One of the most commonly asked questions when starting a new business is whether to setup as a sole trader or limited company. This is an important decision as it will affect matters such as the amount of personal risk you take, how you extract money and are taxed, ownership, and expenses you can claim. Before we delve into the differences of each setup, let’s clarify what each actually means.
Sole trader – You as an individual are the business, the owner, and the worker. There is no legal distinction between you and the business, you personally enjoy all the profits and are responsible for any losses made.
Limited Co – The business is a separate legal entity to you, you may own it by the number of shares you hold, but its profits and losses are its own and can only be accessed in specific ways set out in the rules laid out by the Companies House Act 2006. Your liability to the company is limited (as the name suggests) to what you have invested in the company.
| Sole Trader or Partnership | Limited Company: you are director & shareholder |
| You are the business | The business is a separate legal entity |
| You are the owner | You are a shareholder; you hold all or a proportion of the company’s share capital |
| You are the manager or proprietor | You serve the company as its officer as a director (a company secretary is an officer too) |
| In the event of any legal dispute you will be sued personally unless you have suitable insurance e.g. products and services liability, professional indemnity, employer’s liability etc. | In the event of any legal dispute the company will be sued unless it has suitable insurance cover. It is exceptionally difficult and rare under UK law for anyone to sue a director personally for a company’s wrongdoing. |
| Employment status: You are self-employed; you cannot be your own employee. | Employment status: A director is an office holder, this does not automatically make you an employee. |
| Tax on profits: You pay Class 2 & 4 National Insurance and Income Tax on the taxable profits of your business. | Tax on profits: The company pays corporation tax on its taxable profits. Company tax rates are lower than higher rates of Income Tax. |
| Losses: You are individually responsible for the losses of the business, | Losses: The company’s is responsible for any losses made, unless an officer of the company has been negligent. |
| Extracting profits You may withdraw cash from the business without tax effect. | Extracting profits You are taxed on any income withdrawn from the company only. |
| Borrowing You are free to borrow from the business bank account. The money is effectively all yours, so you are borrowing from yourself. | Borrowing Borrowing by directors is permitted. Limits are set by Companies Act 2006, and there are rules on the amount and how long you can borrow for. |
| Pension You can only have a Personal Pension. The rules on how much you can contribute are stricter than company schemes. | Pension Company schemes may be far more generous in terms of benefits and limits than Personal Pension. . |
| Insolvency If the business fails you will be personally (or jointly with your partners) liable for its debts. You may go bankrupt. This is one of the main reasons why many opt to go down the limited route. | Insolvency If the company fails, your liability is limited to the amount unpaid on your shares (if any) unless you have made a personal guarantee for the company’s borrowing (which is often required by banks). |
| Accounts Although there is no requirement that you prepare accounts for tax purposes, It is difficult to keep on top of your business, collect debts and work out profits without keeping accounts. Your accounts are not submitted to HMRC unless you are subject to an investigation. Your taxable profit is filed under the Self-Assessment process. | Accounts You must prepare annual accounts under the provisions of the Companies Act, these can be abbreviated for filing with Companies House. HMRC require full accounts for Corporation Tax which must be submitted online in iXBRL. Accounts must be prepared in accordance with accounting standards. |
| Paying yourself You can withdraw any amount of profits, but it is not classed as remuneration as you are not an employee. | Paying yourself There is no restriction on the size of your salary, but it is subject to PAYE and NICs. |
| Expenses in general: You obtain tax relief for expenses that are incurred wholly and exclusively for the purposes of the trade. If you can identify a proportion of an expense that relates to business you can claim the same proportion against tax. An adjustment must be made for tax to add back the proportion of any expense that relates to “private use”. Most commonly private use will be in respect of your use of telephone or power, own consumption of goods, and motor running expenses. | Expenses in general: The company obtains tax relief for its expenses if they are incurred wholly and exclusively for the purposes of the trade. If a director incurs private expenses through the company, they may be treated as earnings, if he is a shareholder the amounts are treated as distributions. |
