What you want to know is whether you should set up as a sole trader or a limited company. On most occasions, we recommend a limited company.
And in this article, we’re going to explore why. Setting up a limited company doesn’t offer all the advantages it did ten years ago. However, for us, the benefits that incorporation brings are still worth it if you want to take home as pay between £20,000 and £100,000 – but only just. If you earn more than
Let’s look at the arguments on both sides. First, we’ll consider how you’re taxed on £50,000 worth of profit in your first financial year.
What about taxes on profits when you are a sole trader?
When you’re a sole trader, you pay tax on any profits you make. Without wishing to state the obvious, your profit is the difference between the sales you’ve made and the money you’ve spent. The taxman considers your profit as your income.
If you have £50,000 worth of income or profit in your first year of trading, you’ll pay 20% on any amount between £12,500 and £50,000 (£43,430 in Scotland). Above £50,000 (£43,430 in Scotland), you’ll pay 40%. The first £12,500 is not subject to income tax – this is your annual personal allowance.
There are also two different types of National Insurance to pay – Class 2 and Class 4.
BusinessCostSaver tip – the Government have floated the idea over recent years of abolishing Class 2 National Insurance. At time of writing however, no such plans have been presented.
For your Class 2 insurance, you’ll pay £156.00 over the year.
You’re also taxed with Class 4 and that’s based upon your profit/income. You’ll pay 9% on your profits between £8,164 and £50,000 this tax year and 2% on any amount over that.
So, out of your £50,000, what do you have left?
You’ll pay £7,500 in income tax, £156.00 in Class 2 National Insurance, and £3,723.12 in Class 4 National Insurance.
You’ll pay a total of £11,379.12 in tax, leaving you with £38,620.88.
If you set up as a limited company, how would the situation differ?
What about a Limited Company?
When you operate a limited company, you extract cash differently. There are two “incomes” which are taxed – the income the business makes (in corporation tax) and the income you make (in income tax, national insurance, and dividend tax).
For this article, we’re going to assume that the business makes £50,000 in its first year and the shareholder/director of the business has no income from other sources.
Most shareholding directors pay income tax. They also have a personal tax allowance every year of £12,500.
Limited company shareholding directors do not pay Class 2 or Class 4 National Insurance. They are classed as company employees so they pay Class 1 National Insurance.
For many shareholding directors, the majority of their pay is made up from a “dividend”. A dividend is a payment related to their shareholding in the business and the profit that business has made.
Working with your accountant, we devise the best “split” of income tax, Class 1 National Insurance, and dividends to ensure the tax both you and your company pay come to less than what a sole trader pays.
So, back to your limited company which has made £50,000 profit in its first trading year.
We would recommend that you pay yourself £8,632 in salary. This is the maximum amount of salary you can take home without paying any income tax or National Insurance.
BusinessCostSaver note – as you’re an employee, your limited company is liable to pay National Insurance Employers’ Contribution on your salary. However, by paying yourself £8,632, your Employers’ Contribution bill will be £0.
Your salary is considered a business cost so you can take the £8,632 you’re paid in salary from your profits. You’ll pay 19% corporation tax on what’s left. So, on the remaining £41,368 (£50,000 minus £8,632), your company tax bill will be £7,859.92.
Minus your salary and minus corporation tax, you’re left with £33,508.08.
You still have £3,868 of your personal allowance left for the year (that’s the £12,500 personal allowance you have minus the £8,632 you’ve taken in salary) which you can take off the £33,508.08, leaving you with £29,650.08.
You can pay yourself this £29,650.08 as a dividend. Your first £2,000 of dividends are tax free and, given the size of your salary and dividend in this example, you’ll pay 7.5% tax on the £27,650.08 not covered by your annual dividend allowance.
Your dividend tax bill for the year will be £2,073.01.
BusinessCostSaver note – anything you pay yourself in salary reduces your profits. Anything you pay yourself in dividends does not affect your profits.
So, what’s remaining?
From your £50,000, you paid £8,632 in corporation tax and £2,073.01 in dividend tax, leaving you with take-home pay of £7,859.92.
In this example a limited company wins.
A sole trader would keep £38,620.88 of his or her £50,000 income/profit. A shareholding director would take home £40,067.07. That’s a difference of £1,447.07 that stays in the shareholding director’s bank account and the taxman doesn’t get a claim.
From purely a taxation point of view, in most cases, it’s better, even for small, one-person companies, to run as a limited company than be a sole trader. But, the higher you earn, the picture flips the other way.
Let’s look at some other examples – £10,000, £40,000, £70,000, £100,000, £200,000, and £300,000.
These would be what a sole trader takes home at these levels –
|Class 2 NICs||£156.00||£156.00||£156.00||£156.00||£156.00||£156.00|
|Class 4 NICs||£165.24||£2,823.12||£4,123.12||£4,723.12||£6,723.12||£8,723.12|
For a shareholding director, this is how we’d split the same figures…
|Tax on Dividend||£0||£1,465.51||£5,373.03||£13,270.53||£43,774.47||£74,635.47|
So, how do they compare?
|Better off by||£53.76||£1,288.01||£3,631.49||£2,632.99||£502.65||£2,358.35|
If the figure is around £70,000, being a shareholding director is better than a shareholder.
