One of the first tasks you will have when starting up on your own will be to decide whether to set up a new limited company, or become a self-employed (as a sole trader or partnership). Here we look at some of the differences between the the most popular business structures.
How are sole traders and limited companies taxed?
If you are self employed (as a sole trader, or a member of a unincorporated partnership), your business profits and other personal income is taxed via the annual self assessment process. You cannot defer profits to future years.
For the 2012-13 tax year, the personal allowance is £8,105 – you pay no income tax on this amount. You pay income tax at 20, 40, or 50%, depending on your annual profits.
In addition, you must pay National Insurance Contributions (NICs) on your profits. Class 2 NICs are £2.65 per week (2012/13 tax year), and HMRC will calculate your Class 4 NICs on your annual profits.
You can find out more in our sole trader tax guide.
Limited companies are liable for Corporation Tax on their business profits. The ‘small profits’ tax rate is currently 20% (2012/13 tax year), for profits up to £300,000 per year.
Unlike the sole trader route, a limited company can retain profits and distribute them as dividends in future tax years if necessary. The directors may wish to delay paying income tax on dividends during a good year, and defer paying dividends to the following tax year.
You can find our more in our corporation tax guide.
For the latest tax tables, rates and allowances, visit our tax rate section.
What are the benefits of incorporating vs becoming a sole trader?
- One of the main benefits of working via a limited company is that your personal and business finances are distinct, so if a claim is made against your company, you will not be liable personally (assuming nothing illegal has taken place).
- Under the sole trader route, if a financial claim is made against your business, your own personal finances may also be included in any settlement.
- Setting up as a sole trader is a very simple process. All you need to do is inform HMRC of your intention to go self employed, you can start trading right away.
- Limited company directors, on the other hand, have to deal with more paperwork, and have various legal and statutory obligations. Limited companies are regulated by Companies House, and directors are ultimately responsible for providing accurate and timely accounts on an annual basis, even if your accountant does the actual work.
- Tax-wise, limited company directors have the potential to pay less tax, as they can pay themselves small salaries and high dividends (which are free from NICs), whereas sole traders pay themselves a salary which is liable for NICs as well as income tax.
The route you choose is very much up to you. If you start out as a sole trader, and later on wish to incorporate, this is a very easy process. Your choice may be influenced by conventions within your industry, or if you can only operate under a limited company umbrella.
Whatever you decide to do, we always recommend you discuss your options with an accountant or business adviser before taking the plunge.