Limited company vs. sole trader: What’s the difference?
Most small businesses in the UK are set up as either a limited company or a sole trader. In this article, we explain the definition and characteristics of these two types of business entity. We’ll also talk you through to register your business as one of the two options, and we’ll also discuss some factors you should consider before choosing one way or the other – sole trader or limited company.
What is a sole trader?
A sole trader is a person who works for themselves and is responsible for paying their own taxes to HMRC. Typically, they will do project-based or ongoing work for multiple clients, who will pay them following submission of an invoice by the sole trader. Sole traders are personally liable for their own business losses, and can keep all the after-tax profit their business makes.
This unlimited financial liability means investing in employees or expensive business collateral can be risky for sole traders. However, some successful sole traders do invest significant personal funds into their business.
Multiple sole traders (or companies) can work together in a partnership arrangement, where all parties own a specified percentage of the venture’s profits and liabilities, and each party retains responsibility for their own tax.
The terms ‘freelancer’ and ‘self-employed person’ are interchangeable with ‘sole trader’.
What is a limited company?
A limited company is a private business that exists as a separate legal entity to the people who run it. Limited companies are managed by a board of directors, who typically take a salary from the business; and are owned by shareholders, who are typically compensated through the payment of dividends. In many cases, the directors of a limited company will also hold shares in it.
Because limited companies are independent legal entities, they can enter into contracts or be subject to legal action without direct implications for the individuals involved. They have ownership of their own debts, and directors are only accountable for business losses to the extent of their investment in the company. The directors of a limited company must adhere to seven legal duties, which include exercising reasonable care, skill and diligence; and avoiding conflicts of interest. Directors who breach their duties can face civic action, and in some cases, criminal sanction.
Most new limited companies choose to set up as a private limited company (LTD), where shares in the company are sold to a small number of investors, as opposed to a public limited company (PLC), where shares in the company can be bought by the public.
There’s more detail on running a limited company at Gov.uk.
Which option is best for me: register as a sole trader or set up a limited company?
Put simply, the choice between sole trader and limited company boils down to a choice between simplicity and scalability.
Operating as a sole trader is far simpler than setting up a limited company. Registration is relatively straightforward, and there’s no need to navigate relationships between directors and stakeholders. Furthermore, limited companies face the administrative burden of submitting annual accounts to Companies House and corporation tax accounts to HMRC, whereas sole traders must simply submit a yearly tax return to HMRC.
With these points in mind, working as a sole trader is a good option for individuals who prefer to minimise the business admin and responsibilities that come with working for themselves.
For those of you who don’t mind taking on a slightly heavier administrative workload, operating as a limited company could offer distinct advantages. The key benefit is that limited company owners have limited liability for their business losses. This means the business can scale-up and make significant investments – for instance, in staff or premises – without direct risk to the ownership’s personal finances or assets.
Limited companies are also more tax-efficient than sole trader businesses, since the dividend tax and corporation tax paid by limited companies and their owners tends to amount to a lower personal rate than the income tax and national insurance contributions paid by sole traders.
• Sole trader businesses offer relatively simple management and setup;
• Limited companies offer limited financial liability and tax efficiency for business owners.
How to register as a sole trader
The simplest way to set up as a sole trader is to register online with the government’s digital service. First, you’ll be asked to enter your email address and other personal details. Within ten days, you will receive a letter from HMRC containing your unique taxpayer reference. You can then use your UTR to complete the registration and log-in to HMRC services online, including your annual self-assessment tax returns.
For much more detail on this topic, check our this guide on how to register as self employed.
How to register a limited company
There are two key components of limited company registration. In order to become a legal entity, the company must be registered via Companies House, the United Kingdom’s registrar for companies. And in order to pay corporation tax, the company also needs to register with HMRC.
Both company registration and corporation tax registration can be done within a single application via Gov.uk.
Before you start the registration process, you’ll need to finalise some important details. Who will be the directors, and who will be secretary? Who will be the shareholders or guarantors of the company? What will be your company address and telephone number?
Every limited company in the UK needs to have a unique name. You can check on the availability of a potential business name using the Companies House company name availability checker.
If you’re struggling to think of a name for your company, check out our top tips on how to generate a business name.
More from Tamar Telecommunications: