You’ll be in good company. The vast majority of the UK’s 5.8 million self-employed — 59% — are registered as sole traders.
This stands to reason. Registering as a sole trader is easy and inexpensive to do, so it’s the ideal way to test the waters of self-employment.
But being a sole trader is not all sunshine and rainbows. Before you enjoy the hard-earned profits you hope to make, you have legal obligations to meet and admin to take care of. Plus, being a sole trader also comes with its fair share of risk.
Here are 15 things you should know about setting up a business as a sole trader.
1. You’re automatically a sole trader if you work for yourself…
You don’t need to register as a sole trader to be considered one. HMRC automatically classifies you as a sole trader if you:
- Own a business
- Run it as an individual, that is you sign contracts, deal with suppliers, and hire employees in your own name
This means that, as soon as you start trading, you’re a sole trader by default.
2. …But most people need to register
While HMRC automatically classifies you as a sole trader if you run your own business in your own name, the rules require you to register if you:
- Have gone over the trading allowance. This happens if you earn more than £1,000 from self employment in a single tax year (6 April to 5 April)
- Need proof you’re self-employed, for example because you’ve applied for a loan and the bank has asked about your employment status
- Want to pay National Insurance contributions. You’ll need to do this to qualify for a state pension and some other government benefits
If you meet any one of these criteria, you have up to the 5 October of your second business year to register as a sole trader. So if you start on 11 November 2021, you have until 5 November 2022.
In practice, if you plan to earn all or most of your income from doing business as a sole trader, you’ll eventually meet these criteria and will need to register. So, seeing as registering is simple and free, you might as well get it done straight away.
3. You risk getting fined if you don’t register
Missed the 5 October registration deadline? You risk getting fined.
The fines can range from 30% of tax owed if HMRC judges your failure to register was “non-deliberate”, to 100% of what you owe if the failure is “deliberate and concealed.” You may also get charged interest on your tax bill plus a daily penalty.
The good news is that you can avoid the penalty if you:
- Have a reasonable excuse for missing the registration deadline. This would happen if you missed the deadline because of an event outside of your control
- You didn’t deliberately miss the deadline. Deliberate is when you knew you should’ve registered but decided not to
- Told HMRC as soon as possible if your reasonable excuse ended but you still didn’t register
The lesson is clear. If you miss the registration deadline, it’s best if you own up to it as soon as possible. Hoping HMRC won’t notice will only get you into more trouble.
4. Sole traders have lower admin costs than limited companies
This is because there are far fewer formalities to take care of.
Registering as a sole trader costs nothing. And it’s as easy as signing up on HMRC’s website, filling a form and mailing it, or phoning HMRC. There’s also no need to file your accounts, like limited companies do.
As a result, your accountant is likely to charge you much less for their work than they would if you did business as a limited company.
5. Sole traders’ financial records stay private
Are you uncomfortable with people knowing how your business is doing and how much you earn?
Registering as a sole trader is probably the way to go.
HMRC is bound by confidentiality rules and can only disclose your information in specific and limited ways, for example in fulfillment of a court order. This means nobody can see your self assessment tax return and other financial records unless you willingly hand them over.
In comparison, as a limited company, your accounts and other details about your business are publicly available on the Companies House database. Anyone, including your competitors, can download them and have a look.
The trade-off is that being a limited company carries less risk.
Which brings us to the next point.
6. Being a sole trader is more risky
Where limited companies have a separate legal personality, as a sole trader you are the business.
As we’ve said, this has the advantage of being cheaper and giving you more flexibility. The other side of the coin is that you could get into deep financial trouble if things go wrong.
Let’s say you form a company — we’ll call it Smooth Going Solutions Ltd. The company has 100 shares worth £1 per share. You own all the shares and are also the company’s sole owner and director.
You enter into a contract worth £2 million to supply the local ice rink with blast chillers. Except things go south. You’ve no blast chillers and the ice rink people want their money back.
Because limited companies have separate legal personalities, it’s Smooth Going Solutions Ltd that’s on the hook for those £2 million. You only stand to lose the £100 you forked out to pay for the shares.
Given the situation, that’s a pretty sweet deal, right?
In comparison, if you’d entered the contract as a sole trader, you’d have done so in your own name. You’d be on the hook personally for those £2 million. Which means the ice rink could ask the court to sell your house, your car, and other personal valuables to pay for the debt.
The moral of the story is that being a sole trader isn’t for everyone. You might minimise some risks by buying insurance. But if you plan on dealing in high-value goods or services, you’re probably better off incorporating.
7. Being a sole trader may not be feasible in certain industries
Having a more risky business structure also has another downside. Businesses in some industries may not want to work with you.
This holds especially true in regulated industries like financial services and the energy sector. Here, the stakes are high. So many businesses will want the extra reassurance that comes with being incorporated as a limited liability company.
Being a sole trader may also be tricky if you’re starting a business that requires significant funding, for example because you need to buy expensive machinery to make your products.
As a rule, banks and other investors are wary of dealing with sole traders, again because it’s a risky business structure.
8. You still have to keep good records
Sole traders may have lower admin costs, but you still have to make sure your records are up to scratch.
HMRC requires you to keep your invoices, receipts, and records of your incoming and outgoing transactions for at least 5 years after the self assessment deadline. This means you must keep your 2021/22 records until at least 31 January 2028.
HMRC may ask to see your records at any point during this time. And you may get fined if they decide they’re not ‘complete, accurate, and readable.”
As it happens, keeping complete, accurate, and readable records is easier than you’d think. Your best bet is to:
- Open a separate bank account for your sole trader business
- Buy accounting software like FreeAgent or Xero and connect it to your bank account
This way, you’ll have an automatic, neatly categorised record of all your transactions in one place. Many accounting software programmes also populate your self assessment tax return for you and let you file it straight from the app.
