Sole trader or limited company?

For startups or entrepreneurs first venturing into a new business project, you might wonder whether to incorporate a business immediately or start off as a sole trader.

Read on to learn more about the differences between each business structure and when to opt for one over the other.

Understanding sole traders and limited companies

First, let’s define these two core business types:

  • Sole trader: A sole trader runs their business alone. It’s straightforward, offering complete control and direct profit access, but involves more personal liability for business debts.
  • Limited company: A limited company is separate from its owners or shareholders, and is run by directors (probably you if you’re the founder of a new limited company). This structure offers limited personal liability and more tax planning opportunities but comes with more reporting obligations and regulatory requirements, including preparing annual accounts and corporation tax returns.

Comparing tax implications

Taxation differs for sole traders and limited companies. Here’s how:

For sole traders

Sole traders pay income tax on their business profits and must file annual self-assessment tax returns declaring their annual income and expenses.

Similarly to PAYE earners, sole traders pay income tax on all their taxable profits. As a result, this business structure can often result in a higher tax charge for sole traders making over £50,270 per year.

For limited companies

Limited companies face corporation tax on their profits instead of income tax.
Even though the main rate of corporation tax has now risen from 19% to 25%, this is still significantly lower than the 40% and 45% income tax rates many earners face as sole traders

Eligible limited companies can also claim a range of tax breaks to reduce their corporation tax liability, such as full expensing relief or research and development tax credits.

As a director, you can receive dividends instead of or alongside a regular salary. Since dividends are often taxed at a lower rate, this can help reduce your own tax burden.

Weighing administrative responsibilities

The administrative responsibilities for sole traders and limited companies vary significantly.

Setting up as a sole trader is relatively simple. To become a sole trader, you must register for self-assessment with HMRC and submit tax returns declaring your income and expenses each tax year.

Accounting is often more straightforward for this business structure. While you are required to keep accurate business records, you will not usually need to provide detailed financial statements unless requested to do so by HMRC.

Running a limited company requires more paperwork and hoops to jump through, including registration with Companies House and various company secretarial duties. Other ongoing responsibilities include regular statutory filings and adhering to the Companies Act.

Evaluating liability and risk

Liability and risk also differ between sole traders and limited companies.
As sole traders, individuals are responsible for all business debts and liabilities. This direct connection means that if the business faces financial difficulties, the individual’s personal assets, like their home or savings, could be at risk.

One of the primary advantages of a limited company structure is the limited liability afforded to its shareholders. In this setup, the personal financial risk is generally restricted to the amount of money they have invested in the company. This means that your personal assets are usually protected in case of business failure.

Assessing flexibility and growth

Operating as a sole trader is a flexible option for entrepreneurs at the start of their business journey. Over time, however, it may become necessary to incorporate if you wish to keep growing your business.

Limited companies often have greater opportunities for raising capital. They can issue shares to attract investors, and their legal structure can make obtaining loans and other financing forms easier. Access to capital can significantly facilitate business expansion and growth.

Furthermore, limited companies are generally perceived as more established and credible. This is vital if you have big dreams for your business.

The bottom line: limited companies for business growth

The bottom line is that many growing businesses will benefit from a limited company structure. Here’s why:

More tax-planning opportunities

Incorporating your business can open up more opportunities for business tax planning. Paying yourself a director’s salary topped up with dividends can also help you minimise your personal taxes.

Access to funding

A limited company can access a wider range of financing options, including selling shares, taking out bank loans, and raising investor funding. Financial flexibility is vital for scaling operations, investing resources, and fueling growth.

Enhanced professional image

Incorporation often enhances a business’s credibility. This is essential for dealing with larger clients and forming business partnerships.

Clear separation of personal and business finances

A limited company clearly distinguishes between personal and business finances. This is essential for financial clarity, reducing personal financial risk, and making accounting more straightforward as the business grows.

Final thoughts

Your choice will shape your startup’s journey, influencing everything from tax obligations to growth potential.

Becoming a sole trader offers simplicity and control, ideal for smaller operations with limited risk. In contrast, a limited company provides growth potential, limited liability, and a professional image suited for businesses planning to scale.

As experienced accountants for startups, we can help you comb through the options and choose the one that best suits your venture.

If you’re stuck on which structure to opt for, get in touch with us today.

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