Hardly a week goes by without someone asking us whether they ought to stop trading as a sole trader and instead set up a limited company. It’s a great question and we’re glad they ask it.

Unfortunately, there isn’t really a simple answer – it absolutely depends on your circumstances. That’s why before giving tailored advice on business structures, we always gather all the information we can and do some careful calculations.

Get it right and you could reduce your overall tax bill. Get it wrong and not only might you end up paying more tax but, as a company director, you’ll also have a lot more statutory responsibility on your shoulders.
In this blog post, we’re going to cover some of the broad principles to help you understand why it’s an important decision and some of the pros and cons either way.

If you want more detailed advice, do get in touch.

What’s the difference in tax terms?

Sole traders are self-employed individuals. Legally, there’s no distinction between their finances and those of the business. That means they have to pay income tax on their profits at a rate of 20%, 40% or 45%, depending on how much they earn, along with class 2 and class 4 National Insurance contributions (NICs).

If you set up a limited company, however, you become a company director. Directors are employed by the company. That means they pay income tax and NICs only on the salary they choose to pay themselves.

In addition, they pay corporation tax on the company’s profits at a rate of 19% in 2021/22.

So, overall, there’s a potentially significant tax saving.

As a company director, you’re also insulated from risk if the company goes bust or gets into trouble – the ‘limited’ part of ‘limited company’ refers to your liability. Sole traders, on the other hand, can lose personal assets such as their house or car if the business gets into debt.

In most cases, limited companies are also more likely to benefit from tax reliefs than sole traders.

On that basis, you might think a limited company sounds like a no-brainer on that basis but it’s not that simple.

What’s the catch?

First, limited companies come with a lot of administrative and reporting requirements. You’ve got to register with HMRC and Companies House, share personal information online and complete all sorts of returns and forms throughout the year.

Then, to make sure you take home a decent salary as a company director without paying too much tax, you’ll probably also want to work out the right mix of basic salary, dividends and, increasingly, pension contributions.

Finally, it’s worth noting that in the past year and a half, many self-employed company directors found themselves effectively shut out of Government COVID-19 support schemes such as furlough and SEISS.
Emergency payments were calculated on salary and prior earnings and, for the reasons set out above, most directors don’t earn much purely in terms of salary.

The appeal of simplicity

Operating as a sole trader tends to be pretty straightforward. You just need to stay on top of your receipts and records (easy with cloud accounting software) and submit your personal income tax self-assessment return on time each year.

For smaller businesses, especially one-person operations, it might make sense to hold off on incorporating.

Equally, if your business is growing, it’s almost inevitable you’ll want to embrace limited company status at some point. The trick is knowing when to make the leap.

We can help you to choose the best structure for your business. Contact us today to find out more.