9. Filing your taxes online is the best option
The deadline for self assessment is 31 October after the end of the tax year. So, the deadline for filing your 2020/21 taxes is the 31 October 2021.
But that’s only if you file a paper return.
Filing your taxes online — either through your accounting software or on HMRC’s portal — buys you until 31 January: an extra three months.
But that’s not the only reason it’s worth filing your self assessment tax return online.
For several years now, the government has been working on an initiative called Making Tax Digital. This will make it mandatory for businesses to file their taxes online using HMRC-approved software.
As things stand, only VAT-registered businesses have to comply (Yes, as a sole trader you also might need to register for VAT. More on this in a minute.) But, the plan is that every business will eventually have to comply.
Starting to use accounting software and file online today means you can cross this bit of admin off your list.
10. 31 January isn’t the only key tax date to remember. 31 July is important too
31 January is the deadline for filing and paying your taxes. But it’s not the only tax deadline you have to write in your diary. Depending on the size of your tax bill, you may also have to make payments on account. And the deadline for this is 31 July.
A payment on account is an estimated, advance tax payment. It’s equal to 50% of last year’s tax bill. So, if in 2021/22 you paid HMRC £3,000 in tax, you’ll have to make a payment on account of £1,500 for 2022/23 by 31 July 2022.
Not everyone has to make payments on account, though. You only need to do it if last year’s tax bill was £1,000 or more.
The payment on account counts towards your final tax bill. So if you make a payment on account of £500 for 2022/23 and your final tax bill is £1,000, you only have to pay £500 by 31 January 2024.
11. Working out your taxes as a sole trader is straightforward…
While payments on account may blindside you if you’re new to self-employment, working out your taxes as a sole trader is otherwise fairly straightforward.
There are three components to your tax bill:
- Income tax
- Class 2 National Insurance contributions
- Class 4 National Insurance contributions
You pay income tax at the same rates as if you were employed. The only difference is that, instead of being worked out on your income, it’s worked out on your net profit. This is your income less allowable expenses — expenses that you’ve made ‘wholly and exclusively’ for business reasons.
Class 2 National Insurance is £3.15 per week. But you only pay it your profits for the year are £6,725 or more (2022/23).
Class 4 National Insurance is:
- 10.25% on profits between £11,908* and £50,270
- 3.25% on anything over £50,270
* The Secondary Threshold is £9,880 until July 5th, 2022, and rises to £12,570 from July 6th, onwards. £11,908 is average across the tax year.
12. …But being a sole trader isn’t always the most tax-efficient option
When it comes to your taxes, simple and straightforward isn’t necessarily best.
When you reach a certain level of income, setting up as a limited company may mean you pay less tax than you would as a sole trader.
Let’s say your profit as a sole trader in 2022/23 is £49,000.
This means you’d have to pay:
- £7,286 in income tax (your first £12,570 is tax-free while the rest is taxed at 20%)
- £163.80 Class 2 contributions
- £3,801.93 Class 4 contributions
This would put your total tax bill for 2022/23 at £11,251.73
In comparison, as a limited company, you could work it out like so:
- Pay yourself a tax-efficient salary of £9,100. This is within the tax-free personal allowance, so you don’t pay income tax. It’s also under the threshold for paying National Insurance, but you’ll still qualify for credits. In other words, the government treats you as if you’ve paid it
- Your company has to pay 19% Corporation Tax on its profits after all expenses and salaries have been accounted for. In this example, the total liability for the year would be £7,581.
If you take out the remaining retained £32,319 profit as dividends, you will pay a further £2,349.39 in dividend tax during 2022/3.
S0, your total tax bill – including all business and personal taxes – would be £9,930.39.
It is worth remembering that a limited company is a distinct entity from its directors and shareholders. We’re combining the business and personal taxes just to make a comparison with the self-employed model of working.
13. Regularly set money aside for your tax bill
Unlike employees, sole traders don’t have their income tax and National Insurance contributions deducted at source. You’ll need to pay them later.
The problem with this is that it’s easy to forget you owe the taxman when you’re busy drumming up business and paying your other bills. If you’re not careful, you may find yourself without enough money to cover your tax payments come 31 January.
With this in mind, it’s a good idea to get into the habit of setting some money aside for your tax bill every single month. A good rule of thumb is to save about 25% of every invoice.
Many accounting software programs will also show you how much tax you owe at a glance. But, bear in mind that this is usually an estimate based on how you’ve recorded your transactions. If you’ve miscategorised a payment or have some invoices missing, it’ll impact how much tax the program thinks you owe.
14. You might need to register for VAT
If your business really takes off, you’ll need to register your VAT. The VAT threshold is currently £85,000 a year.
The requirement for registration is triggered as soon as you go over the threshold. You’ll then need to start charging VAT to clients, filing quarterly VAT forms, and paying it to HMRC. You’ll also be able to claim back the VAT you’ve paid on your business purchases.
This isn’t nearly as complicated as it sounds.
Most Making Tax Digital-compliant accounting software can apply VAT to your invoices automatically. It’ll also work out how much VAT you have to pay HMRC (or whether you’re due a refund), and make it easy to file your paperwork online.
15. You can always change if being a sole trader no longer suits
Think being a sole trader is no longer for you?
You can change to a partnership or limited company at any time. In fact, most self-employed people start off as sole traders and ‘upgrade’ to a limited company when their business grows enough that the benefits — primarily less risk and a more tax-efficient structure — outweigh the extra costs.
The key is to weigh the pros and cons carefully, because once you’ve incorporated, switching back to being a sole trader can be costly and involved.
The best way to go is to speak to an accountant. They can discuss your situation with you and help you decide what legal structure would make most sense.