This is one of the most frequent questions we’ve had in our time working with startup businesses – is it better to set up as a sole trader or as a limited company?
The honest answer is that it really depends on your circumstances. For one business, creating a company might be essential to reduce directors’ liability and offer tax-efficient remuneration. For another, the simplicity of a sole trader structure might outweigh any benefits of incorporation.
We’ll focus on the tax differences in this blog post, but bear in mind that various other factors should come into your decision too, and it’s always best to get advice from an expert first.
How do taxes work for sole traders vs limited companies?
Sole traders are self-employed, and there’s no legal distinction between the business’s finances and their own. This means they’ll pay income tax on all profits, at a rate of 20%, 40% or 45%, as well as class 2 and class 4 National Insurance contributions (NICs).
Limited company directors, meanwhile, are classed as employees of the company for tax purposes, so they only pay income tax and NICs on money they draw as a salary. They’re also required to pay tax on any dividends they receive, at a rate of 7.5%, 32.5% or 38.1% depending on their income tax band.
Meanwhile, profits that stay within the company are charged corporation tax, at 19% in 2021/22.
The general rule on expenses is that you can deduct costs that are incurred ‘wholly and exclusively’ for the purposes of trade.
Sole traders can apportion certain expenses for both private and business use, claiming only the amount that was spent for the business. They claim this as part of their self-assessment tax return.
For example, a sole trader working from home could deduct a portion of their utility and internet bills, based on how much of the house they used for business purposes and the period of time they used it for.
Employees and directors of limited companies claim expenses as they go, through the company PAYE scheme, rather than as part of their tax return. They’re also often able to benefit from full tax relief on items they purchase for business use, such as equipment, machinery and vehicles.
Generally speaking, limited companies also benefit from more tax reliefs than sole traders – things like R&D relief, creative sector tax relief and the patent box are all specific to corporation tax.
In certain cases, these tax differences can give limited companies a tax advantage over sole trader businesses. Plus, the protection of limited liability means there’s a lower risk of forfeiting your personal assets if things go downhill in your company – in contrast, sole traders may be personally liable for all of their business debts.
The public image that comes with a limited company can also lend you some extra legitimacy in the eyes of clients or investors.
On the other hand, limited companies come with higher administrative and reporting requirements, and for some people, giving up some privacy by putting your details on the Companies House public register might be a problem.
Operating as a sole trader tends to be relatively straightforward, as long as you keep the right records and submit your tax return on time each year.
We can help you to choose the best structure for your business.