April 30, 2018 Sole Trader or Limited Company 2018/19 What are the differences between a sole trader and a limited company? Making the decision as to which structure your business operates as is very important, whether that be in terms of tax savings, perception to the outside world, keeping things simple or future plans you may have. In this article we will review some of the main differences between trading as a self-employed sole trader compared to a limited company, in terms of the tax consequences, administration and other non-financial aspects with regards to the 2018/19 tax year. Our advice in this article about the topic of ‘sole trader or limited company’ is geared towards freelancers, contractors and modern small business owners as that is our main area of expertise. Let’s start with a bit of basic information for those of you just starting out in business. UPDATE: See our new article here: Limited Company vs Sole Trader 2019/20 Sole trader You start to “trade” when you sell a product or service to a customer. If you just do this as a single individual, you are a sole trader (if two or more of you are working together, you are a partnership – but for this article we’ll assume it’s just you). You need to tell HMRC that you’ve started trading and, each year, send in a tax return and pay tax and national insurance on your profit above a set level. You can continue to trade as a sole trader for as long as you like, regardless of your profit level. Once your turnover reaches the VAT registration threshold which for 18-19 is £85,000 you usually need to register for VAT – but you can still be a sole trader. You can choose to voluntarily register for VAT before your turnover reaches this level if you wish. You can also still have employees as a sole trader. Limited company A limited company is a separate legal entity, with you as its owner (if you are working with one or more other people, you can own the business jointly – for simplicity, in this article we’ll assume it’s just you). You will be the director of the limited company – which means you run the business and are responsible for it – and you will also be the shareholder, which means that you own the company and can receive dividends from available profits. You must legally create the company by registering it with Companies House. Companies pay corporation tax on their profits and you must register with HMRC for this. You can be paid a salary by your limited company and will pay personal tax and national insurance on it in the same way as if you were working for someone else. You can also have other people as employees. Any profit left after you’ve paid your expenses, salary and corporation tax can be paid to you as a dividend. You will pay personal tax on your dividends in the same way as you would on dividends received from any other UK company. As with a sole trader, you have to register for VAT once your turnover reaches the registration threshold (with some exceptions) and you can choose to register for VAT before your turnover reaches this level if you wish. So, how do you decide which of these two business structures would be best for you? First of all lets consider the tax differences between the two structures. For the purposes of this section we’ll assume that you are a UK non-Scottish resident, have no other sources of income and that you want to draw all available profit out of your limited company. We will also assume you are the sole director and shareholder of the company. Sole trader tax As a sole trader an individual must pay tax on all profits over and above their personal allowance. For most tax payers the personal allowance is £11,850 for the 2018/19 tax year. Once the personal allowance has been breached, tax is paid at the rate of 20% in the basic rate tax band (the next £34,500 of income above the personal allowance), 40% as a higher rate taxpayer and 45% in the additional rate band (over £150,000 income). There are now slightly different tax rates for Scottish taxpayers which are not covered in this article. There are also potential other tax hits including the withdrawal of your personal allowance once your earnings go above £100,000 and high income child benefit tax if your income goes above £50,000. As well as tax, for a sole trader there will be two forms of national insurance to consider, Class 2 and Class 4 – both Class 2 and Class 4 national insurance are calculated and paid via your self assessment tax return. Class 4 national insurance This is purely based on your self-employed profits (i.e. it is not affected by other sources of income you have). It is calculated along with your self-assessment tax return and is payable at 9% of profits between £8,424 & £46,350 and 2% for any profits above this. Class 2 national insurance In the past this was paid directly to HMRC (not as part of your tax return) but this is now paid through your tax return. It is charged at a rate of £2.95 per week if your business profits are above £6,205. Limited company tax and income tax on dividends A limited company pays corporation tax on profits at a rate of 19% for 2018/19. For reasons explained in our separate article here, as the director of your own company, you will probably only draw a salary of £8,424 in 2018/19. This will be tax free as it is covered by your personal allowance of £11,850. You will draw your remaining post tax retained profits out as dividends (you don’t have to draw out all profits but for comparison purposes to a sole trader for this article we are assuming you do). Dividends are tax free if you have any remaining personal allowance. Above this, you get a £2,000 tax free dividend allowance for 2018/19 (so a total of £5,426 dividends tax free). Above