Should you be a sole trader or limited business?
One of the first decisions you need to make when you start a business, is what kind of legal/tax structure it will take. Tax specialists Kreston Reeves explain the pros and cons of being a sole trader or limited business to help you decide.
When choosing how to set up your business in the UK, there’s no one size fits all solution; the right choice varies from situation to situation. You have three main options to structure it:
- As a sole trader (or partnership if there is more than one founder/owner).
- As a limited company.
- As a limited liability partnership.
Most businesses would choose either option one or two. Limited liability partnerships are normally used by specific types of businesses (such as lawyers and accountants). In essence, they have the limited liability benefits that limited companies do, but they are taxed like a partnership.
On that basis, let’s focus on the two main scenarios – sole trader or partnership and limited companies – and see what the characteristics, pros and cons of each are.
How does a sole trader or partnership work?
The characteristics of being a sole trader or partnership are:
- No limited liability – the business is not a separate legal entity from its owner(s).
- Owner(s) are taxed on the profits made personally. Personal income tax rates go up to 45% for earnings over £150,000 per annum.
What are the pros of being a sole trader or partnership?
- No public filing of accounts. The business’ financial records do not appear on public record.
- If the business is loss making you will be able to offset these losses against your any other income you have personally, so potentially reducing the personal tax you will need to pay in that period.
What are the cons of being a sole trader or partnership?
- No limitation of liability. The owner(s) are personally liable for any liabilities the business has and their personal assets could be at risk.
- All profits are distributed and taxed on the owner(s).
- No flexibility in how the owners get remunerated by the business. All profits taxed under income tax rates on the owner(s).
- Does not offer a flexible structure to obtain further external investment.
- May not provide a credible image of the business in the marketplace.
How does a limited company work?
The characteristics of being a limited company are:
- Limited liability – the business is a separate legal entity from its shareholders/directors.
- The company pays Corporate Tax on the profits made in the business. Current corporate tax rate is 19%, reducing to 17% in 2020.
What are the pros of being a limited company?
- Limitation of liability – the owners are not held liable for any of the liabilities of the business.
- Provides flexibility of how the founders are remunerated. They can have salary, dividends and also be provided with benefits by the business eg. pension contributions, private medical cover etc. All of which provides greater tax planning opportunities.
- Being a registered limited company gives the business an impression of scale and being an established business, potentially access to a greater customer base that would not do business with a sole trader.
- A limited company provides a structure whereby third-party investors can invest easily in the entity.
What are the cons of being a limited company?
- The company’s accounts need to be filed on public record each year, within nine months of the year end.
- Running a company is more costly with annual public filings and financial statements needing to be prepared under the Companies Act.
- What option is best for you will depend on your specific business, the risks involved, the size of your business and how profitable it is. Getting the choice of structure right is important and doesn’t just come down to tax, so do get professional advice.
Which option is right for you?
When deciding which option is right for you, it’s important to think about where your business will be in the next three, five or ten years. Visualising how you will grow and develop your business may impact on your decision about its structure at the very beginning.
Photo by Lauren Mancke