Are you a UK resident planning to set up your own small business? If so, you’ll need to make a critical decision on legally setting up your company. Your business structure will affect your finances, liabilities, and legal operations.
In early 2022, there were 5.5 million private sector businesses in the UK, a 1.5% drop from the beginning of 2021. Most of these were small businesses with 0 to 49 employees, 5.47 million of them. Only 35,900 businesses were medium-sized, and 7,700 were large companies with 250 or more employees.
All this is to say that you are not alone in wanting to strike out on your own. With so many individuals running small businesses in the UK, there is no one-size-fits-all approach to the right type of business structure.
While there are several different types of businesses in the UK, you’ll need to determine if you want to operate as a sole trader or a limited company. The structure you choose can impact almost every aspect of your business, including how much tax you will pay, the amount of earnings you generate, and even what happens should your company face difficult times.
This makes it vitally important to consider both options' pros and cons and which type of business structure is best for your situation.
Read on to find out the differences between a sole trader and a limited liability company in the UK and how to get a company registration number for your business.
What Is a Sole Trader?
His Majesty’s Revenue and Customs (HMRC) office defines a sole trader as an individual who is not registered as an employee by any commercial entity but who works and generates revenue as an independent person.
If you become self-employed and do not register a limited company, you and your business are legally considered to be one and the same. By default, this makes you a sole trader.
A sole trader is a self-employed person who has full ownership of their business. As a sole trader, you do not have a separate legal identity from that of the owner (yourself). This means you take and accept full liability and responsibility regarding everything and anything that may occur in your business.
Being a sole trader does give you complete control of your business. There’s also far less administration and government red tape to deal with. But, this type of setup comes with increased personal risk.
Under current UK law, there are disadvantages to being a sole trader because there is no legal distinction between your assets and those of your company. So if you were to pile up a mountain of debts, creditors have the right to claim your personal assets (including any property you own) in their effort to recover the debt.
Furthermore, if someone decides to sue you in court, you could end up on the wrong end of a judgment and find yourself liable to pay for any incurred costs.
What Is a Limited Liability Company?
There are seven different types of companies in the United Kingdom, each with its own benefits and drawbacks. The most common type is a public limited company.
In a public limited company, the shareholder can be anyone from the public. The shareholders all have the responsibility of managing the company’s finances. However, those owning more shares have more say in the decision-making process.
For example, if a member of the public holds 1% of the company shares, they don’t have much of a say in the company's financials compared to someone who owns 50% of the shares.
Limited Liability Partnership is also available for those starting a business with a partner. In this type of business entity, some or all partners have limited liability, meaning they are responsible for their misconduct and negligence. The partners in an LLP are allowed to directly manage the company without having a board of members vote.
Overall, the main difference between a limited company and a sole trader is the legal separation of you as the owner from your company as an independent legal entity.
Does a Sole Trader in the UK Need a Business Number?
In a word, no.
As a sole trader, your business is not incorporated, which means it doesn’t need or is required by law to have a company business number. Your business also isn’t legally separate from you, the owner. As such, you, as a sole trader, are often referred to as your business.
That said, to legally become a sole trader, you must register yourself as self-employed using the Company’s House government portal within three months of starting your business.
In contrast, a limited company is incorporated and has an identity separate from its owners. This is why a limited company needs to be registered with the Companies House, which is the government agency that assigns a company with its registration number. The Companies House will issue a certificate of incorporation, validating your registration status.
Tax Implications for Sole Traders
Presently, all business owners in the UK have to fill in a document called a tax return and send it to HMRC every year. It will contain details regarding all of your income, including any profits your business generates. Typically, this is a self-assessment tax return, meaning you are responsible for properly filling out all the information.
However, as of 6 April 2024, sole traders will have to report their income figures to HMRC once every quarter plus one extra time at the end of the year for a total of five times under a new system called Making Tax Digital for Income Tax.
Sole Trader Revenue Classification
Under the current law, sole traders keep all their earnings after paying the appropriate taxes through the tax self-assessment system. This means as a sole trader, your earnings are entirely dependent on your performance during a calendar year.
This can mean generating considerable profit. However, there’s always a risk you won’t generate enough income to allow you to enjoy a decent standard of living.
Alternatively, if you own and operate a limited company, you can give yourself a salary out of your business earnings, which is taxed at standard PAYE rates. You can also receive income in the form of bonuses and dividends.
