Limited Company or Sole Trader – Which Is Best for My Business?
Once you have come up with your new business idea and name you then must decide whether to set up as a sole trader, a partnership or a limited company. It can be quite confusing and there is lots of conflicting advice out there. It is essential you choose the right structure for you and your business activities, as rushing into this can cause problems further down the line. This guide will help you to understand the different entities and will briefly discuss their main advantages and disadvantages.
Sole Trader Summary
If you are self-employed as a sole trader or as part of a partnership your business profits and any other personal income is taxed via the annual self-assessment process. For the 2017/2018 tax year you will have a personal allowance of £11,500. Once this has been exceeded, tax is paid at the rate of 20% on business profits up to £45,000. When profits exceed £45,000 you are considered a higher rate tax payer and the rate of 40% is applied. It is worth bearing in mind if you have any income over £150,000 you will be classed as an additional rate tax payer and will be taxed at 45%.
In addition to income tax there are National Insurance contributions to consider which are collected via the self-assessment process, with sole traders subject to class 2 and class 4 contributions.
Limited Company Summary
If you form a limited company your business is considered separate to you as a person and your personal assets would therefore be protected. Your business is subject to corporation tax at a rate of 19% for the 2017/18 tax year. Directors would ordinarily draw a small salary from the company within their personal allowance and as the salary is an allowable business cost for corporation tax, 19% is saved on the gross salary. The remainder of the director’s funds would be in the form of dividends which are paid out of post-tax profits and are banded the same way as income tax. There is a £5,000 tax free allowance with dividends above this being tax at 7.5% until the higher band is reached where they will then be taxed at 32.5%. Once the additional rate band is exceeded they will be taxed 38.1%. There are no national insurance contributions on dividends.
Sole Trader vs Limited Company
The main advantage of a limited company is that your personal and business finances are separate. Any business debts occurring within a limited company remain the responsibility of the company, whereas debts occurring within a sole trader business remain the responsibility of you, and personal assets including your home are not protected.
Setting up and operating as a sole trader is a very simple process. You just need to ensure you inform HMRC of your trading activities within three months of trading. You need to complete an annual self-assessment declaring your income and expenses by the 31st January following the end of the tax year. In comparison setting up as a limited company can be a complicated process and there are more legal requirements to consider. You have to complete and submit a company tax return and accounts prepared in IXBRL format to HMRC along with annual accounts to Companies House.
Operating a business via a limited company can look more impressive as you simply look like a bigger operation and are therefore often more respected. This is particularly something to consider if most of your competitors are trading as ltd.
There are potentially more tax savings to be made operating through a company but every scenario is different and your individual situation should be discussed with an accountant.
There is no right or wrong answer and deciding on your business entity really does depend on your individual specific situation. Many companies decide to start out as a sole trader and then incorporate in to a limited company as they grow.