this, dividends within your basic rate tax band (total income up to £46,350 in our example for 2018/19) are taxed at 7.5%. Dividends in the higher rate are taxed at 32.5% and any dividends where your total income is above £150,000 are taxed at 38.1% in the upper tax band. As mentioned earlier, there are also potential other tax hits including the withdrawal of your personal allowance once your earnings go above £100,000 and high income child benefit tax if your income goes above £50,000. Tax comparison 2018/19 of limited company and sole trader The following table shows the resulting take home pay, at a range of profit levels, for both a sole trader and the owner/director of a limited company, after factoring in both income tax and corporation tax. As you can see, at each profit level the take home pay through a limited company is higher – however, the savings are not enormous and other factors need to be taken into account before making your decision, some of which we discuss below. Cost Of the two business structures, operating as a sole trader has the advantage of simplicity. When setting up you simply need to contact HMRC and register for self-assessment. Every year that you are self-employed you will be required to file a self-assessment tax return and pay any tax due by the 31st January following the end of the tax year in question, there may also be payments on account. For example, for the 2018/19 tax year (6th April 2018 to 5th April 2019) the tax return and tax payment is due to HMRC by 31st January 2020. On the tax return you will need to declare your sole trader income and expenditure – in some cases where your annual sales are below the VAT threshold (£85,000 for the 2018/19 tax year) you are simply able to report three figures on the return – being total sales, total expenditure and the profit made. Your tax return will also need to declare any further income received from other sources. You don’t need a fancy book-keeping system, often a simple spreadsheet will be fine. Trading as a Limited Company is generally more complicated. Initially you need to check if the company name is available as two separate companies cannot trade with the same name or names that are too similar. Once you are comfortable with the name you must register this with Companies House who will provide an incorporation certificate showing the company number and confirming the company is now a legal entity. You will then need to setup a bank account in the companies name (you can’t just use a personal account). A limited company has shareholders, who own the company, and the shareholders appoint directors to run the company on their behalf. When it comes to freelancers / contractors the two positions are usually held by the same people but it’s important to understand the differences. Dividends are paid to shareholders, and salaries are paid to the directors. As a limited company the business is more traceable as details of the company directors and shareholdings are held on public record. The company will also be required to have a registered office address which is often the premises from which the company does business. If preferred, perhaps for privacy, there is scope to use a different address as a registered office and some companies choose to pay a small fee to use a central London address, for example. As a director of a limited company you have certain legal duties that must be fulfilled in order to comply with the companies act. These include, but are not restricted to: Maintaining full & accurate accounting records Prepare and filing of annual accounts with Companies House and tax returns with HMRC Filing of a confirmation statement with Companies House, detailing the details of directors and shareholdings etc. Ensuring that the company complies with relevant tax and employment law A limited company is usually required to file its full accounts and corporation tax returns with HMRC and abbreviated accounts with Companies House. The corporation tax is usually due for payment within 9 months of the company’s year end. In most cases the directors of a company will need the assistance of an accountant. A good accountant will ensure that the required documents are filed on time and also that the company is maximising its tax efficiency in regard to extractions by the directors/shareholders. Limited liability This is one of the main reasons why a lot of businesses choose to trade as a limited company. Limited liability status was first fully established in the 1890’s when the House of Lords upheld that a company had its own legal personality. This ruling ensured that creditors of an insolvent company could not sue the individual shareholders for money that was owing to them. This rule of law still holds true today and as such incorporation can prove extremely useful in protecting private assets. In the event of a limited company incurring an unforeseen liability (such as a legal claim) in most cases this liability will be limited to the assets owned in the name of the company. The directors do need to be careful with regard to personal guarantees and the potential for wrongful trading (e.g. continuing to acquire credit which the company has little chance of servicing), in these instances they can become personally liable. For a sole trader there is no such distinction between personal and business assets as the business and the individual have no separate legal status. Therefore, personal assets such as the family home could be at risk, certainly where the business operates in a fairly litigious or highly sensitive sector. This risk can be somewhat covered off by having sufficient insurance policies in place. Perception The perception of a business can be different