Are you a small business startup and don’t know which legal structure to use between a sole trader and ltd company? Worry not as we’ve created this article to help you make an informed decision.
Before a business is started, it must have a legal structure. In the UK, it is estimated that 3.4 million people operate as sole traders, while 1.9 million people operate as limited companies. This means that a sole trader is the most popular legal structure for small businesses. Also, it accounts for 60% of small businesses in the United Kingdom.
But what are the differences between these two legal structures and which one is the better structure to use? Depending on your circumstances and type of business, you may find one structure to be suitable for you than the other.
What is a sole trader?
A sole trader is typically a self-employed person who is the sole owner of their business. This is also the easiest form business structure out there and that’s one of the reasons why it is very famous.
Advantages of a sole trader
- It is very easy to set up – starting a sole trader is very easy and it takes just some minutes to become one in the presence of the law, and there’s hardly any paperwork. All that is required is for one to complete the annual Self Assessment tax return.
- No extra costs – unlike having a limited company, starting a sole trader doesn’t cost you a thing. This is because there is no arranging of annual returns, no corporation tax, and you don’t have to pay extra fees in order to continue operating. Just the completion of the annual Self Assessment tax return is needed.
- There is a lot of privacy – if you’re a sole trader, you will have the privacy that limited companies don’t have. This is because it’s not mandatory for you to list your business on the Companies House.
Disadvantages of a sole trader
- Challenging to raise funds – it can be very difficult to acquire capital or funding from key sources. In most cases, banks and other investors prefer to give capital to limited companies. As a result, this might be a setback if you want to expand.
- Unlimited liabilities – sole traders are normally seen as a separate entity by the UK law. This implies that if the business gets into debt, the business owner will personally be liable. Therefore, business owners could lose personal assets if things become faulty.
- High tax rates – when your business grows and starts making certain profits, tax rates may turn out to be higher on you than if you were operating as a limited company. That’s when it is the right time to switch from sole trader to limited company.
What is a limited company?
A limited company is a form of business structure that has its personal legal identity, separate from its owners and its managers. It is still the same even if it is operated by one individual, who can act as the shareholder or as the director.
Advantages of a limited company
- Your name is safe – when you register a company no one can use it. But if you’re a sole trader, you don’t have similar protection. As a result, this is very important if you have an iconic name.
- Tax incentives – generally, limited companies are more tax-efficient when compared to sole trading. This is because you pay Corporation Tax on your profits instead of income tax. As a matter of fact, this can be more profitable. Moreover, there is a wider range of allowances and tax-deductible costs that a limited company can demand against its profits.
- Limited liability – this is one of the biggest advantages of having a limited company. There is a legal difference between you and your business. Therefore, if the business fails, you will only have to lose the company assets and not your personal possessions.
- Recognizable – when you are a limited company, many institutions and people will regard you a bigger deal than when you remain a sole trader. This is very important, especially for sole traders who want to grow and become a force to reckon with.
Disadvantages of a limited company
- It’s costly and time-consuming – as a result of more paperwork involved, it may need up costing you more and a lot of dedication is required, too. Furthermore, you will have o pay a fee to incorporate your business and that’s why you will have to acquire an accountant.
- Added responsibilities – the responsibilities can come in the form of what is referred to as the Director’s Fiduciary Responsibilities, which simply outline what a limited company director must perform legally.
- Transparency – with a limited company, there is no privacy as your company can be found on Companies House. Here, there are details about your directors and your company earnings. This is not a good idea for some companies.
What is better a limited company or sole trader
To determine which of these two legal structures is better, we decided to compare them head-to-head in different categories. These are as follows:
- Liability
A limited company is its own legal identity; hence as a shareholder, your liability is limited, while as a sole trader, there is very little difference between you and the business that you run. So, if there are any business debts, they become yours and thus your own assets are not secure if things go wrong.
- Tax
Sole traders pay tax on their business profits, through the Self Assessment tax return system. And the last date for online tax returns is 31st January after the end of the tax year. While for a limited company, tax is deducted from the director’s salaries through Pay As You Earn (PAYE) and paid at regular intervals at HM Revenue & Customs (HMRC).
In addition, each and every director is required to complete a tax return unless they did not get any pay or gains; regardless of whether any tax is owed. Also, if the directors are shareholders, they may get dividends from the company.
IN 2016, the dividend tax credit was removed and replaced by a dividend allowance, which implies that the first £2,000 dividend is tax-free. Because of these changes, there are very few differences between a sole trader and a limited company.
