Sole Trader v Limited Company
A difficult question that the self-employed face is whether to trade as a sole trader/partnership or to trade as a limited company. However, the answer isn’t definitive and is dependent on many factors ranging from the type of business you are running to the type of person you are. Whichever one you choose has different implications for tax, legal and financial responsibilities. The aim of this article is to give you an insight to the advantages and disadvantages in terms of tax purposes of being a sole trader/in a partnership or forming your own limited company. Hopefully it will inform you on the structure most beneficial to you.
As a sole trader, you are the business. You have full control and ownership of the business and are able to manage it in any way you like. On the contrary, a limited company is its own legal entity. Instead you serve the company as a director of the company and act as a shareholder. In most cases, you are considered as an employee but this status is not automatically granted in terms of Employment Law, the National Minimum Wage or for Tax Credits.
Tax – Sole Trader
You are subject to income tax on the taxable profits of your business. For the tax year 2013/14, you pay 20% tax on income between £0 - £32,010 and 40% tax on income between £32,010 - £150,000. Income above £150,000 is taxed at 45%. The personal allowance amount for persons aged under 65 is £9,440. You are also required to pay Class 2 & 4 National Insurance contributions (NIC). Class 2 NIC are at a flat rate of £2.70 per week. However, you may not need to pay Class 2 NIC if your earnings are below £5,725 for the whole year. Visit http://www.hmrc.gov.uk/working/intro/class2.htm to see if you may be exempt from paying Class 2 NIC. Class 4 NIC is calculated based on your profits for the year. For 2013/14, you pay 9% on annual profits between £7,755 and £41,450 and then 2% on any amount over that. Any trading losses you incur on your business can be offset against other your income to reduce your tax liabilities.
Tax – Limited Company
For a limited company, it pays corporation tax on its taxable profits. Company tax rates are lower than the higher rates of income tax. If you are employed under your company and taking a salary, your earnings from that employment are subject to income tax and Class 1 NIC due through PAYE (Pay As You Earn). The amount you pay is dependent on your earnings. Shareholders of the company who are on a higher tax bracket may have to pay higher a higher tax rate on any dividend income they receive. Losses from the company can only be offset against its other income but not against your income as an individual.
What does it all mean?
Now for most people, the above two paragraphs may have been not only been of little help but confused you further. Here is a scenario that will make things easier to understand and hopefully give you enough information to aid you in that important decision.
You have a trading income of £16,000 pre tax and wish to extract all the profits for yourself. As a sole trader, you will be taxed at 20% for any income in excess of your personal allowance. The total tax liability including the Class 2 & 4 NIC amounts approximately to £2,181 (assuming 48 weeks and available personal allowance of £9,440). The tax calculation for a limited company is slightly more complex as you have more flexibility in how you distribute the income. For simplicity sake, you take the minimum annual wage that is not liable for PAYE tax or NIC which is around £7,000. Company profits under £300,000 are taxed at a rate of 20%. Taxable profits is £9,000 and amounts to a corporation tax liability of £1,800. This leaves £7,200 to be distributed as dividend which is taxed at 10% for income below the earnings threshold of £32,010. The total tax paid equates to £2,520. In this scenario, it is marginally better to see that remaining as a sole trader is more beneficial as you pay much less tax. However, calculations may differ depending on the trading income and how much salary you take. The general idea is that as your trading income increases, its becomes more and more beneficial to trade as a limited company than as a sole trader (40% income tax versus 20% corporation tax).
Just a Final Note
You are better off trading as a sole trader for tax purposes if your annual trading profits are not high. However, many businesses opt to form limited companies for reasons that extend past tax issues. Should the business fail, you will not be personally liable for its debts if you were a limited company. If you plan to sell the business after a few year then limited is again a better choicAlso if you plan to expand the business then getting finance for your business may be easier if you were a limited company. There are many varying circumstances that makes being one more appealing than the other but if you still appear unsure then just contact us and we’ll be sure to offer you tailored expert advice to aid your decision.
By Wilson Law at Tax Affinity Accountants
Tax Affinity Accountants are experts in Tax and Accountancy. Based in Kingston upon Thames they are considered in the Finance Industry to be the small business experts. Helping and supporting business throughout the UK, they regularly help new and established businesses with valuable support.
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