One of the biggest questions that can hold up starting your own business is whether or not you should trade as an individual (sole trader) or a limited company.
In this blog I will be highlighting the differences between the two in order to help you decide which way is right for your business.
A limited company is a separate entity
As a sole trader you directly earn the money from your business, your name is used on any purchase invoices and you are personally responsible if anything goes wrong.
Directly earning money is useful as you know that once you get paid the money is yours and you can spend it however you like. Any tax due has already been paid on your profits.
Being personally responsible for the business’ purchases and debts can also pose problems. If invoices become overdue or you fall victim to financial penalties, you could find yourself having personal belongings taken away to pay the debts.
By law a limited company is regarded as a separate person or entity which means any money made belongs to the company, as do any debts.
The upside being that if any action is taken to retrieve outstanding debts then your personal belongings would be untouched, with only company assets vulnerable to being seized.
The downside is that in order to have the money earned by the company available for personal use, you must draw it from the company which often results on you personally paying tax on it again after the company has paid its corporation tax on the profits.
A limited company is complex
A sole trader just has to fill in the relevant pages on their income tax return each year. Sometimes they may produce a simple set of accounts to help see how well the business is going but the tax return is the only thing that needs filing.
A limited company is more complicated, in addition to a company or corporate tax return, a set of company accounts must be filed each year with Companies House, as well as being attached to the tax return. There is also an annual return that needs to be filed to Companies House which in addition to the time spent, will cost you £13 in administration fees.
If you draw money from the company in the form of dividends you will also need to file an income tax return each year to show this personal income. Alternatively you will need to set up a payroll – if you do not already have one – if you wish to pay yourself a wage.
This makes limited companies more difficult, time consuming and expensive to keep up with compliance and obligations for accounts and tax.
Limited companies can help reduce tax
Unlike income tax for sole-traders, corporation tax for limited companies is always charged at 20%.
A sole trader pays 20% but only for taxable profits up to £31,785. After that the rate jumps to 40%, then to 45% once you reach £150,000 profit. You do get your £10,600 personal tax free allowance, but for larger profits it is clear that limited companies pay less tax.
As mentioned above, the profits leftover for a limited company are not technically yours but with some careful planning you can draw out a portion of profit to cover your basic tax rate band and leave any excess in the company to draw next year if things do not go so well. You can even draw it out at a rate lower than 20% if you use dividends.
There are also National Insurance Contributions (NIC) to take into account, as a sole trader must pay these on top of income tax at a rate of 9%. A limited company does not have to pay any NIC’s which cuts out roughly a third of tax due.
Financial year ends
Another difference is the year end of your business. Sole traders complete tax returns up to the 5th of April each year, so your financial year end would usually be on the 5th of April, or if it is on a different date, you still complete your tax return for the 5th of April following your year end.
The deadline for this to be completed is the 31st of January regardless of your financial year end. Any tax due needs to be paid on this date and if you have more than £1,000 tax to pay, you will have to pay the next year’s tax in instalments in the following year.
In addition, regardless of when you start, your first tax return has to be up to the next 5th of April, with your second tax return being for your financial year up to your year end. This results in a portion of your first financial year being double counted and you could pay extra tax. This tax can be reclaimed when your business ceases, but until then you have an amount of money that you cannot access which is never a good thing in a business.
For a limited company, your financial year end is the period you need to complete your tax return and accounts to, with accounts due to be filed with Companies House within nine months. Tax due must also be paid on this date, however the tax return can wait twelve months before being filed. So when you decide your financial year end for a limited company, you need to make sure you are aware of your annual deadlines.
A limited company’s name is protected
When you register a limited company, the name becomes protected preventing anyone else from using it. They may have a similar name or trading name but the official name will belong to your company as recognised by Companies House.
As a sole trader you can have a trading name, but this is not protected. To avoid someone else using the name you may have to copy-write it or seek legal advice, both of which can be costly.
Is it really set in stone to be one or the other?
The best thing about making a decision like this is that it isn’t a case of should your business be a limited company or sole trader, but more about which one is right for your business now.
It is common practice to start up a sole trader business and when the business grows, form a limited company to take over the assets and enjoy the tax benefits, while being reassured that you are making enough money to pay for the additional complexities.
In the same way a limited company that has been shrinking could wrap up and the owner can register a self-employed business until funds are at a level where he can afford to be a limited company again.
There are two ways to wrap up a limited company, the first is to dissolve the company, making it cease to exist. There is usually an administration charge of £10 made payable to Companies House to do this. You must be sure to transfer the assets from the business before you do this, (making sure this is done through official channels) because any funds remaining upon dissolution of the company will be frozen and become property of the crown.
The alternative method is to make the company dormant, this means the company still exists but is not trading. This is useful because you can reactivate the company at any time, retaining the company name which would still belong to the company during its dormant state. The only downside is that annual returns will still need to be completed for Companies House along with a simplified set of accounts known as dormant accounts. While dormant, a company will not have to file tax returns.
We are able to sit down with you and discuss these points if you feel you would like an outside opinion or more advice to help you come to a decision that will benefit you and your business. If you would like more advice or assistance regarding the above, please do not hesitate to contact us.