- Accounts and tax returns
Typically, sole traders are not legally demanded to file or have annual accounts but they still need to keep a record of business income and expenses or filling in their tax returns. On the other hand, a limited company is required to prepare annual accounts from the company’s records at the end of every financial year.
These are usually filed with HRMC as part of the tax return and later forwarded to all shareholders and Companies House. In addition, the ltd company is required to file a Confirmation Statement with Companies House, which is made up of information in connection with the shareholders, directors, and registered office.
- National insurance
For a limited company, both the employer’s and employee’s National Insurance (NI) is payable on the directors’ salaries and bonuses. But when it comes to a sole trader, the National insurance charge is more than that paid by a limited company. The sole trader pays Class 2 National insurance contributions of £2.95 per week and Class 4 contributions on profits in excess of £8, 424.
- Perception
A limited company is normally viewed by other people and institutions as a better model to work with than a sole trader. This is because it gives an impression of a sound-based organization and may appear to be more credible than a sole trader. So, contractors, businesses, and clients will be more willing to work with a limited company than a sole trader.
How much tax do you pay as a sole trader?
As a sole trader, you are required to pay tax on all of the profits from your business. All that you’ve to do is fill in a Self Assessment tax return every year, defining your expenses and income. Additionally, you will be needed to make flat-rate Class 2 NICs throughout the year, which is £2.95 a week for 2018/19.
In case your annual profits are greater than £8,424 for the financial year 2018/19, then you will be required to pay Class 4 NICs (9% on profits up to £46,350 and 2% on annual profits greater than this figure for the year 2018/19). This is paid together with your income tax and the figure is computed from your Self Assessment tax return.
How much does it cost to set up a limited company?
A limited company can be set up using different formations. These include incorporating it directly through Companies House, using a formations agent or requesting an accountant to form your company.
The standard registration feet to start a company is around £12 for the ‘standard’ Companies House web incorporation service, which normally takes a maximum of 24 hours to process. Methods of payment are through debit card, credit card or PayPal. For those who intend to submit a paper application, the charge is £40 and it may take between 8 and 10 days to be processed. But if you want the same day set up for the paper application, then you will have to pay £100.
For those who intend to utilize the web incorporation service, you will be required to fill different online forms that combined make up what is known as Form IN01 (featuring company’s registered address, company director details, shareholder details, and company’s proposes share capital).
Each and every applicant is instantly given with the Companies House model Articles and Association and the Memorandum of Association is automatically created.
So, it will depend on what you decide to do. If you decide to set up the company on your own by incorporating it directly through the Companies House instead of acquiring a formations agent or accountant, the process will be somehow cheaper.
How do I become a Ltd company
Changing your business from a sole trader to a limited company when it grows is very beneficial. With a limited company, you will have an iconic name to your business, operate your business in the most tax-efficient manner, be responsible for everything you do, and pitch for work that you wouldn’t be able to get as a sole trader. But how do you become a limited company? Here are the steps to follow:
- Select the type of limited company you want
The moment you decide to become a limited company, you should know which type of company you want to create. You will have to decide between private Limited Companies (LTDs) and Public Limited Companies (PLCs). Most people prefer forming LTDs as PLCs require a minimum share capital of £50, 000.
- Choose a name
This is one of the most annoying parts of forming a limited company as you have to create a name that is unique and not in the market.
- Set up your limited company
After finding a name for your company, the next step is to set up your company by providing personal details to help the Companies House identify you as a company director, and you can commence running it.
- Finish the corporation process
The Companies House is in charge of all limited company registration in the United Kingdom. Their website offers detailed information and it clearly states the documents that must be completed and returned to the Companies House for the completion of the incorporation procedure. The documents can be filled by you, your accountant or your company formation agent and they include:
- Memorandum of Association – this has a limited company name, location, and business type.
- Form 10 – it has the director’s names, addresses and registered limited company.
- Form 12 – it states that the limited company abides by terms and conditions of the Companies Act.
- Articles of Association – it states the director’s powers, shareholder rights and much more.
After you complete these 4 steps, your company is set up and you’re now a limited company.
Conclusion
When you compare and contrast these two legal structures, choosing one over the other can be quite challenging but both of them have their own advantages and disadvantages. As a startup, a sole trader is the best option as it is easier to start, and has minimal costs.
But when the business grows, you should shift to a limited company from a sole trader due to the vast benefits that you will stand to gain such as tax efficiency and limited liability.
Overall, you should take your time and select the right structure for your business as it could affect many things from paperwork to profits and much more. If you are not sure about whether to go with a sole trader or a limited company, then speak to an accountant as their knowledge may be vital when it comes to tax reality.