Sole Trader vs Limited Company

The Basics

The tables below enable you to compare and contrast the Sole Trader and Limited Company structures so that you can see what the differences are and what it means for you. Read through them carefully and then discuss it with your accountant.

What is it?

Sole Trader

Limited Company

There is no legal difference between you and your business A separate legal entity (an artificial legal person), distinct from you
The money you make belongs to you and is counted as your personal income The money the company makes through trading belongs to the company

Being a Sole Trader means there is no legal separation between you and your business. You trade on your own account so the money you make belongs to you and counts as your income.

Using a Limited Company means buying or creating a separate legal entity, like an artificial legal person. This trading vehicle owns assets and makes money. It is taxed separately from you.

What is my legal liability if something goes wrong?

Sole Trader

Limited Company

Total. (That’s everything). No legal separation means that everything you own is at risk if your business goes wrong You can manage this risk with insurance Limited to your investment in the business. (but Directors have other risks). This is no protection from stupidity – if you borrow against your house to start a business and the business fails, you will still lose your house

What’s my employment status?

Sole Trader

Limited Company

You are self-employed You now have three roles. You are a director. You are an employee. You are an employer. Each role comes with a set of responsibilities and rights

Sole Traders are “self-employed” but if you work for a Limited Company (even your own) then you are an employee. Watch your language here, especially when talking to a government department. Be clear on your employment status because it affects your tax and NI.

How does the money work in this legal structure?

Sole Trader

Limited Company

Remember that the money you earn is yours… Remember that the money you earn belongs to your company…
Because the money is yours, you record it on your tax return: (Sales minus Expenses = Profit or Loss) You could: * Pay yourself a salary. * Claim your expenses. * Have your company contribute to your pension plan. * Share profits with the business owners in the form of a dividend.
This profit is your income and you will pay income tax on this profit (This ought to worry you) You may pay income tax on your salary. Your company will pay corporation tax on any profits

Sole Traders account for their business on their Self Assessment Tax Return using the Self Employment pages.

You enter your sales (business turnover)

You then list your expenses under various categories

Your sales minus your business expenses then becomes your trading profit. Because you are trading as an individual, this counts as your personal income

With a Limited Company the money does not even belong to you. All the invoices have been in the company name and it holds the money. So, how do you get your hands on it? You have four basic options…

The company can make employer’s contributions to a pension plan for you – you get the money later. Remember this is a business expense for your company

The company can pay you a salary – again, this is a business expense

You should claim reimbursement of expenses because everything the company pays for reduces the need to pay salary (and potentially income tax)

If profitable, the board of directors (usually you!) can pay a dividend to shareholders (usually you!)

That’s great but how is this money taxed?

Sole Trader

Limited Company

Income Tax Income Tax Corporation Tax
First

£8,105

0%

Next

£34,370

20%

You choose your salary and therefore your income tax First £300,000 of profits taxed at 20%
Next

£107,525

40%

Over

£150,000

50%

Tax is due in January and July Tax due nine months after year end

You can see that as a Sole Trader you are going to be paying income tax on your net profits. So unless your income and expenses are evenly balanced, any profit above £8,105 will mean between 20p and 50p of each £ of profit going to the Revenue. If you already have other income that you pay tax on then your Sole Trader profits will be added on top of this, running the risk of pushing you into a higher tax bracket.

With a Limited Company, you choose your salary so you choose how much income tax you pay. Keeping your salary low however means that the company profits will be higher and your company will pay Corporation Tax on any profit it makes.

You can see from the figures that a profitable Sole Trader will pay more tax than a profitable Limited Company once profits go above £42,475. Below that figure you need to consider the impact of National Insurance (see later). That’s why a widely used structure for small companies is to pay a small salary and take the rest out as dividends. Companies also pay tax less frequently than Sole Traders.

