sole trader or company
In this article I am going to explain the main differences between being a sole trader and trading through a limited company. With Companies I am only going to talk about the main two, but they come under a heading of “Incorporated entities” (not to be confused with paranormal entities!) which covers charities, community interest companies, limited by guarantee, the list goes on… I'm also not going into off payroll working or the IR35 rules, this subject is far to lengthy to talk about here!
Choosing the structure of your new business is important, get it wrong and you could find you have an enormous tax bill that could have been avoided or even in extreme circumstances losing your home. So, what is a sole trader and limited company?
A Sole trader, often called, self-employed or (mostly in America) a Sole Proprietor. This is the most simple form of trading. To become self-employed all you have to do is fill in a form with HMRC and away you go. Sole traders are often sub-contractors, or freelancers, but you can also run something like a shop and have employees, but it might not be as efficient.
Tax is simple (in comparison to a company!). You report your profits every year to HMRC on a self-assessment tax return and you pay Income tax at either 20%, 40% or 45% (as at April 2019). There are a few rules on what you can and can't claim as expenses when working out your profit. (see the blog about business expenses).
However, you are personally liable for the debts of the business. This means, if the business runs up a debt, it's down to you to pay it off!
A limited Company is like a pretend person for legal purposes, so it is technically separate from you. It's owned by the Share holders and run by the Directors. If you own all of the shares, you own all of the company.
There are lots of different types of company and they are all registered at Companies House. The main two that people know are private and public companies. Public companies (Plc's) are the big guns, Tesco, Amazon & Google that kind of thing. It basically means anyone in the public can buy shares.
In private companies (Ltd) you cannot buy shares unless the owner(s) agree to it. Usually it's just you, or a business partner that will own shares in the company. When you register and incorporate your business at Companies House you will be issued (normally) 1 share at £1 each.
99% of the time you will be a private limited company.
Tax is more complicated, the company pays Corporation tax on its profits on a CT600 (normally), but if you take an income from the company you will also pay income tax. The rules are much more strict than a sole trader, For example, you can't just take money for yourself from the bank account, you have to take it in certain ways such as a salary and dividends.
It's usually more tax efficient to trade through a company, the tax rates are lower and you have more options for tax reliefs. You can also control your personal income. So, if you wanted, you would never pay tax at 40%.
A company offers more protection, if the company runs up a debt, it's normally the company's credit rating that is affected, not yours (although whether the company gets any credit in the first place may be down to your own credit rating).
Here is a quick table showing the main differences. Then I’ll show you a worked example of how the tax works (sorry there's a bit of maths involved!)
WARNING: THE NEXT SECTION CONTAINS NUMBERS
Let’s start simple (yep this is the simple bit!), you're a sole trader and you have profits of £50,000. Here is how roughly how much tax you'll pay for the 2018/19 tax year, rounded to the nearest whole number to make it a bit more simple, I'm also going to ignore Student loans but this could potentially add to your savings.
Minus personal allowance: (£11,850)
Taxable profit: £38,150
Basic rate tax @ 20% £6,900
Higher rate tax @ 40% £1,460
National Insurance £3,640
Total tax bill: £12,000
Now let’s look at a company, you first pay Corporation tax on your profits and your personal income is taken as a salary up to the point where you pay National Insurance, then you take the rest as a dividend.
Minus your salary (£8,424)
Taxable profit: £41,576
Corporation tax @ 19% £7,900
Total personal income £40,000
minus personal allowance (£11,850)
minus dividend allowance (£2,000)
Taxable income £26,150
Tax @ 7.5% £1,960
Total tax bill: £9,860
Using the same profit but a different structure saves £2,140 in tax!
This is essentially how the big companies end up paying very little or next to no tax, they structure the company so that they can move the profits to a more tax efficient location. I wouldn't recommend this for most small businesses, the cost of setting this up far outweighs the tax cost!