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Sole trader vs limited company: what's the difference?

If you’re self-employed, you’ll need to register as a sole trader or limited company to pay tax. But which structure is best for your business? Read our guide to find out about the advantages and disadvantages of working as a sole trader or setting up a limited company.

If you’re self-employed, you’ll need to register as a sole trader or limited company to pay tax. But which structure is best for your business? Read our guide to find out about the advantages and disadvantages of working as a sole trader or setting up a limited company.

Written by
Mubina Pirmohamed
Business and landlord insurance expert
11 MAY 2021
4 min read
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What’s the difference between a sole trader and a limited company?

Every business in the UK, large or small, must have a legal structure in place for tax purposes, even if that business is only one person. For most private business owners, self-employed workers and freelancers, the choice comes down to operating as a sole trader or a limited company. 

As a sole trader, you are the sole owner of your business. You may employ staff to work with you, but you have complete control of the business. You keep all the profits after tax, but you are also personally liable should the business get into trouble. 

If you form a limited company, you are setting up a separate private organisation. You are not personally liable for the business – even if you’re the director and sole shareholder. The business is its own legal entity, so you can only lose what you put in. Rather than keeping the profits, you pay yourself through a combination of salary and dividends.

What are the main advantages of being a sole trader?

Many self-employed business owners and tradespeople choose to work as a sole trader because it’s a simple structure and easy to set up. To operate as a sole trader, you must complete an annual self-assessment tax form. Otherwise, there’s no extra paperwork or legwork involved.  

As a sole trader, you get to keep all the profits of your business after tax. You can take out or borrow money from the business whenever you want, as long as you keep enough aside to pay your bill from HMRC. 

What are some of the disadvantages of being a sole trader?

One downside of working as a sole trader is the legal responsibility you assume for your business. Because the business is legally under your name, you could be personally liable if someone sues the business or the business goes into debt. This means you could end up losing your personal assets, even if they have nothing to do with the business. One of the ways you can protect your interests is to make sure you’re properly insured for the risks that might affect your business. 

Although you benefit from the tax-free personal allowance working as a sole trader, you could end up paying more in tax, as the corporation and dividend tax rates that apply to limited companies tend to be lower. But this depends on your business’ income level. 

Although it’s easier to start working as a sole trader, it could mean your business may lack credibility in the eyes of banks and other investors, and you could find it harder to expand in the long run. Unlike sole traders, limited companies must be registered at Companies House. That means anyone can check  the annual financial report for any limited company. This could make a limited company appear more trustworthy and professional compared to a sole trader. 

What are the main advantages of being a limited company?

One advantage of forming a limited company is limiting your own personal risk. If the business gets into trouble, you only stand to lose what you put into the business; any other personal assets should be safe. 
Depending on your business’ income, tax law will favour limited companies in many cases. A limited company pays corporation tax on their profits and dividend tax, and the two combined still often work out at a more favourable rate than income tax. 
Plus, if you form a limited company you can claim tax relief on certain running costs through your business expenses. For example, if you’re using your home as your office, you can claim a percentage of your utilities bills as business expenses. Or you could claim accommodation and food as expenses if you’re travelling for work. You could also claim expenses for advertising services, business insurance costs and bank charges, as long as it’s all solely for your business. 

Another benefit of forming a limited company is that it gives a more professional appearance to investors and other companies you may want to work with. To become a limited company, you have to register with Companies House and provide them with yearly accounts. That mean, as we touched on before, anyone can look up your business on the register and see how you’re doing, making your business more publicly accountable and transparent. 

What are some of the disadvantages of being a limited company?

Although there are several benefits to forming a limited company compared with working as a sole trader, one thing that may put a lot of people off is the extra responsibility and paperwork involved

As the director of a limited company, you accept certain legal duties. When you register your limited company with Companies House, you’ll have to pay a small set up fee and file a memorandum of association and articles of association. These are legal statements that define the structure and rules of your company. As the director, you’re legally responsible for following your company rules and for acting in the best interests of your company. This means putting what’s best for the company before your own personal interests, disclosing any potential conflicts of interest, and keeping accurate records of decision making. 

It can be more difficult for you to take money out of the business compared with a sole trader. In a limited company, you’ll be paid a salary and receive dividend on the shares in the business that you own. Any dividends will have to be paid out of retained profit, so if you’re not yet showing a profit, you won’t be able to take dividends. You’ll also pay tax on any income and dividends you receive – subject to the usual allowances and exceptions.

You’ll also have more accounting to do. You’ll need to file your yearly accounts with Companies House and complete an annual tax return with HMRC, to work out how much corporation tax you owe. Also, you’ll most likely have to fill out a personal tax return if you’re the director. 

An alternative is to register the company as an employer and set up payroll if you want to be an employee of the company and take a salary. You can do this yourself or you can pay an accountant to do it for you. Remember, if your company has any employees who are not direct members of your family, it will also need to have Employer’s Liability insurance by law.

Which option is best for me?

It really depends on your circumstances, the size and structure of your business, your attitude to risk and liability, and your plans for the future. A team of founders could support one another through tricky times, share decisions and complement one another’s skills. On the other hand, a solo founder can be a driving force because they can make decisions quickly without needing to get a consensus of agreement with others in the company. Also, costs could be lower as a sole trader because, in the early days of your business, you wouldn’t need to cover any salaries other than your own. 

Your motivations for setting up your company and your ambitions matter too. You may want to be the next Steve Jobs and own a company whose products are eventually sold globally, or you may simply want to be your own boss, doing smaller-scale work that you enjoy.

It’s quick and easy to set up as a sole trader and that may be why it’s the more common option – in the UK in 2019, there were 3.5 million registered sole traders, compared with 2 million limited companies.  But it could be worth talking to a financial advisor to work out if forming a limited company could benefit you in the long run.

How can I make sure my business thrives whichever route I choose?

Understand and learn from your customers about what your business is doing right and wrong. Take good advice from experts and mentors when you need it. Update your business plan to take account of the reality of running your business and the conditions you find yourself in. Put in the hard work that’s needed and keep a close eye on your cashflow, so that you don’t run out of money.  

Setting up and running a business is a lot of hard work and a lot of responsibility. And you won’t want to see all that hard work go to waste should something unfortunate happen. When starting your business, it’s a good idea to consider what protection different types of insurance could offer you. You’ll also need to factor the insurance premiums into your running costs.  

The type of business you’re in may determine some of the insurances you take out. For example, it may be that you need professional indemnity, insurance for premises, motor insurance, insurance to cover your stock, and so on. Many businesses that interact with the public could benefit from public liability insurance. And just to recap, if your business employs any staff who aren’t from your immediate family, then employers’ liability insurance is a legal must.

To work out what you might need, see our guide to the different types of business insurance.

Whatever you decide, compare business insurance with us and we can help you find the  right deal for your business.

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