Thankfully, in 2011, Corporation tax rates have fallen back to 20% making them the same as the income tax rate which applies to Sole Trader profits. Previously there were a number of deliberate, and somewhat spiteful, attempts by the Treasury to increase the tax on people who are enterprising enough to turn themselves into a Limited Company. This kind of “Personal Service Company” still looks attractive if:

Your work is a contract for services and will not be caught by IR35

You claim every possible business expense that you can

You minimise salary as low as possible and reward your shareholders with dividends

You look very closely at paying employer’s contributions to your pension plans as these are a business expense and act to lower your profits. This is particularly helpful near retirement as a useful percentage of the pension pot can be drawn as tax free cash

In general, dividends attract a lower income tax rate than salaried income and they are free of National Insurance which makes them a very effective way of sharing the profits of a successful company.

Be careful…

The most widely used structure for smaller businesses making decent profits is to be a Limited Company, paying a small salary, claiming expenses and taking the rest as dividends. Please use an accountant to help you with this. A wise accountant can help you set this up properly to minimise your tax bill. This becomes even clearer when we turn to look at…

National Insurance (the hidden tax)

Sole Trader

Limited Company

Remember – NI is really income tax
Class 2 = £2.65 a week Employees NI Employers NI
Class 4 = 9% of all profits above £7,605 12% of salary between £7,592 and £42,484 13.8% of all salary above £7,488
Class 4 = 2% of all profits above £42,475 Then 2% of the rest
(Yes, that’s income tax AND national insurance on your profits) You choose your salary so you choose your NI bill

Sole Traders pay…

A fixed weekly charge then face a further NI charge on their profits ON TOP OF the income tax they have paid. This means that when your profits go above £8,105, you will pay a combined income and national insurance tax of 29p in the pound then 42p and 52p at the higher rate.

It’s important that you put this money aside every time you make a sale so that you have it ready to pay the tax demands in January and July each year. A good rule of thumb is to put aside 25% of each sale because this allows for the deduction of expenses and will probably leave some left over. It’s always better to have spare money than be looking for money to pay a tax demand you haven’t planned for.

If you are going to be self employed it is also a very good idea to pay your Class 2 contributions because they entitle you to a handy range of state benefits.

If your Limited Company pays you…

…a big salary then you have BOTH an employer’s and employee’s NI contribution to make. This is a disaster as your tax bill would be 20% + 12% + 13.8% (45.8%) at the lower rate and 40% + 2% + 13.8% (55.8%) for a higher rate salary. At salary above £150k your marginal tax will be 50% + 2% + 13.8% (65.8%).

You can minimise your NI bill by keeping your salary small. Remember, the dividends you receive do not attract an NI charge but any salary you pay to yourself and others does! This is a good reason to think very carefully before employing someone else – not only will you have to deduct their tax and NI but you will have to pay the “employment tax” (Employer’s National Insurance) which is 13.8% of whatever they earn.

The obvious move here is to pay dividends instead of salary and to counter that there is now a slightly higher tax rate on large dividend payments. Get advice.

Build your NI record without paying contributions

One interesting quirk of the NI and Income tax system is that if you pay yourself more than the lower earnings limit (£107 a week) but less than the primary threshold (£146 a week) then your NI contributions are credited to you although you pay no deductions. This means that if for some reason you did want to keep your salary very low you would still maintain an NI record for things like state pension. Please confirm the current position with your accountant.

Use your accountant to help you plan the right balance of salary and dividends so that you minimise your tax bill.

Which NI Contributions pay for which benefits?

Class 1 national insurance contributions count towards contribution-based Jobseeker’s Allowance, Incapacity Benefit, Bereavement Benefits, Retirement Pension and Maternity Allowance

Class 2 contributions count towards the same benefits as Class 1, but Class 2 will not always count towards contribution-based Jobseeker’s Allowance

Class 3 (voluntary contributions) count towards bereavement benefits and Retirement Pension

Class 4 contributions do not count towards any benefits. However, you still have to pay these if you are self-employed and have profits over a certain level (see above)

Tax Table

Here is a simplified tax table for the financial year ended 5th April 2013.

