Sole trader vs limited company for freelancers?

 In Contractors & Freelancers

How do you know which option is best, and when is the right time to change from one to the other? Let’s take a closer look at the pros & cons of each.

Big or small, every business has to have a legal structure for tax purposes. The vast majority choose to establish themselves as a sole trader or a limited company.

For freelancers, both options offer benefits, but the choice can be confusing. 

Each scenario has potential benefits and drawbacks. We’ll aim to demystify them here.

What does sole trader status involve?

Sole trader is the simplest type of business structure — which is probably why it’s the most popular, with an estimated 3.4 million operating in the UK. You can set one up on the GOV.UK website. As the name implies, a sole trader is the sole owner of their business and also considered self-employed.

That’s why people usually start their freelancing career as a sole trader. Registering a new sole trader business is easy and paperwork is minimal. Any business’ profits are yours to keep after tax has been paid – though any losses the business makes are yours as well. 

As earnings stabilise and grow, many sole traders look to limited company status as a natural next step. By doing so, they can often pay less tax while making themselves appear more established and legitimate to larger clients. 

What does it mean to become a limited company?

A limited company is a distinct legal entity that exists separately from its managers and owners. When the limited company is run by just one person, he or she acts as both shareholder (owner) and director (manager). 

As a freelancer with limited company status you are entitled to be paid a salary, and also receive dividends from any profits the company makes. 

The law requires you to submit a number of tax returns and file accounts with HMRC and Companies House each year. As a director you assume full responsibility for ensuring all returns and filings happen within the set deadlines — with stiff penalties if you don’t. 

Depending on the size of client budgets and complexity of the freelance work being performed, becoming a limited company can make it easier to expand by adding associates or bringing in other managers.

Staying put as a sole trader – what are the advantages?

  • Accounting for sole traders is simple and straightforward. You have less paperwork to worry about, fewer expenses to track, fewer tax returns, and no requirement for annual account filings to Companies House.
  • Sole traders can keep their business affairs private. Limited companies are compelled by law to make some information about their business available to the public, for example, listing the names of directors and shareholders. Sole traders face no such requirement.
  • Sole traders can sidestep much of the administrative load that limited companies have to carry. Limited companies have to submit corporation tax returns, VAT returns (if the business is above the VAT threshold of £85,000 per annum), and file annual accounts. Sole traders only have to complete and submit an annual self-assessment return.

Making the jump to Limited Company – what are the advantages?

  • You could pay less tax. By moving to limited company status, you can minimise what you pay in income tax and National Insurance Contributions. You’ll pay a 19 per cent Corporation Tax on company profits, and can use dividends alongside salary to further optimise your tax bill. Dividends are taxed from 7.5% for basic ratepayers. 
  • Expenses are tax deductible. As a limited company, you also get to claim more business expenses: business travel, mobile subscriptions, meals & subsistence when working away from the office, and more. Those expenses can be deducted from profits and as such won’t be subject to tax.
  • Your personal assets are protected. Because the limited company is a separate legal entity, if you face financial difficulties or experience a negative trading situation and need to close, your personal assets can’t be taken from you to pay creditors.
  • More credit options. If sole traders need to borrow money for their business, it has to be done off the back of their personal credit rating. Limited companies can have credit ratings that are separate from their owners, which can then be used to support borrowing to invest in growth.
  • More business opportunities. Some large corporations have procurement rules that require them to work exclusively with limited companies, while many others prefer to avoid working with any unincorporated business. Establishing a limited company helps seed confidence that you are established, stable, and a safe pair of hands that will be around for the long term.

Still unsure which option is best for you?

When you’re starting out as a freelancer, adopting sole trader status usually makes the most sense. Your tax and accounting responsibilities are more straightforward – and accounting fees or software costs tend to remain low. When your earnings start to pick up, that’s when the benefits of limited company status become more attainable.

If you need help deciding whether to stay put or make the move to a limited company, contact us.

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