dependent upon the trading vehicle it operates as. Simply by trading as a limited company, a reputation can be enhanced, as it can give a potential customer a sense of permanence and credibility compared to a sole trader – to some people a limited company looks more like a proper business. Tax planning opportunities In the comparison table, we assumed that all available profits were taken out of the business each year. For a sole trader, there is no choice. They pay tax on the profit they make each year, regardless of whether or not it remains in their business bank account. While the same is true for the profit made by a limited company, it pays a flat rate of 19% corporation tax on it’s profits (2018-19 tax year). There is no requirement for any or all of the profit to be drawn out as dividends, so many owners of limited companies only draw out sufficient dividends to cover their personal expenses and leave the rest of the profit in the company bank account. In this way, they can potentially avoid the higher rates of income tax and unless the business makes a loss, the profit will still be available to draw on in later years. This can be useful for freelancers and contractors who might want to build up cash in their company so they can take a break from work but still continue to draw down dividends. It can also be useful for cyclical businesses that have a couple of strong years but expect a couple of tougher years. They can smooth their dividends over the years (assuming sufficient post tax profits overall to support the dividends). Expenses There are subtle differences in the types of costs that are allowable for tax purposes and the way they can be claimed between the two types of entity, self-employed or limited company. As a director of a limited company you are considered an employee therefore can access a range of tax free benefits and perks. One of the most common of these is being provided with a mobile phone or a computer. So long as there is some business use these items can be provided tax free. As a sole trader you would need to add back to profits any private use element of any type of equipment. We have written a guide outlining some common sole trader expenses. It should be considered that in both types of business structure expenses claimed need to be wholly and exclusively for the purposes of the trade of the business. Pension payments The treatment of pension contributions made through a limited company is very different to contributions made personally. As a sole trader you can gain tax relief on payments into a pension but these amounts can be fairly restricted dependent upon your level of income. For an individual where income is below the higher rate tax threshold there is a tax benefit but this is added to your pension contribution by way of grossing up the contribution and the tax benefit is currently somewhat hidden in the short term as it sits in your pension fund. We have another article detailing how pensions work for the self employed. As a director the rules can be more generous, the company may pay a contribution into your pension of up to £40,000 per tax year (based on 18/19 rates) and more in some cases where there are allowances unused from previous years. Company pension contributions on the whole will usually also be an allowable cost for corporation tax purposes (HMRC look at the combination of salary, benefits and company pension contributions to ensure the total ‘remuneration’ is not excessive). Disclosure : we would always recommend discussing pensions with a pensions advisor before making any decisions as there are various rules and details to be aware of. Sideline business People often come up with an idea for starting their own business and want to try it out as a side business first whilst also holding down a job as an employee. Running the side business is fine to do as a sole trader if you’ve got a bit of room left in your basic rate tax band (i.e. if your salary is below £46,350). However, if you’re already above this level, any profit you make from your trading venture will immediately be taxed at 40% (or 45% if above £150,000). If you form a limited company, the tax rate on your profit will only be 19% and you can leave any profit in the company to avoid paying any further personal tax. On the other hand, if you make a loss in the early days of your business venture, you may be able to claim “sideways relief” as a sole trader. This basically means deducting the loss from your employment income and getting back some of the PAYE tax you’ve paid. If you have traded as a limited company, you will not have this option, but will be able to carry forward the loss in the hope of setting it against future profits. IR35 (employment status) It’s important to be aware of IR35 which is legislation around employment status when you trade through a limited company – this is something that particularly affects contractors and freelancers. We have a detailed IR35 guide, but if you are concerned that there is a risk that you may be caught by IR35 and could potentially be seen by HMRC to be an employee of your client then being a sole trader could be a better route, if the client allows. Conclusion You can see from this article that choosing between a sole trader or limited company involves many tax and non-tax issues. Overall, trading as a limited company can offer benefits of both security and tax advantages at certain profitability levels, however every business is different and a one size fits all approach is not suitable. We strongly recommend that if you are considering a sole trader vs limited company that you seek the advice of an experienced and qualified accountant to advise you on your specific circumstances.