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The type of business structure that you trade through isn’t just a decision for startups. Sole trader is undoubtedly a popular gateway structure for many entrepreneurs starting their own businesses, but of course things change in time.
Businesses grow, earnings increase and a business structure that was once the right fit may no longer be suitable. Many sole traders will in time complete the limited company formation process with incorporation offering more benefits as their business evolves.
But many self-employed people start out on day one operating through a limited company. And some already trading may close down their limited company or let it become dormant and operate as a sole trader instead.
Understanding the advantages and drawbacks of each business structure is important to ensure that you choose the right one for your specific circumstances and goals and give your business the best chance of success.
In this post we’ll examine the differences between limited companies and sole traders, the benefits and drawbacks of each, when might be the right time to consider limited company formation and how Gorilla Accounting can help.
The Differences Between the Limited Company and Sole Trader Business Structures
Setup and Simplicity
Limited Companies: The limited company formation process is more complex than setting up as a sole trader. You need to select a unique company name that meets Government guidelines and appoint directors, shareholders and identify the persons with significant control. Memorandums and Articles of Association must also be produced to formalise the above and outline why the business was formed and how it will be run.
The business must be registered with Companies House for which a fee must be paid. To make the limited company formation process easier, startups will often engage a professional to handle it for them.
Sole Traders: It’s much simpler to start a business as a sole trader. You need to choose your business name and register with HMRC as a sole trader. There’s no registration fee to do this. It’s a good idea to also familiarise yourself with your tax obligations and the associated deadlines and open a business bank account to separate your business and personal finances.
The Legal Structure
Limited Companies: A limited company is a completely distinct and entirely separate legal entity from its directors and shareholders. This has various implications in terms of the level of financial risk and tax obligations.
Sole Traders: With the sole trader structure, the owner and the business are the same legal entity. This keeps things simple but means the owner bears personal liability for any business debts as well as all other aspects of its operation.
How You’re Taxed
Limited Companies: The limited company pays Corporation Tax, starting from 19%, on its taxable profits and income tax is levied on any salary and dividends that the directors and shareholders receive from the business. Through a limited company you can operate more tax-efficiently with more allowable expenses available to lower your taxable profit and the flexibility of utilising dividends, which are taxed at a lower rate than income tax on salary, as part of your remuneration package can increase take home pay.
Sole Traders: Things are simpler for sole traders who just pay income tax on the taxable profits of their business. This is generally less tax-efficient, however, and in the additional rate tax band the tax rate would be 45%. As a sole trader you don’t pay yourself a salary. Instead, you can withdraw funds from the retained profit in the business, known as a drawing.
Financial Risk
Limited Companies: Limited company owners and directors bear personal responsibility for any business debts only up to the amount of funds they’ve invested in the business. Known as limited liability, this provides a significant layer of financial protection and reassurance for those operating through an incorporated business that their personal assets are safeguarded should the business encounter financial troubles.
Sole Traders: Due to the business and the owner being the same legal entity, unlimited liability applies. This means sole traders have personal responsibility for any debts incurred by their business which are theoretically uncapped and can place personal assets at risk from creditors.
Your Personal Privacy
Limited Companies: As part of the limited company formation process and subsequent reporting obligations, certain information about limited companies and the stakeholders has to be disclosed to Companies House. This includes things such as the registered office address, details about the directors, late filing penalties and more and this information is on public record.
Sole Traders: Information about sole trader businesses and their owners remains private with the business owner in control of what appears in the public domain.
The Administrative Burden
Limited Companies: Administrative obligations for limited companies are relatively high with various statutory filing requirements needed including annual accounts and confirmation statements. Annual Corporation Tax returns are also required as well as self-assessment tax returns for those being paid by the company.
Sole Traders: The administrative requirement for sole traders is much lower with the primary responsibilities being the annual self-assessment tax return and the associated record-keeping. Using accounting software such as FreeAgent can help to simplify this and get you ahead of the curve with Making Tax Digital.
Business Perception and Growth
Limited Companies: Limited companies are generally perceived more positively by potential clients and investors. There are various reasons for this including the stricter monitoring and regulation, transparency and the image of stability and professionalism that incorporation exudes. This can be advantageous for limited companies when competing for new work or when seeking investment to fund growth. Limited companies also have the option of selling shares in the business to generate capital.
Sole Traders: On the flipside, sole traders can be viewed by some in a less favourable light which can put them at a disadvantage against limited companies, and for some clients it can be a prerequisite that you operate through a limited company for them to engage with you.
When Might a Limited Company Be The Right Fit?
The nature of the work you do and your income has a significant bearing on whether the limited company business structure is the most suitable. Here’s some examples of where that is the case.
Your Work Involves Significant Sums of Money: If the nature of your work involves large sums of money or you operate in an industry where there’s a higher risk of incurring debt or legal action being taken against you, the financial protection afforded by operating through a limited company makes it the sensible choice.
You’re a High Earner: If you earn, or expect to earn, a high income then a limited company structure can help you increase it further. When your business is incorporated you can significantly improve your tax-efficiency and reduce your overall tax liability whilst being compliant with your obligations meaning you can pay significantly less tax than a sole trader earning the same amount.
You Want to Grow Your Business: If you have plans to expand your business and achieve significant growth, operating through a limited company gives you significantly better options to raise capital. Lending institutions and investors will look at you more favourably making it easier to raise funds. Alternatively, you could raise equity finance by selling shares in your business.
When Might Personal Ownership Be The Right Fit?
Personal ownership is suited to many small business owners that benefit from the less onerous reporting obligations and don’t need the financial protection afforded by limited liability.
Contractors and Freelancers: Sole trader is an ideal fit for many self-employed people such as contractors and freelancers. It’s a popular structure for freelancers working in sectors such as graphic design, development and copywriting, for example, with the ease of setup and low admin requirement making it attractive to those that want to keep things simple.
Part Time Businesses & Side Hustles: Smaller part time businesses or larger side hustles are a great fit for the sole trader structure. Examples include craft businesses, musicians and sellers on platforms such as Etsy or Vinted where owners might fit their business activities around a full-time job. The minimal business admin is beneficial and they don’t need the financial protection or tax advantages afforded by incorporation.
You Work in a Trade: The sole trader business structure is popular with tradespeople such as gas installers, electricians and plumbers due to its overall simplicity.
Limited Company Formation With Gorilla
Whether you’re just starting your business and want to operate through a limited company immediately or you’re a sole trader that’s decided to incorporate, Gorilla can complete the limited company formation process for you and expertly manage all your business and personal accounting needs.
We can of course advise you on which business structure best suits your circumstances and business goals, and if you decide to incorporate, our limited company formation service will expertly handle the entire incorporation process for you from start to finish. We can even have your limited company set up the same day!
And once you’re trading, our limited company or sole trader accounting packages ensure that all your business and personal accounting needs will be expertly managed whichever business structure you choose. If you’d like to learn more, please request a callback today.
