A question often asked by individuals just starting up is what legal structure should they use, a sole trader (self-employed) or limited company. Below is some advice, although it’s not such a simple question to answer based on limited information.
There are more than just tax considerations here. Before we dive into the tax aspects let’s look at some of the implications of setting up as a sole trader or limited company. See our advice below:
Assuming we are dealing with an individual (no business partners or employees) who sets up in business by themselves, we have the following situation.
This is often the simplest route.
- You and the business are the same – just one person. You are the business.
- No need to prepare statutory accounts, all you need are details of your income and expenditure (although I would highly recommend you do prepare accounts).
- Only the one tax return – the self assessment due 31 January.
- No annual return for Companies House – you are not a company.
- No need to register for PAYE and therefore no need to pay HMRC tax and NI on a monthly basis – you are not an employee and you have no employees.
- May need to take out insurance (personal liability, indemnity), as will not have limited company protection
- You are personally responsible for the debts of the business
- You can only have a personal pension – there is no company pension.
Chosen by many. Quite often individuals feel it gives their business some respectability, though I really don’t know why.
- You and the company are separate – you are an individual and the company is also an individual (albeit a legal one) and you work for the company. The company’s assets are not yours, they belong to the company. All you own are the shares in the company.
- Will need to prepare statutory accounts for HMRC and Compnaies House.
- Will need to submit a corporation tax return to HMRC.
- Often (due to the way the owner/director takes money out of the company) a self assessment return will need to be submitted for the owner/director.
- There is an annual return that must be completed each year and sent to Companies House (this is in addition to the accounts)
- Requirement under company law to keep books and records.
- You are not personally responsible for the company’s debts, unless you have personally guaranteed them or continued to trade while insolvent.
- Should also consider taking out any liability insurance required and not rely on limited liability status.
- May have to register for PAYE and submit monthly payroll returns to HMRC, depending on level of pay and benefits.
- The company can make contributions to a personal pension plan or it can have its own pension plan.
In general, there is a lot more admin (accounts, tax returns, company secretarial work) in running a limited company than there is in being a sole trader. In your early days, you may want to focus on getting your business up and running rather than being bogged down in admin.
Now we’ll look at some of the tax consequences of each option.
- All profits are taxed under income tax, so if you are are higher rate tax payer then your profits will attract the higher rate of tax (40%) as opposed to the corporation tax rate of 20% (for small companies).
- Pay class 2 and class 4 NI (9%), which is generally significantly cheaper than the class 1 NI paid by employees (12%) and employers (13.8%). You can almost forget about the class 2 NI as currently it is less than £3 a week.
- You can offset trading losses against other income (e.g. rental income)
- You are free to withdraw money from the business without tax consequences – it is your money. It is not classed as wages but as drawings and does not reduce the business profits.
- If you use your own assets in the company (e.g. car, computer) you can claim capital allowances on the business use. There is no employee benefit – you are not an employee.
- Profits are charged to corporation tax
- Wages are subject to PAYE and class 1 NI. Class 1 NI falls into two categories, primary (employees) which is 12% and secondary (employers) which is 13.8%
- As a director and shareholder, you may wish to withdraw money by way of dividends to avoid the NI. This is common, but you should know that dividends do not reduce company profits, they can only be taken if there are sufficient distributable reserves (retained profits) in the company and a dividend declaration has been made.
- If you use company assets for personal use, you are likely to have a taxable benefit. That company car could prove very costly. Employee benefits have to be reported on P11Ds, which means having to be registered for PAYE, so if you’re are keeping your wages low to avoid having to register for PAYE you may want to watch you don’t end up with any taxable employee benefits.
A good comparison of the differences can be found here.
So the question remains – which option is best? A general guide is if you are a basic rate taxpayer it may be better to be a sole trader initially while you are building up your business. The basic rate of tax is 20%, which is the same as the small companies rate for corporation tax, so there is no saving. You may save a bit on the class 4 NI by setting up a company and taking dividends, but this will likely be offset by increased costs for accounts, tax returns and admin.
Once your business has grown and is making reasonable profits, you may wish to incorporate. Again, this is not a straightforward decision as it depends on what you intend to do with those extra profits. If you take them out of the company, they will still be subject to income tax, so there is likely to be no tax saving. If you intend to build up funds for a rainy day, new project, expansion of the business then it is easier to do so if you are a limited company as the small companies corporation tax rate is significantly less than the income tax higher rate of 40%.