Sole trader vs. limited company: the key advantages and disadvantages

What are the differences between working as a sole trader and setting up a limited company? Mart Abramov of TaxScouts shares his thoughts on this to help you choose the most suitable business structure for your venture.

The UK has more self-employed workers than ever before, according to Direct Line for Business. As a result, more and more people are looking into what's best for their businesses, so they can make a decent living and increase their chances of success.

One of the most important decisions you need to make in the early days of setting up your business is whether you're going to go down the route of operating as a sole trader or setting up a limited company. They both have their advantages and disadvantages, which can make it difficult to choose the option that's best for you.

To help you with this, I'm going to explain how the two options differ and take you through some of the ways in which each could benefit you. Read on to learn more.

How do sole traders and limited companies differ?

Before looking at the advantages and disadvantages of the two options, we should look at how the different business structures work.

As a sole trader, you will be self-employed and have full ownership of your business. As a result, you'll be entitled to all your profits after tax but will also be responsible for any losses. You can set up as a sole trader through the government's website, and the process is relatively simple — you just need to ensure you do this within three months of starting your new venture. You won't be required to pay any registration fees.

If you decide to set up a private limited company, this will mean that the business is legally separate from those who run it. In addition to this, your company's finances will be separate from your own. You will need to register your business with Companies House under a unique name. Once this has been done, you'll be covered by limited liability, which means you can only be held accountable for debts up to the amount you've invested or guaranteed to the limited company. Now, I'll talk through some of the in-depth differences between the two and explain why one option might benefit you more than the other.

Sole traders have fewer business responsibilities

As you might expect, when you're working as a sole trader, you'll have fewer business responsibilities. For example, you won't be required to submit company accounts each year like limited companies are. The extent of informing the government about your income and outgoings will stop at you having to fill out your self-assessment tax return every year.

The owners and directors of limited companies must take on fiduciary duties, which include filing full annual accounts and tax returns with Companies House, as well as filing Corporation Tax accounts with HMRC. These accounts must always be in line with accounting standards, too, which means most limited companies find they need to hire an in-house accountant or enlist the help of someone from an external company.

As you can see, when you have a limited company, there's far more paperwork and hoops to jump through, and this can take up a lot of your time and energy. These are two things that are already going to be in short supply when you're starting out and trying to give your business the best chance of succeeding. So, it's important that you carefully consider whether you'll be able to handle the additional workload before registering as a limited company.

Limited companies will usually offer more legal and financial protection

Sole traders are given unlimited liability, so your business' financial and legal responsibilities will start and end with you. As a result, if your business accrues a debt, you will be personally pursued for the money, which could put you at risk of bankruptcy. Similarly, if someone decides to sue you, the case will be brought against you personally. Sole traders should always take out a suitable business insurance policy, as this will help to protect you. Depending on what kind of work you do, you might require public liability or professional indemnity insurance and, if you have staff, the law requires you to have employers' liability insurance.

A limited company is seen as a separate legal entity, so you won't be held personally accountable for any debts or insolvency. Likewise, as long as you have the appropriate insurance, any legal disputes will be brought against the company, rather than you as an individual. In this respect, registering your business as a limited company can give you more financial and legal protection than you would have as a sole trader.

Registering as a limited company might be more tax efficient

Sole traders are required to pay two types of National Insurance: Class 2 if your profits are £6,205 or more, and Class 4 if your profits are £8,424 or more. However, these rates are typically higher than they are for limited companies — especially if you begin earning £25,000 or more. If you find yourself in a higher Income Tax bracket, working as a sole trader could be a lot less tax efficient than registering your business as a limited company.

Limited companies are required to pay Corporation Tax on all forms of taxable income, which includes trading profits, investments, and chargeable gains. However, company tax rates tend to be significantly lower than the Income Tax some sole traders will pay. So, if you've moved in to higher tax bracket and are concerned that you're paying more than you need to, it's well worth considering whether registering as a limited company could help to keep your costs down.

Registering as a limited company will give you more pension options

When you're a sole trader, you don't have a lot of options when it comes to paying into a pension: you will have to set up a personal one. But, when you have a limited company, you can take out and pay into a company plan. The terms of company plans tend to be more generous than those of a personal pension. Just remember that, if you have a limited company, you will be required to offer a pension plan to all of your employees and must fulfil your auto-enrolment duties when hiring any new staff members.

Working as a sole trader and setting up a limited company both have their advantages and disadvantages. Choosing the right option for you is likely to depend on where you are in the process of running your own business, and what your biggest concerns are. For example, if you regularly feel like there aren't enough hours in the day and you're not sure you could take on any additional work at the moment, remaining a sole trader could be the best option as it requires far less paperwork. But, if you want to provide yourself with more legal protection and possibly even reduce your tax bill, registering as a limited company could be a great move.

With thanks to Mart Abramov, CEO of the digital tax advisors TaxScouts.