What are the differences between Sole Trader and Limited Company?

A friend asked me whether she should set up as a sole trader or as a limited company for her new business venture.  A difficult question to answer and one that has been asked of small businesses for many years, so what are the differences? This is useful reading for those who are studying for any of the CII  AF5, R01, R03 or R06 exams.

This article is relevant to examinable tax year 2021/22.

What is a sole trader?

A sole trader is a self-employed person who runs his/her own business.  A good reason for setting up as a sole trader is simplicity. As well as receiving all the profit though, they are also liable for any debt.  When the individual dies, the business dies also.  As far as tax is concerned, the person pays income tax on the profits from the business as well as class 2 (flat rate) and class 4 (profit related) national insurance contributions.  A self-employed person has to keep accounts of course, but they don’t have to be made public.

What is a limited company?

A limited company is privately owned with limited liability, which means that the owner’s liability for debt is limited – it is the Company that is sued, not the individual.  The Company is a separate entity from the director/main shareholder, and any earnings belong to the Company.

As far as tax is concerned, a limited company pays corporation tax on its profits at 19% (and a company tax return has to be filed 12 months after the year-end) and the employees (the directors) pay income tax and NI on their salary. The employer has to pay NI as well on the Employee’s salary and on any bonus they might receive. Drawings of dividends are subject to tax above £2,000 per tax year but are not liable to national insurance. Dividend tax is lower than the income tax due on standard salaried income, it is taxed at 7.5% to the extent that it falls in the basic rate band, at 32.5%  to the extent that it falls in the higher rate band, and at 38.1% to the extent that it falls in the additional rate band.

A limited company also has to keep accounts, but they do have to publish them with Companies House and so they are available to anyone who cares to have a look.

Note: Corporation tax is set to increase to 25% from 1 April 2023 but the 19% rate will continue to apply to companies with profits of not more than £50,000, with marginal relief for profits of up to £250,000. Also the government plans to increase dividend tax by 1.25% from 6 April 2022.

So which is best for my friend?

Well it depends a lot on how much money she thinks she’s going to make.

With smaller profits, it may be that the sole trader route is better – with larger profits, then it is often more tax efficient to trade as a limited company, because salary up to the personal allowance can be taken, with the rest taken as dividends, which pay no NI and also enjoy a dividend allowance. But other reasons could be to protect personal assets and give a more professional feel to her business, which would help with getting credit from suppliers.

However, directors of limited companies have more paperwork to deal with and also have more statutory obligations as they are regulated by Companies House.  Even if they have an accountant, the ultimate responsibility to provide accurate accounts still lies with the director.

There is no right or wrong business structure for my friend – it’s usually the one that best suits the individual situation, but hopefully with a few more facts and an understanding of the main benefits of each option, she can now make an informed decision.

A lot of people starting their own small businesses start off as a sole trader and move to become a limited company later on.

Grab the resources you need!

Download taster resources for AF5, R01, R03 or R06 if one of those exams is in your future.