One of the most important decisions you’ll have to contend with is the structure and legal status your business will use moving forward: will you operate as a sole trader or as a limited company?
The structure you choose can have an impact on almost every aspect of your business, including how much tax you will pay, what earnings you can make, and even what happens should your company get into difficulty. What might work for one company will not necessarily work for another. So, it’s vital that you weigh up the pros and cons of both and make an informed decision.
In this article, I’ll be discussing the advantages and disadvantages of being a sole trader or a limited company, so you can decide which business model will serve the needs of your company as it develops. Keep reading to learn more.
The fundamental differences between sole traders and limited companies
A sole trader is a self-employed person with full ownership of their business: it does not have a separate legal identity from that of the owner. That means that a sole trader takes full liability. To become a sole trader, you must register using the government portal within three months of founding your business.
A limited liability company is one which is legally distinct from the identity of the owner. It has a unique company identity, which must be registered (for a small fee) with Companies House. Because of this, there may be more than one owner or director, and they will have limited liability — meaning their personal finances won’t be affected should the business struggle financially.
Sole trading vs limited companies: Which is right for your business?
For many smaller businesses or self-employed tradespeople, being a sole trader offers a few financial advantages, but it also brings an increased level of risk. Becoming a limited company can protect owners from these risks by giving them limited liability, but it can also mean a lot more admin and fiduciary duties for the directors.
In this section, we’ll discuss the benefits and negatives of different aspects of both models, including earnings potential, tax efficiency, and liability.
Setting up
It’s simpler to sign up to be a sole trader as you’re essentially signing up for Self-Assessment. You’ll need to register if you’re earning over £1,000 in a tax year, to prove that you’re self-employed or if you want to make voluntary Class 2 National Insurance payments to help you qualify for benefits and the state pension. A National Insurance number is a must too, so sign up if you don’t have one already. Bear in mind that if you fail to register or register too late, then you could be penalised.
When you register your limited company through Companies House, you’ll be registered for corporation tax at the same time. To register, you need at least three pieces of documentation, which can be any of the following:
- Town of birth
- Mother’s maiden name
- Father’s first name
- Telephone number
- National Insurance number
- Passport number
The £50 fee can be paid by debit or credit card and your company will usually be registered within 24 hours. Alternatively, you can register by post, through an agent or using third-party, but you’ll need to register for corporation tax within three months to start doing business. Postal applications cost £71 and take 8-10 days to process.
Earnings
Sole traders keep all of their earnings after tax, which is paid via the self-assessment system. This means that your earnings are entirely dependent on your performance that year – so while there’s the potential for large profits, there’s also the risk that you won’t make enough money to earn a decent salary.
The owners of a limited company draw their earnings in the form of a salary, which is taxed at standard PAYE rates. They can also draw their earnings in the form of bonuses and dividends, subject to overall performance. In the last few years, the government has been reducing the tax-free allowance for dividends (from £5,000 in 2017 down to £1,000 in 2023/4 and £500 in the 2024/25 tax year) – meaning that limited company directors have faced a reduction in tax-free earnings from these additional sources of income.
Tax
Because limited companies are registered at Companies House, they must pay corporation tax. For large companies, the rate of corporation tax is actually lower than it is for sole traders – meaning it’s often a far more tax-efficient model for businesses with high turnovers and big profits.
From the 2024/25 tax year, Class 4 National Insurance for the self-employed will go from 9 per cent to 8 per cent with no Class 2 NICs to worry about.
While this form of taxation may be efficient for smaller traders with lower incomes, they’re often less so for higher earners – especially if you begin earning £25,000 or more. So, should your earnings reach a higher income bracket, then you might find that registering as a limited company and paying yourself a salary is a more tax-efficient solution.
Sole traders must fill out a self-assessment tax return and register as self-employed with HMRC, but as a general rule their tax obligations are much less complex than those of a limited company.
However, because they have full liability, they can be held to account for any fines or penalties that result from a late return or making an error in their paperwork.
Responsibilities and personal liability
Being a sole trader allows you complete control of your business, and there’s generally much less admin to deal with, but this comes at the cost of an increased level of personal risk.
Under UK law, there is no legal distinction between your assets and those of the company, so if you run up debts, creditors have the right to claim your personal assets (including any property you own) to balance the books. If a client or customer decides to sue you or take you to court, you could be liable to pay any costs yourself.
Because directors in a limited company have limited liability, it’s very unlikely they’ll be held to account for debts or lawsuits incurred by the business (with the possible exception of criminal activity or negligence). While a sole trader could be made bankrupt if their enterprise fails, directors of a limited company cannot: their personal assets will be protected, while the company goes into liquidation.
For this reason, it’s vital that sole traders have professional indemnity or public liability insurance in place to offer them some protection. These sorts of policies can be costly, so you should factor this into your decision: it may be a matter of deciding whether the simplicity that sole trading offers is worth the increased risk and insurance costs.
Summary
When it comes down to choosing sole trader or a limited company, the legal model you want to decide on for your company ultimately depends on what sort of company you want to start.
Small enterprises and self-employed tradespeople may prefer the simplicity and control over earnings offered by sole trading, while those with ambitions of starting a larger company with lots of employees might be tempted by the security that registering as a limited company offers, particularly in terms of liability. It all boils down to your individual business model and goals for the future.
Limited Company or Sole Trader – Key comparisons
| Limited Company | Sole Trader | |
|---|---|---|
| Legal status | Company is a separate legal entity from its owners | Business and owner are treated as a single entity |
| Setting up | Simple. Cost between £50-£71 | Simple and free |
| Paying yourself | Salary and/or Dividends | Pay yourself from profits |
| National Insurance | Class 1 NICs on salaries | Class 4 NICs |
| Tax returns | Full company accounts required | Self-assessment |
| Tax efficiency | High | Low |
| Can you sell your business on? | Yes | No |
| Is your company name protected? | Yes | No |
| Is your personal financial liability protected? | Yes | No (liability is unlimited) |
Mart Abramov is the CEO of digital tax accountancy, TaxScouts
Further resources
- How to become a sole trader – Setting up as a self-employed sole trader is a simple way to start a business. In this guide, we show you how to do it
- Can two people run a sole trader business? – Can two people run a sole trader business and can you register a newly formed limited company as ‘dormant’ and start off as a sole trader?
- What is the definition of a sole trader and being self-employed – What does it mean to be a ‘sole trader’? Is there any difference between a sole trader and being ‘self employed’?
- Tax advantages of a limited company versus sole trader – Haydn Rogan explains the tax advantages and disadvantages of status as a limited company and as a sole trader
