stages of your business set up, then we are supportive of it.
Costs (time and money)
If you appoint a good accountant, then there is no difference in time cost between both structures. The main difference in monetary cost is in the accounting fee, accounting for a Limited Company is more complex than a Limited Company.
Take a look at the accounting fee table for a direct comparison for all revenue bands. The overall cost to you including tax savings impact, depends on revenue (your accounting fee) and profit level plus any other income you have (level of tax benefit), so there is no one-size fits all.
As a rule of thumb, if your business makes more than £85k revenue generally the answer is be a Limited Company. Below this level, it depends on whether you have other income and your current/expected growth rate.
Tax benefits on selling
A Limited Company is slightly simpler to sell, as the processes for a transfer of share ownership is routine compared to transferring a sole trade, especially if selling to overseas buyers.
The important consideration is that Limited Companies are tax-advantaged at the point of sale due to a tax relief called Entrepreneurs Relief. The rules change each year, but in principle, if you are a significant shareholder (>10%) and you have held the share a qualifying number of years, then you only pay 10% Capital Gains Tax on the sale proceeds, rather than it being taxed as income.
Comparison of benefits
The below are the key benefits for each structure versus the other. As highlighted, some are generalisations, for which detail is provide above.