Limited Company or sole trader – which is better

Most businesses start their life as a sole trader.  As they grow they may evolve into partnerships or be turned into limited companies. Just because this often happens does not of itself mean that all business should be started as sole traders.  Sometimes there will be reasons to set up a limited company from the start.  This decision must be taken having considered all the implications, and not just because some public servant or guy down the pub suggested it.

The most important distinction between a limited company and a sole trader is the word ‘limited’.  It refers to the financial liability risked by those involved in the business.  If you set up a company then your personal financial risk is limited to the amount you invest by way of shares. This might be £1, £10 or £100, but is unlikely to be much more.  Of course any money or assets held by the company could be lost if it all goes belly-up.  The key thing is that your personal finances, house, savings etc are protected.

This protection may be particularly important if your business is one where you could be sued if something goes wrong. Perhaps someone could be injured if you do work badly or lose money if you give bad advice.  In these cases a limited company may provide valuable protection.  Professional Indemnity insurance (and other insurances) may be worth considering whatever your business structure, and may even make sole trader acceptable once the risks are covered.

Limited company protection comes at a price.  The company is a separate legal identity from the individual behind it.  You cannot do what you like with company money – it is not yours.  Once you, as a director and/or shareholder, start to take money out of the company there will be tax implications.  There are only 3 ways to take money out of your company:

1. As salary – with PAYE tax and NIC deducted

• As dividends (paid to all shareholders)

• By taking back money originally lent to the company.

This latter one is important.  Should you lend money to the company you of course risk losing it if something happens.  You can however take this money back out of the company as and when you wish without any tax implications at all.  The same applies should you transfer assets into the company like a computer or premises. The computer owes you the market value, and you can take that out as it suits.

Tax liabilities can be quite different depending on the structure of your business.  As a sole trader you pay income tax and National Insurance Contributions. Once your profits are in the range of roughly £7,475 to £42,475 (2011/12 figures) then the tax you pay is 20% on each extra £1 profit. What is often forgotten is the 9% NIC on the extra £1 profit.  This means that for each extra £1 you make you lose 29p to the Revenue.  Go above about £42,475 and your profits are taxed at 41% being 42% tax and just 2% NIC. Only the really profitable people pay 52% (50% tax and 2% NIC).

By comparison the limited company profits are taxed differently.  A rule of thumb is that for profits under £300,000 the company tax bill is likely to be 20% (2011/12). Above £300K and the rate rises gradually to 26%. That top rate should come down to 23% by 2014/15.

The reduced company tax burden may be one reason to consider a company if your profits are going to be say £30,000 or upwards. A lot however turns on how much money you need to extract from the business for normal living, so there is no one figure above which company is the clear way to go.

Unlike a sole trader the company will claim as an expense the salary payments to the director(s).  These will reduce the profits and so the company tax bill.  There will of course be some tax and NIC payable as a result of the salary payments.

Companies are more complicated to administer.  This means you in business will need to be more disciplined with your paperwork than you might get away with as a sole trader.  The extra complications mean that accountant’s fees will be substantially higher too.  This is another thing to factor in when deciding which option is best for you.

Choosing whether or not to set up a company is a big decision.  It may be messy or expensive to change your mind later. For this reason I strongly suggest you speak to an accountant before you finalise your plans.