Sole trader or limited company – when does it make sense to make the change?

It is common for an individual starting a business to operate as a sole trader. It is quick, simple and with very few reporting requirements. But as a business grows the sole trader structure is rarely a suitable long-term solution.

The approach below outlines the reporting and tax approach of sole traders and limited companies and explains when it makes sense to change your corporate structure.

Sole traders

The Government’s Department for Business, Energy and Industrial Strategy (BEIS) reports that in 2022 some 3.1m people operate their business model through sole trader arrangements. It is easy to understand why.

A sole trader needs simply to complete an online form with HMRC registering as self-employed. All earnings will be taxed as income, Class 4 and Class 2 National Insurance contributions and paid to HMRC. There is no need to file accounts, just the requirement to submit a self-assessment tax return to HMRC once a year.

For small or micro businesses this is often enough – you keep full control over the business and keep all the money.

However, being a sole trader does have its drawbacks. You will be taking on all the risks and will be personally liable for any debts. It can also be very difficult to raise finance, for example, a bank loan to grow the business or to help with cash flow. And as the name suggests, it is not possible to start and run the business with a partner.

Depending on the nature of the business it can also be challenging for some sole traders to sell their products or services to clients to customers due to the fact there is less credibility and reputation compared to a limited company.

Limited companies

The sole trader structure is typically less tax efficient when an individual starts earning higher profits as the income tax rates are 20% and, for higher rate taxpayers, 40%. When you start to hit the higher rate of income tax it will often make sense to start thinking about transitioning to a limited company.

There are good tax reasons for doing so with greater flexibility in how a director of a limited company can extract remuneration via salary, dividends and pension contributions. The tax a director pays will typically be less when compared to a sole trader. And if profits remain below £50,000, they will be taxed at just 19%, rising to 25% when exceeding £250,000 with a marginal relief calculation between those ranges.

Importantly, a limited company offers its directors a greater degree of protection should the company fail; it is considered a separate legal entity with losses limited to what a director contributes into the company. Directors will not be personally liable for any further debts. Given its structure, you can set the company up with friends and family.

Limited companies can also benefit from a wide range of tax-free benefits and other tax reliefs, including R&D tax credits, that are not available to sole traders. Directors will find it easier to raise finance with the banks due to their higher credibility and legal protection to support growth.

Finally, and importantly, limited company structures provide in the longer term more sustainable routes in terms of inheritance and exit strategies.

But a limited company does come with additional compliance responsibilities and costs, especially in terms of setting up the entity and the need for a separate business bank account. You will need an accountant to prepare the company’s annual accounts and corporation tax returns. In addition to potential PAYE schemes, directors will also be required to make tax returns if they take dividends. Limited companies’ statutory accounts and information will appear on Companies House open to public scrutiny.

For ambitious companies, there will come a point when adopting a limited company structure is essential. It is important to speak to an accountant who will be able to assess your circumstances and advise you on the best structure to fulfil your goals in business.

Sole trader or limited company – the tax perspective

When does it make tax sense to switch from a sole trader to a limited company model? In all examples we have used the 2023/24 tax rates and have assumed the director takes the minimum salary up to the personal allowance (£12,570) and the rest as dividends. For 2023/24 the dividend allowance is £1,000 where you pay no tax on this amount.

In a Limited company the Director Shareholder can choose their remuneration method for flexibility and can decide when to take money out or reinvest back into a company but the sole trader is always taxed on the profits they make regardless if they take them or not. But from the table, you can see as the profits increase, the company route is the more tax efficient option.

If you would like to discuss this in more detail, please do get in touch.