As income rises into six figures, there’s a cigarette paper between the two but still in favour of incorporation. When we get to £200,000, you’re only £502.65 better off as a director. At £300,000, you’re £2,358.35 better off as a sole trader than a shareholding director.
But, business is more than about taxes.
Are you giving up any benefits being incorporated?
If you’re a sole trader, your income and profit are considered essentially one and the same thing.
If you’re a shareholding director, profit is what your company makes and income is what you personally make.
Taking out money
For sole traders, extracting cash from the business is easy. You can take money out of the business and incur no additional tax for taking it. All you need to do is make sure you have the money for HMRC when it becomes due.
With a limited company, any money you draw you have to take out as either salary or dividends. There is paperwork and process behind both. You can only withdraw dividends from retained profit. If you’re not showing a profit, you can’t take out dividends.
Borrowing from the business
As a sole trader, you can borrow money from your business with no tax consequences. If your personal borrowing takes your business account into overdraft, you can even claim tax relief on the bank charges and interest you incur.
If you borrow money from your limited company and don’t pay it back within 9 months, you have to pay a tax charge of 32.5% to HMRC – more if the loan is interest-free. Getting it back can take up to 9 months after the end of the tax year in which the loan is made – so you’ll be waiting a long time before you see it again.
For most sole traders, accounting is very easy. If your turnover is less than the VAT threshold (currently £85,000), you can do a simple three-line set of accounts. Sole traders often work on cash accounts too – much easier and cash flow friendly than accrual accounting.
If you run a limited company, you must complete annual accounts and submit them to Companies House and HMRC. Your accounts must be prepared to generally accepted accounting standards – that’s going to be more expensive for you than if you were a sole trader.
Treatment of losses
As a sole trader, you can offset your trading losses against any other income streams you have (subject to a cap of £50,000 a year or 25% of your adjusted income if you’re earning £200,000 a year or more, whichever is the greater).
A limited company can only offset its trading losses against other company income but not against your income as a shareholding director.
Running a limited company is more complicated and expensive than being a sole trader, but being a sole trader also has some big downsides.
What benefits are open to limited companies that aren’t open to sole traders?
Other than taking home more money as a limited company shareholding director, a benefit which increases as the amount you make goes higher, why should you incorporate?
If the business fails
If you’re a sole trader and you become insolvent, you’re personally liable for all debts and you will be chased for them, maybe even into bankruptcy.
For limited companies, the situation is different. Your liability is limited to the amount of unpaid share capital in your business (which could be as low as £1). Unless you have traded while insolvent, you are protected personally against all claims.
BusinessCostSaver caveat – this is true in theory but rarely true in fact. Firms that extend credit to your limited company (like a loan or finance on an asset like plant or machinery) may require you to sign a personal or director’s guarantee. Some landlords may require you to do the same. Basically, if it doesn’t work out and the company becomes insolvent, you’ll be chased for the money as if you were a sole trader.
BusinessCostSaver caveat 2 – if you have borrowed money from your company and have not paid it back, this is what’s known as an overdrawn director’s account. An insolvency practitioner will, in most cases, attempt to force you to pay back the overdrawn director’s account in full to pay back to the creditors of the company.
More control over money
As a sole trader, all of your income is taxed at up to 45% – it’s that simple. You can’t go back to the taxman and ask him if it’s OK to pay 45% on one amount of money but nothing on another because you might want to invest it in something later.
With a limited company though, you can leave money in the company bank account to accumulate, once your corporation tax of 19% has been applied. You can effectively shield the cash that is left after corporation tax and take it as dividends at a later time (when it could potentially be more tax efficient to do so). You would also have the option to reinvest the funds into your business at a later time.
This flexibility on how to use money out of a limited company extends into pensions too.
As a sole trader, you can only have a personal pension. Over time, the amount placed into your pension pot is likely to be much smaller than for a limited company shareholding director. The tax reliefs you can benefit from aren’t that substantial.
That’s because with a limited company pension scheme, both the director and the company contribute to a pension pot. You have a yearly pension limit of £40,000 and your limited company could make a substantial contribution to that figure. Better still, any contribution your company does make can be taken from your profit figure to reduce your corporation tax bill.
Also, limited companies can have access to more complex but customisable pension plans like SIPPS and SAAS. However, this is not really a consideration until your business achieves a certain size.
As a sole trader, you can claim against mobile phones and computers but only partially. If registered to a limited company, you can deduct the cost of mobile phones and computers from your business profits and pay no personal tax on them.
And for limited companies, the list of tax-free benefits goes on – car parking charges, childcare, home phones, public transport (including up to 60 taxis a year under certain conditions), medical check-ups, school fees, and travel. You can even claim £150 on personal entertainment every year and take up to £1,000 for yourself after 20 years as a long-service award.
As a sole trader, you can’t charge yourself rent but a limited company can rent space in your home for you to work in to offset your mortgage interest and council tax! However, you will have to declare the rent your company is paying you on your Self Assessment.
If you are a sole trader, you can deduct a portion of your house costs including mortgage interest, council tax, utilities, and so on. Check with your accountant before making these deductions though as they can be challenged.
So which direction do I take?
Every business’s needs are as different as the needs of the men and women who own and run them.
It’s best to speak with an accountant as soon as possible. Talk us through your business and how it will run. Tell us what you want from it. Using all the information you give us, we can then give you what we believe to be the very best advice.