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When should I become a Limited Company?

Self employed tax

Whether you have just started out running a business, have leaped into being self-employed as a sole trader, or have been trading for a while, one of the big questions is whether you should be a sole trader or a limited company.

It’s important that you consider all of the options when deciding between the two structures, as picking the wrong one could land you with a much bigger tax bill than you’d like.

But don’t worry, we’re here to break down the pros and cons of both, and give you some pointers on how to pick which one is right for you.

Take the quiz - should you be a Sole Trader or a Limited Company?

What is a sole trader?

A sole trader is the simplest way of running a business. There is no legal separation between you and the business you run, and you can get started as a sole trader with just a phone call to HMRC to register as self-employed.

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Pros of being a sole trader

As a sole trader, you will pay tax and national insurance under the self-assessment scheme, which means that after the end of the personal tax year (5th April) you will submit your tax return to HMRC. Your income tax and national insurance are calculated based on your taxable profits.

If you are not comfortable working out your taxable profits yourself then you should get an accountant to do it for you to avoid fines and investigations from HMRC.

Sole traders have the benefit of limited compliance work to keep their accounts and tax ticking over. Currently, all you have to do is submit a tax return to HMRC once a year and you’re set! (Well, you have to pay your taxes too of course!). From 2024 most sole traders will have to submit 5 tax returns to HMRC each year, but the overall compliance burden is still less than a limited company.

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Cons of being a sole trader

Although it is nice and simple to set up and operate as a sole trader, there are a few downsides to consider.

First of all, there is the fact that there is no legal difference between your business and you as an individual. That means that if something goes wrong, you personally are legally and financially responsible for it.

And then there is the tax situation. Having to make payments on account in January and July can make cashflow difficult to predict, and if you’re earning a large profit as a sole trader that tips you into the higher tax brackets, you may end up paying a pretty hefty tax bill that may be reduced by operating through a limited company.

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What is a Limited Company?

A limited company is a private company consisting of multiple owners, managers, members or subscribers. You can form a limited company quite easily directly on the Companies House website or by using an incorporation agent or accountant.

This type of business is legally separated from its owners. So, when you register as a limited company (which must be done on Companies House in the UK), this company becomes a separate entity in itself. This is when you and your business are considered as completely separate legal entities.

Limited companies can be owned or operated by several people. However, this isn’t a legal requirement. You may choose to be the single operator or director of a limited company in order to retain the benefits of being “separate” from your business. In fact, many small businesses that were previously sole traders, choose to become limited companies for the benefits it can offer them.

As the director of a limited company, you have limited liability on your business’ debt or losses. Your business is responsible for its actions, including paying its debts and liabilities.

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Pros of being a Limited Company

Limited company owners can pay themselves in whatever form they like, which offers you the opportunity to be more tax-efficient – a huge attraction to operating as a limited company and certainly one of the main advantages when it’s done correctly.

Many owners of limited companies pay themselves in a combination of dividends and salary. The advantage here is that dividends have a lower tax threshold, so they allow you to be more efficient with tax than you could be if you simply paid yourself a salary.

It’s important to remember that a limited company pays corporation tax as well as the owner/director having to pay their own tax personally. However, a good accountant will make sure that you’ll end up in the best position possible to minimise your tax bills.

Next up is the fact that if you incur losses or debt, you’re not necessarily personally liable. If your business incurs losses or debt, it’s not your responsibility to deal with these. All directors and possibly shareholders will be responsible for the debt, which means that your personal assets are protected. However, after the credit crunch many financial institutions and banks ask for the directors of a company to personally guarantee at least some of the debts.

Limited company business models are generally better perceived because of the limited liability setup of the company. Contractors, clients and other companies are more likely to work with a limited company because they perceive this type of company to have more credibility. It just helps you look a little bit bigger than perhaps you are – fake it ’til you make it!

As the director of a limited company, your company is a separate entity to you. This means that you don’t need to worry about having insurance policies to avoid being sued personally. In any legal dispute, the worst outcome is that your company will be sued, and not yourself. You will however need to make sure that you have all of the appropriate insurances to operate through a limited company.

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Cons of being a Limited Company

While there are definitely advantages to the limited company structure, there are disadvantages to consider too. Running a limited company means that there is more financial admin and compliance to take care of. You’ll need to not only do your personal tax return as a director, but also a set of statutory accounts for Companies House, a corporation tax return for companies house, and your annual confirmation statement.

Because of the more public nature of a limited company, you may have less privacy than operating as a sole trader. Your company accounts and details are visible on the Companies House website for all to see! When you form a limited company you agree to submit this information to Companies House each year and not doing so can result in penalties and fines. This information will also include your registered office, which for many people is their home address. If you want total privacy then you may want to use a virtual office to be listed on the website instead of your home address.

Whereas when you are a sole trader you can withdraw money from your business as and when you like via drawings (whether you make a profit or not), it’s more complicated to withdraw money from a limited company. You need to make sure you have the correct balance of salary and dividends to ensure tax efficiency. A good accountant will help you out with that though!

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When should you make the switch to a Limited Company?

Setting up a limited company is a big step, and the timing has to be right for you. Here are our top triggers for going limited:

If you’ve been self-employed for a while and are making high profits each year, a limited company is worth considering for the tax savings.

Becoming a limited company is vital if you are operating in an industry that leaves you open to liability like getting sued.

If you have aspirations of high growth for your company, then businesses often find a limited company gives them more options for financing.

You should form a limited company if you have any intellectual property that gives your business value and could be sold later on.

If you plan on exiting your business in the future then a limited company is much easier to do this with.

When should I stay as a Sole Trader?

If your income isn’t very high then a sole trader is probably a better option for you.

If you make a loss and still want to draw money out of your business, then stay as a sole trader to avoid huge tax bills.

If you have employment income and make a loss through your sole trader business (as a side hustle perhaps), then staying as a sole trader may let your write off some of your losses against your PAYE income for a tax rebate, whereas you can’t do that with a limited company.

Still undecided?

We’ve created a handy little quiz to help you organise your thoughts on this matter – you can access it back at the top of the page and it only takes a minute!

Or give us a call and we’ll be able to point you in the right direction.

No matter whether you are a sole trader or a limited company, Mazuma are able to sort out all of your accounts and tax needs for you, for a low monthly cost.

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