Sole trader vs Limited company: What's the difference?

When starting a small business, one of the most important decisions is about choosing the right legal structure for your business. The different types can significantly impact key areas, including the payment of tax, control over the business, and legal liability.

The main options are:

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• sole trader
• limited company, or
• partnership.

The UK private sector consists of six million businesses with sole traders being the most popular - there are about 3.5 million of them! 2 million businesses trade as limited companies and there are around 400,000 partnerships.

When it comes to choosing the best option for your business, there is no single magic answer. However, it is important to know the main differences in order to understand what would be the best choice for you.

In this blog post, we're going to focus on the two most common options - sole traders and limited - also known as "Ltd" - companies. Larger companies can choose to become a plc - a public limited company. These are typically (but not always) on a stock market with shares that people can buy, and for this reason plcs need to follow more rules.

Let's take a look at some of the key questions we often get asked...

What is the difference between a sole trader and limited company?

Paying taxes as a sole trader

Being a sole trader is often seen as the simplest form of having a business, but in both scenarios, you can be your own boss. And will need to make sure you set aside money to pay tax on your profits.

As a sole trader, you will need to pay income tax on what you earn from your self-employment and complete a self assessment tax return each year. You're taxed on the profits (income minus expenses) that the business makes regardless of whether you take that money out or leave it in the business.

Side note: Many sole traders use their personal bank account to start running their business especially when they're starting out. At untied, we don't require you to have a separate business bank account, and we make it easy to work with different sorts of account. But - especially when you start growing - banks may encourage you to have a separate business bank account. If you are a sole trader, the Financial Services Compensation Scheme covers you up to £85,000 for all your accounts - including your business account - with any individual bank. untied's open banking technology links into most UK banks, regardless of what type of account you have.

Sign up for untied as a sole trader - free 30-day trial included

Paying taxes as a limited company

When you establish a limited company, your business is a separate legal entity, and you pay a different type of tax called Corporation Tax. The company will have its own business bank accounts.

You also must keep detailed records and prepare accounts each year (which need to be filed with Companies House), send an annual company tax return to HMRC and provide an annual confirmation statement to Companies House, which confirms the most recent information about your company.

Any money you take from the company will need to be accounted for. People who own limited companies may take a salary from the company (and this means the company registering for Pay as you Earn - PAYE - so that tax is calculated and deducted as the salary is paid), or dividends. This is a share of the profits that is generally in proportion to the amount of the company you owe. Dividends are not an expense of the company - so the company makes profit, pays tax, then the dividend is paid from the after-tax profits. You are also likely to have to pay tax on the dividends you receive, unless they are of a low amount (and this level is getting lower), and to complete a self assessment tax return each year.

Having a limited company is more complicated - and if you miss deadlines you can find that the company gets more penalties than if you were a sole trader. On the other hand, having a company can mean that the overall tax rate is slightly lower.

You can do this yourself or use an accountant. While untied does not support limited companies, we partner with accountants that can help.

Whether you choose to be a sole trader vs a limited company, you must register for VAT if the taxable annual turnover exceeds £85,000.

National Insurance

National Insurance is a different type of tax from Income Tax, and represents the most significant difference between both legal structures.

As a sole trader, you only pay Class 2 and Class 4 NI contributions.

However, when you are a limited company owner and paying yourself a salary, you will pay more National Insurance, as you pay both the employer’s and employees’ National Insurance contributions. However, may people who own limited companies pay themselves in a different way - using dividends. As already mentioned, this is taxed at a lower rate, but you may find that the cost of maintaining the company and paying an accountant to do the calculations to get it right outweighs any tax benefit.

Business liability

As a sole trader, any business debts become your debts, as the business and you are treated together as one. That means, if the company got sued, you are personally liable.

As a director of a limited company you have limited liability if the business incurs any losses or debts, as those sit with the company. You're not completely and wholly responsible for the business, unlike when you're a sole trader.

How do I pay myself from a limited company or as a sole trader?

If you have a limited company, you have to decide how you would like to pay yourself which can be through a salary by setting up a Pay As You Earn (PAYE) scheme or you can also choose to pay yourself through dividends.

Alternatively, you can opt to do a combination of both ways to pay yourself. There will be different tax consequences depending on which route you choose.

As a sole trader, you don't receive a salary or wage in the traditional sense. Instead, for tax purposes you and the businesses are basically the same. You may see what you make as 'drawings' from your business - you ‘draw’ the money you have been paid by your customers to pay yourself as a sole trader.

You will probably need to complete a self assessment tax return for the dividends you receive (and will need to include your salary on this as well).

What are the advantages and disadvantages of being a sole trader?

Advantages

• Registering as a sole trader with HMRC is free. If you're an untied user, we can do this for you
• Little paperwork other than an annual self-assessment tax return
• You don't need to set up a PAYE scheme to pay yourself
• Greater privacy than a limited company, as company details are listed on the Companies House website
• You keep all of your business’ profits as sole owner
• Personal tax and national insurance is cheaper than for limited companies
• You don't need to set up a separate business bank account
• You can use the untied app (and even deduct the cost as a business expense)!

Disadvantages

• You are fully liable for any loss your business makes, so you may have to use your own money to repay any debts, meaning that sole traders can lose personal assets if things go wrong
• It is harder to get funding as a sole trader. Banks and other investors tend to prefer limited companies, which could limit expansion opportunities
• There’s no one to share accountability with. Whilst you can hire staff, any and all important business decisions fall to you.

What are the advantages and disadvantages of setting up a limited company?

Advantages

• As director of a limited company, you can pay yourself in a combination of salary and dividends. With dividends having a lower tax threshold than salaried pay, this can mean you are much more tax-efficient than when just paying yourself a salary.
• All shareholders have a limited liability should your business incur losses or debt; it’s not your personal responsibility. This means personal assets aren’t exposed – you only stand to lose what you put into the company
• Should you ever wish to sell your business, there are likely to be more opportunities than with other business structures.
• Once you’ve registered a company name nobody else can use it, in contrast to sole traders who aren’t offered the same protection (although a sole trader could register this as a trademark).

Disadvantages

• There may be more difficult and time-consuming administrative and tax requirements running a limited company as opposed to operating as a sole trader
• You need to set up a PAYE scheme with HMRC in order to pay yourself a salary
• You’ll still need to do a personal self-assessment in addition to these other requirements
• You’ll incur a tax charge on any assets bought through the company that are used personally – for example a company car charge
• You’ll need a separate business bank account for the company
  
• Information about your business can be found via Companies House, meaning details on directors and your company’s accounts are required to be shown publicly. This sort of transparency may not appeal to everyone.

Can you switch from being a sole trader to Ltd company?

Yes, you definitely can! It is a fairly simple process. We see many people starting out as a sole trader and as their business grows, they then move to setting up a limited company. Some also move back to being a sole trader again.

Which is best for you?

There is no right or wrong decision. Ultimately, you need to weigh up the difference between limited or sole trader, as the structure you choose could impact on everything from profits to paperwork. Don’t rush into any decision and speak to an accountant if you’re unsure, as their expertise is often invaluable when it comes to tax.

How to get started as a sole trader?

Just start trading!

Remember that you need to register with HMRC by 5 October after the tax year in which you start trading. As an untied user, we help you do that as part of our 5-star service so you can get your 10-digit Unique Taxpayer Reference (UTR) number, which you'll need to be able to file your taxes.

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