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 2022/23.

What is a sole trader?

A sole trader is a self-employed person who runs their 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 a sole trader dies, the business dies also.  As far as tax is concerned, a sole trader pays income tax on the profits from the business as well as class 2 (flat rate) and class 4 (profit-related) National Insurance (NI) contributions.  A sole trader may 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%. A company tax return has to be filed 12 months after the year-end. The director is an employee of the Company and pays income tax and NI on their salary. The Company pay NI 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 NI. Dividend tax is lower than the income tax due on salary. It is taxed at 8.75% to the extent that it falls in the basic rate band, at 39.35%  to the extent that it falls in the higher rate band, and at 39.35% to the extent that it falls in the additional rate band.

A limited company has to keep accounts and must send them to Companies House so they are available to anyone who cares to have a look.

Note: Corporation tax is currently 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.

The pros and cons of each method?

With smaller profits, it may be that the sole trader route is better. All that is required is to register with HMRC so that you pay the correct taxes and National Insurance for the amount of profit you generate. In fact, a lot of people starting their own small businesses commence as a sole trader and move to become a limited company later on.

With larger profits, it may be more tax efficient to trade as a limited company and manage your remuneration. Salary up to the personal allowance can be taken tax-free, with further income taken as dividends, which are not subject to NI and benefit from the dividend allowance. (Although dividends are paid from profits which have already been subject to corporation tax). Other reasons could be to protect personal assets and give a more professional feel to a business, which could help with getting credit from suppliers.

However, directors of limited companies have more paperwork to deal with and also have 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.

Care also needs to be taken not to breach the off-payroll working rules which can apply where an individual provides services through their limited company and can result in them being treated as an employee of their client for tax purposes.

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.

Grab the resources you need!

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