One of the most important decisions you can make when starting a new business is its legal structure. Should you operate as a sole trader or a limited company?
The structure you choose will affect many aspects of your business, including your tax position, your personal remuneration, your legal liability and legal responsibilities.
To help you make an informed decision, this brief guide sets out the main differences between the two business structures: sole trader or limited company.
However, the decision is not a simple one and many factors can influence your choice, so it may be important to take professional advice on legal and financial implications from a small business specialist like Accounts & Legal.
If you decide to set up a limited company, you must register the name of your business with Companies House. Registration of the business will also register your company for Corporation Tax at the same time.
When registration is complete, you will receive a Certificate of Incorporation. You will also need to create a written document known as the Articles of Association and file it with Companies House when you register your company.
This is a statutory legal document that forms the basis of your company's constitution. It defines your company's share structure and the rights attached to different share classes, details how the company will be governed, outlines rules and protocols for the appointment and removal of company directors and defines the procedures and provisions concerning the sale or transfer of company shares.
As a sole trader, you will be a self-employed person and you will own your business.
If you set up a limited company, you will be a director of the company but you may have to share ownership of the business with other shareholders.
Although you are a director of a limited company, you are classed as an employee for tax and National Insurance purposes.
As a sole trader, you can pay yourself a salary from any net profit you make on your business. All of the profits are yours to pay a salary or reinvest funds in the business.
If you are a director of a limited company you can pay yourself a combination of salary and dividends. As dividends are taxed at a lower rate, this will reduce your tax bill and provide a more tax efficient method of remuneration compared with salary alone.
There are also other ways to take money out of the business as a director, including bonus payments, pension contributions, directors’ loans and private investments. We explain these in an article ‘What is the most tax efficient way to extract cash from your business?’.
It’s important to prepare for your financial future even if you are fully involved in running and growing your business.
Sole traders must make their own provision by taking out a personal pension and making regular payments, which are eligible for tax relief. They are therefore an efficient way of reducing your tax bill.
In a limited company, you may be able to take advantage of a company pension scheme as well as investing funds in a private personal pension scheme.
Financial reporting is straightforward for sole traders. You submit details of your income and allowable business expenditure on your annual self-assessment tax return. You do not have to prepare or submit full accounts, although it can be useful to prepare them so you have a better understanding of your financial position.
Limited companies have to prepare and submit a full set or an abbreviated set of statutory accounts to Companies House in accordance with recognised accounting practice.
Read More: How To Read A Company Balance Sheet
The financial measure of the success of your business is the profit it makes – the surplus of income over allowable business expenditure. Whether you are a sole trader or director of a limited company, you pay tax on those profits.
As a sole trader you pay income tax and National Insurance contributions on the profits of your business through an annual self-assessment tax return. To arrive at your taxable profit, you can claim a range of allowable expenses. The rate of income tax and National Insurance contributions is equivalent to that of a private individual and includes the same personal allowances.
A limited company pays Corporation Tax, which is also based on income minus allowable business expenditure. However, Corporation Tax rates for smaller businesses are lower than the equivalent income tax rates and companies can claim a wider range of allowable expenditure.
Don’t forget that, as a director of the company, you may also be liable for personal income tax and National Insurance contributions, depending on the type of remuneration you take.
Read More: Profit And Loss Forecast Template & Guide
One of the most important differences between sole trader and limited company is the scope of personal liability.
As the name suggests, the directors and shareholders of a limited company have limited liability for debts or losses incurred by the company. That means there is no personal liability and less personal financial risk if you form a limited company.
For a sole trader, the opposite is true. You are personally responsible for any debts or losses and you may have to use your own money to cover any debts. The personal financial risks are therefore much higher.
Whatever your chosen structure, you have a responsibility to operate your business in accordance with the law. It’s also important to take out certain insurances such as public liability, product liability and professional liability policies to protect your business in the event of legal action.
Directors of limited companies have additional responsibilities, known as fiduciary responsibilities. Apart from preparing and filing annual accounts in line with accounting standards, you must also ensure you make decisions in line with the interests of the company, avoid any conflicts of interest and exercise care and due diligence.
There is also a greater administrative burden for limited companies, which can be time-consuming and distract you from taking the business forward.
If you run a limited liability company, competitors, lenders and other interested parties can access information about your business from records held at Companies House.
As a sole trader, your business affairs have greater privacy.
Depending on the nature of your business, clients and prospects may take image into account when assessing you as a supplier.
In general, a limited company would be regarded as a more substantial operation and that may be important if the client is looking for scale of resources and long-term commitment.
However, if you are a sole trader providing specialist services, size of business may not be important when it comes to winning contracts.
Lenders may also take the size and image of the company into account when assessing your business for finance.
Although you start your business as a sole trader, you may find there are limitations as your business grows. For example, you may want to access finance for growth, you may want to increase your personal earnings or you may want to reduce personal financial risk — challenges that may be easier to overcome if you are running a limited company.
It is possible to change structure from sole trader to limited company and we have published this article, which explains the options available to you.
Making a decision about the right structure for your business can be complex and must be based on sound business and financial principles.
If you would like advice on the most suitable structure for your business, our team of experienced small business advisers and accountants will be glad to help.