In this article we will look at the advantages of being incorporated versus those of being a sole trader. In many cases changing from sole trader to limited company can be advantageous but not always. There are several considerations but it usually comes down essentially to the amount of profit you are making. It would hardly be worth changing from sole trader to limited company if you were working part time and making just a few hundred pounds a week. Conversely if you were making thousands per week it would almost certainly be more beneficial to be a limited company. The other big advantage of running your business through a limited company is prestige. A company looks more professional and gives the impression of being a sizeable operation. So let’s examine in more detail.
A limited company allows an entrepreneur to keep their own assets and finances separate from their business. You are only liable for any company debts up to the level you’ve invested. It is therefore a good way to get investment without risk to your own personal wealth.
Unlike limited companies a Sole Trader’s personal and business financial affairs are treated as a single entity. The law makes no distinction between the business and the individual and the business owner is subject to unlimited liability. Should your business fail, you could potentially lose personal assets such as home, car etc…
2.1 Profit retention
When it comes to taking profits there are tax advantages that the limited company has over the sole trader. A sole trader is taxed on all earnings made during the tax year regardless. Whereas the business owner of a limited company has the option to retain post-tax profits within the limited company for distribution or investment later. For example imagine that a sole trader makes a £100,000 in a tax year, he will pay tax at the higher rate. Whereas the limited company owner making the same £100,000 will pay the corporation tax at 19% but could take a lower salary and dividends for himself and spouse and avoid paying tax at the higher rate of 40%. He/she could then access the cash in later years when they are earning less or have retired and are in a lower tax bracket. Sole traders will always be taxed on all their profits and income earnt in the current tax year.
A limited company can pay the owners dividends which are not subject to National Insurance contributions (NIC). This is a significant tax saving compared to the sole trader who pays NIC on all income. So, potentially as a company director and shareholder you can pay yourself a salary up to the current tax threshold and the rest in dividends thus avoiding NICs completely. Also, for the 2017/2018 tax year directors qualify for £5,000 tax free dividends which gives additional tax savings over being a sole trader. As a limited company you can consider sharing your shareholding with your spouse thus qualifying for another £5,000 tax free dividends and spouse’s tax allowance. Very beneficial if the spouse has no other source of income.
Directors of a limited company are considered to be employees whereas sole traders are self-employed and therefore cannot be an employee. The main advantage here is that because directors are classed as employees they can claim some of the employee perks that sole traders are unable to claim. For example the range of benefits that attract tax savings through salary sacrifice and the Cycle to Work scheme etc..
4. IR35 5% reduction for general expenses
Contractors who work through a limited company are allowed to claim a flat rate 5% reduction from their total IR35 income. This allows for the general administrative expense of running a business. There is no restriction on the use of this allowance and there is no requirement to prove this expenditure. It is in lieu of the general expenses for a contractor and can in many cases represent a profit. Contractors who operate as sole traders cannot make such a claim.
There are pension advantages for limited companies over being a sole trader. As a sole trader you can only have a personal pension. For a limited company, pension schemes are far more generous in terms of benefits and limits than a Personal Pension. Limited companies can have self-administered schemes (SAS) that have considerable flexibility and control over how it invests. Company pension contributions will also be an allowable cost for corporation tax purposes (subject to HMRC rules).
The current VAT threshold is £85,000. Sole Traders and Limited Companies are both subject to the same VAT rules.
7. National Insurance Contributions (NICs)
Limited company directors, pay Class 1 National Insurance and Sole Traders pay Class 2 and Class 4 National Insurance.
This article is not exhaustive but demonstrates that there are tax and profit advantages in setting up as a limited company at certain profitability levels. Making sure you get the right business structure is important from the outset and can cost you dearly if you get it wrong. If you are about to set up as a sole trader or limited company we at Tax Compute can offer a free no obligation consultation on choosing the right structure for your business. Whether it be sole trader, partnership or limited company we will ensure your business status is the most tax efficient and right for your business.