Tax advantages of a limited company versus sole trader

By Haydn Rogan on Small Business UK - Advice and Ideas for UK Small Businesses and SMEs

Being a sole trader means that you run your own business as an individual and are essentially self-employed. This is the most popular way of trading in the UK, with 3.1m sole proprietorships recorded at the beginning of 2023.

By contrast, a limited liability company is a separate legal entity to you, with separate finances.

Each option has its own advantages and disadvantages, and anyone starting out in business will need to decide what will work best for them.

Here, we look at some of the major differences in terms of legal liability, taxes and bureaucracy.

Also see: Should I go sole trader, partnership or limited company?

Liability

A key advantage of a limited company structure is that it ringfences your personal assets. If your business fails or is sued, you will only lose any investment in the business and won’t be personally liable for meeting charges such as litigation costs or damages from your own finances. Although, in some cases, lenders may require personal guarantees.

As a sole trader, you and your business are one single legal entity. You are personally liable for any debts and liabilities you incur in the running of your business, including taxes, putting you at greater financial risk should something go wrong.

However, the sole trader structure can offer some financial benefits.

Any losses you incur as a sole trader can be offset against your other income for tax purposes, something that can’t be done in a limited company structure as the company is a separate legal entity. For many business start-ups, where losses may be initially incurred while the business gets established and finds its feet, operating as a sole trader can provide an advantage by allowing you to offset any losses against other income to reduce your tax bill.

In addition, because your finances and those of the business are legally one and the same, it also means you can freely borrow from the business’ funds to cover personal expenses if needed. It is important to remember, however, that you will still be taxed on any profits you withdraw from the business.

Tax differences

Limited company taxes

Limited companies must pay corporation tax.

As of April 6, 2023 it’s 25 per cent, up from 19 per cent previously (the figure remains unchanged for the 2024/25 tax year). This applies to businesses with profits of £250,000 or more and applies to all profits. A small profit rate is in place for companies with profits of £50,000 or less. A system of taper relief is in place for companies whose profits fall between these thresholds – find out how much you’d pay using the government calculator.

There are potential further taxes payable when extracting value from the business, including income tax and National Insurance Contributions (NIC), based on the salary you decide to pay yourself (which will be deductible against company profits) and taxes on any dividends (paid out of post-tax profits). You do, however, have control over the timing and method of extraction.

Sole trader taxes

For sole traders the tax rules are different. You will pay income tax on the profits of your business regardless of whether or not you have extracted those profits for personal use or invested them in the business.

In the Autumn Statement 2023, Chancellor Jeremy Hunt removed the requirement to pay Class 2 National Insurance Contributions as of April 6, 2024, with a view to abolishing it entirely. Class 4 National Insurance Contributions will be reduced from 8 per cent to 6 per cent on April 6, 2024.

Until then, on top of income tax on the business profits, sole traders, being self-employed, must also pay Class 2 NIC (£3.45 a week in the 2023/24 tax year if the Lower Profits Threshold of £12,570 per year is exceeded) and Class 4 NIC (8 per cent on profits of the business between £12,570 and £50,270 in the 2023/24 tax year, and 2 per cent on profits over £50,270). You must also register for VAT if your taxable turnover is above the VAT registration threshold, which is £85,000 in 2023/24, rising to £90,000 for 2024/25. This is all calculated and reported to HMRC via the annual self-assessment process and completion of self-assessment tax returns.

Also see: 5 most common tax mistakes when you’re self-employed

Key differences

Due to the lower corporation tax rates, especially for businesses with lower turnover, limited companies are generally taxed less on their profits than a sole trader and therefore tend to be more tax efficient. This is especially so if the profits are invested back into the business rather than extracted, as profits ploughed back into the business are taxed at a lower rate than would be the case if a business operated as a sole trader.

Limited companies can also offer a wider range of tax-free benefits to directors and employees and open up access to certain tax reliefs that aren’t available to sole traders, such as R&D tax reliefs.

However, unlike a sole trader, money cannot be borrowed from the business’ bank account for personal use with impunity. Doing so in a limited company will be considered a ‘benefit in kind’ and carries potential tax ramifications.

Bureaucracy

While a limited company structure offers limited liability and potential tax advantages, it involves more bureaucracy to set up and manage, which you will either need to spend time doing yourself or paying others to do for you.

Overall, a limited company structure comes with more reporting requirements and, as a quid pro quo for the benefit of limited liability, the directors of the company have a wide range of duties and fiduciary responsibilities, which can, in turn, create additional costs and paperwork.

For example, as a director of a limited company you must register the business with HMRC and are legally required to set up a separate company bank account. Accounts must be prepared each year and submitted to HMRC – and they may need to be audited. This offers less privacy, as these accounts are publicly available to everyone online via Companies House, along with your details and those of any other directors.

However, the limited company structure offers greater flexibility in the way you can allocate shares and employ people, allowing you to issue shares in the company to spouses and family and/or appoint them as salaried directors to improve tax efficiency. A corporate structure can also help to create a more professional impression to your clients and suppliers.

Due to the additional formalities in forming a company, setting up as a sole trader is the simplest way to get your new business off the ground.

To become a sole trader, you must register with HMRC as self-employed. This consists of a straightforward online registration form. Timing does matter, however, since there can be financial penalties if you fail to register before the end of the relevant tax year once you’ve started trading.

Unlike in a limited company structure, as a sole trader you aren’t legally required to open a separate business bank account. That said, it’s generally advisable to do so in order to keep better track of business income and expenditure and assist in preparation of tax returns.

Sole trader profits must be calculated for each tax year (April 6 – April 5). Like a limited company, accounts (i.e. a record of business income and expenses) must be prepared to determine the profits of the business, but unlike a limited company they don’t need to be audited or submitted to HMRC, unless specifically requested.

It is possible to change from a sole trader to a limited company, and vice versa, but it is usually easier to start as a sole trader and incorporate later rather than the other way around.

Ultimately, it is important to think carefully about what works best for you and seek professional advice if you’re unsure. Having the right structure in place to suit your specific circumstances and ambitions will put you on a strong footing for future success.

Haydn Rogan is a tax law specialist and partner at national law firm Weightmans.

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