Tax Effect Of Your Legal Structure – Year End 5th April 2013

Rates

Employed

Sole Trader

Ltd Co – salary

Ltd Co – dividends

Income Tax on rising profit / salary
0 – £8,105

0%

0%

0%

0%

£8,106 to £42,475

20%

20%

20%

£42,476 to £100,000

40%

40%

40%

£100,000 to £150,000

40% + gradual loss of personal allowance

40% + gradual loss of personal allowance

40% + gradual loss of personal allowance

above £150,000

50% and no personal allowance

50% and no personal allowance

50% and no personal allowance

National Insurance
Class 1 Employees £7,592 – £42,484

12% then 2%

12% then 2%

Class 1 Employers > £7,592

13.8%

Class 2 fixed

£2.65 week

Class 4 £7,605 – £42,475

9% then 2%

Corporation Tax – on profits
£0 – £300k

20%

£300k – £1.5m

Marginal relief

> £1.5m

24%

Other

Employers NI is a business expense but still ‘money out’

Dividends free of NI and attract a reduced income tax charge at higher rates (get advice)

This table is a summary of the tax position and does not constitute financial advice. Please consult an accountant before making any decisions based on this information. These rates only apply in the tax year ended 5th April 2012.

Notes for the tax table:

NI – 12% between primary threshold (£146 a week) and upper earnings limit (£817 a week). This means that you start paying NI earlier than income tax. 2% above upper earnings limit.

Sole Trader – income tax and NI are charged on profits not sales. Use expenses wisely to reduce declared profits. 9% between lower profits limit (£7,605) and upper profits limit (£42,475). 2% above upper profits limit.

Ltd Company – taking a salary means paying Employers NI as well as Employees NI so the most common structure is “small salary, big dividends”. Employers NI is deductible as a business expense. You still have to pay it but the cost will reduce your profits liable to Corporation Tax.

Personal Allowance Once salary rises above £100,000, the personal allowance reduces by £1 for every £2 of income above the £100,000 limit until it disappears completely at £113,950. You’ll then pay 20% on the first £42,475 and 40% on the rest. Couple this with new 50% tax rate at £150k and the uncapped Employers NI contribution and you can see why any entrepreneur earning a large salary from their business is in urgent need of good quality tax advice.

Please note that this is a vastly simplified table to show the principles involved. It does highlight the danger of using salary as a reward in your own Limited Company. What makes it so ineffective is the Employer’s National Insurance, which is really a surcharge on employing people – even yourself. It may be wise to pay some NI so that your pension and benefits record are up to date but keep it to a minimum. The most common structure for a Limited Company is ‘small salary, big dividend’

If you’ve had a big redundancy payment, here’s a tax tip

The power of making a loss

If you have received a redundancy payment in the same tax year that you want to start your business then using the Sole Trader structure to make a loss could be useful for tax planning.

Sole Trader

Limited Company

Your losses can be set against other personal income. Consider creating a loss to offset the tax paid on your redundancy payment A loss just carries forward into next years accounts
(if this sounds attractive or useful, please take professional advice about your situation from an accountant) A loss means that you can’t pay dividends unless you have retained profits from earlier years

How does this work?

Dave Gibson is being made redundant at the end of December. His package is generous and although some of it is tax free his company deducts 40% income tax from the rest. He knows that the tax year does not end until the following 5th April so he makes up his mind to earn nothing else in those three months. This might result in a tax refund. His accountant recommends that he goes one step further and starts as a Sole Trader so that he can pay all his start-up costs and expenses before 5th April. He makes sure that he doesn’t receive any income before the new tax year. The result of all this is that he makes a “loss” and this is offset against the income tax already paid. To his delight, the Revenue then refund most of the 40% tax that was deducted from his excess redundancy, just as his accountant promised. Speak to us if this is similar to your situation.