A question I get asked often is “Should I set up as a sole trader or a limited company” Another question that usually comes straight after is “What is the difference between a sole trader and a limited company?” So, I thought I’d put this short article together to explain in simple terms the difference between the two and summarise the advantages and disadvantages of both.
What Is A Sole Trader?
This is the easiest and quickest way of setting up in business and is the most common business format for small businesses. In a nut shell, being a sole trader simply means that you have started a business.
All you need to do is to inform the HMRC within three months of starting to trade. Accounting is simple, you don’t need to submit your physical accounts to the HMRC and reporting your profits each year is straight forward.
- Easy to set up, simply register with HMRC within 3 months of starting to trade.
- Simple accounting and simple tax returns.
- You can take cash out of the business without any complex tax implications
- In the event of a legal dispute, it is you that will be sued
- If the business fails then you are personally liable for all outstanding debts
- Restrictive and risky if you want to grow the business beyond just you.
Being a sole trader is easy to set up, there are a number of risks involved however you are able to ensure that you mitigate those risks by having good insurance in place.
What Is A Limited Company?
In the eyes of the law a limited company is a separate legal entity. Think of it as a person. In real terms, this means that legally it can sue and be sued.
A limited company is owned by one or more shareholders. These shareholders may receive a share of the profits. These payments are known as dividends.
A company is run by one or more directors. The directors are responsible for running the company. If you think of a company as being a ship, the shareholders own the ship and the directors are the crew who sail the ship. A person can be a director and a shareholder at the same time.
- Can be more tax efficient if you have profits greater than £35k
- Limited liability if the business fails
- Better exit strategies
- Accounting requirements can be more complex
- More administration required
- Costly accountant fees
Becoming a limited company certainly has advantages is you expect a higher turnover and profit or if you expect to be exposed to higher risks during the course of your business. Having a limited company gives more credibility that although may not be necessary for some small businesses that serve a retail market, it certainly does add prestige when dealing business to business.
Main Differences Between A Limited Company And Sole Trader
|Sole Trader||Limited Company|
|Accounts don't need to be submitted to HMRC||Accounts need to be submitted to HMRC and Companies House Annually|
|You are the business owner and manager||You are an officer of the company as a director. If you own the company you are also a shareholder.|
|If the business fails then you are liable for all the debts||If the company fails then you are only liable for the amount of share capital assuming that you haven't personally guaranteed any debts|
|In the case of a legal proceedings, you will be sued and responsible unless you have adequate insurance||In the event of legal action it is the company that will be sued. Again, insurance is available. It's worth noting that under certain circumstances such as fraud, manslaughter etc the directors of a company can also be held liable|
|You pay class 2 national insurance contributions. You also pay class 4 NI and tax on any profits that the business makes after allowances.||The company pays corporation tax on profits, Corporation tax is lower than income tax. Dividends may be paid to shareholder if there is a profit. There are many tax advantages available under this regime.|
|You can draw money from the business without any tax implications||Any money taken from the business is taxable either as a wage or a dividend.|
|Upon death the business dies with you||In the event of death the business still exists.|
Sole Trader Vs Limited Company
Deciding on which business format you take is very much dependent on your situation. You have to consider many things including your projected turnover and profit and the level of risk that you expect the business to be exposed to.
Many businesses start off as a sole trader and then convert to a limited company after a period of trading. This is relatively easy to do.
Hopefully this article has given you the basics and explained the difference between the two entities. Speaking to an accountant in more depth should help you decide which option is best for you.
This is one of a series of basic business articles. Like my Facebook page or join my newsletter to be informed when I publish more.
Please feel free to post any questions in the comments section below