Keep in mind that in the last few years, the government has been reducing the tax-free allowance for dividends (from £5,000 in 2017 down to £2,000 in 2021). This means that limited company directors are facing a reduction in tax-free earnings from additional sources of income.
Limited Company vs. Sole Trader: Which Is Right for You?
Deciding if you should operate as a sole trader or as a limited company is a question you should think over carefully. Weight out the pros and cons of both business structures before you make a final decision.
Taxes
Each business structure comes with its advantages and disadvantages regarding the UK's taxation system.
Taxation Laws for Sole Traders
As a sole trader, your taxes will be more straightforward, relying entirely on your total income tax bracket. However, you’ll have fewer tax planning opportunities than with a limited company.
Sole traders are not required by law to pay a corporation tax. Instead, you are obliged to pay income tax at the standard rate and make National Insurance contributions on all profits.
As a sole trader, you pay income tax at 20%, 40%, or 45% on your profits. You must also pay class 4 national insurance at 10.25% or 3.25%. Tax rates are progressive, so they change as your profits increase.
You can declare some business expenses to reduce your taxable income amount. However, business expense rules are more restricted than those available to a limited company.
A sole trader can only claim tax relief on the cost of food and drink when you’re travelling on business, and only if your journey involves an overnight stay, is outside your normal working pattern, or if your business requires you to spend time on different client sites and not very long at any of them.
Taxation Laws for Limited Companies
When classified as a limited company in the UK, you must pay a corporation tax. The amount you pay depends on your profits. Often, the corporate tax rate is lower for larger companies than for small businesses. So, operating as a limited liability company makes it tax-efficient for businesses with high turnovers and large profits.
Of course, as a small registered business, you have the right to claim a wealth of expenses against your taxes. These include but are not limited to:
- Health checks and eye tests
- Business Insurance
- Advertising, marketing, and PR
- Accommodation
- Bank charges
- Childcare
- Use of home as an office
- Gifts, entertainment, and trivial benefits
This can be an important advantage if you have high annual operating costs or are part of a specific industry with additional tax breaks. For example, the Construction Industry Scheme (CIS) offers tax breaks for materials bought for construction. This can be a significant benefit. So, look out for special tax breaks in your field.
Remember that you’ll also need to pay personal income tax on the salary that your company pays you. This equally applies to limited liability partnerships where both owners need to pay income taxes on their separate salaries.
Cash Flow
Another important consideration is liquidity.
Sole traders can withdraw as much money from the business bank account as they need, which will not affect how much tax they pay. In contrast, a limited company will be considered a separate legal entity. So, you can’t draw money out of its bank account freely the way you can when you operate as a sole trader.
Instead, there are three ways your company can pay you money:
- A fixed salary for the work you do
- Dividends on any shares you own if the company generates enough profit
- Reimbursement against business expenses that you have incurred
However, if you take money out of the company over and above these three options, you run a real risk of paying extra tax.
Paperwork and Administration
A legal responsibility that falls on the shoulders of a company director is filing the company’s paperwork on time.
As a sole trader, you currently only have one document to file with the government each year, which is your tax return, although this will change when Making Tax Digital begins.
In contrast, a limited company director already has at least four documents to file annually.
Your limited company must file a set of accounts and a document called an annual confirmation statement at Companies House. These documents re-confirm your company information, such as name, registered office address, etc.
A limited company must also file a corporation tax return with HMRC. Each company director must file a personal tax return if they are running a limited liability partnership.
In addition to this, it’s safe to assume you would be an employee of your limited company and receive a salary. Under this scenario, you would need to register your company as an employer, and it will need to operate payroll for you.
If you conduct business as a sole trader, you are classified as a self-employed person who does not need to have your business operate a payroll unless you hire staff.
When it’s all said and done, all of this means that you or someone else will have to spend a great deal of time preparing and filing paperwork. A company formation agent can help with this process, but this will likely result in significant accounting and management fees.
Wrapping Up
As you can see, the decision to operate as a sole trader or as a limited company requires due diligence on your part and careful consideration.
If you’re looking for the least complicated business setup, sole trader would appear to be the route to go. But again, whatever direction you decide to go in, take your time, weigh your options, and make decisions that will help you achieve your immediate and long-term goals.
Not sure which option is right for you? Speak with a Borderless expert today. We can help you set up your business, hire internationally, and navigate the legalities of work in the UK and beyond.
