Sole trader or limited company for side business?

Question, I work full time on a salary of £50k and I am also about to start a business. I am not sure whether to set this business up as a sole trader or a limited company – which will be the most tax efficient? I have no plans to give up my full time job at this stage and my estimate of the profit from my new business is £30k per year.

sole trader or limited for side business

Answer, July 2016

If you setup your business as a sole trader then you will pay income tax on the profits at the higher rate of tax which is 40% – this is because your employment income is above the basic tax rate threshold which is £43,000 for 16/17.

You will also have self employed national insurance to pay which at your level of earnings will be:

  • Class 2 national insurance – at a fixed rate of £2.80 per week
  • Class 4 national insurance – at a rate of 2% for profits above £8,060 (this would usually be 9% but because your employment earnings are in the higher tax band you pay a reduced level of national insurance on your self employment, to save you over-paying ni)

With a salary of £50k from your employment you are also at the child benefit withdrawal threshold so bear that in mind.

If you setup your new business as a limited company, the company will pay corporation tax at 20% on it’s profits. Any money you take out of the company will be classed as dividends – your first £5,000 of dividends will be tax free, with any further dividends taxed at 32.5% (as you are in the higher rate tax bracket).

A key consideration, therefore, is going to be how much of your businesses profits you need to extract.

Here is a comparison of the tax and national insurance charges if you take out all of the £30k of business profits:

Screenshot 2016-07-20 08.06.59

You can see there is a small tax saving of £409 with the limited company, but the difference is not substantial.

Let’s now do a comparison assuming you don’t need to extract all of the £30k of profits – we’ll assume you are happy to leave £10k of retained profits in the company.

Screenshot 2016-07-20 08.11.17

With the sole trader scenario, the tax and the national insurance are unchanged because you are taxed on your sole trader profits, regardless of whether you need the cash or not.

However with the limited company you can see that the personal tax on dividends has been reduced substantially by only extracting £14k of a possible £24k of dividends. The tax saving of the limited company is now £3,659.

So you can see that if you are willing to keep some of your profits retained in the company it can make the limited company a much more tax efficient structure.

Retaining profits in your company can be useful if you want to  invest in equipment or staff, for example.

There are also many other differences to consider between a sole trader and a limited company, which we cover in our article limited company vs sole trader 2016/17.