Is it better to operate as a sole trader or limited company?

14 Mar 2022

One of the first decisions you'll have to make when deciding to go into business is the legal status of your enterprise. Will you operate as a sole trader or limited company? These are the two most popular methods to run a business in the UK and will have profound implications on every aspect of your business. Tax, regulations, and employment are just three issues pivoting from your chosen status. Here we'll discuss the strengths and weaknesses of each to leave you better informed, no matter what choice you make.

Ltd or sole trader

Operating as a sole trader or limited company, a current data snapshot

Between 2000 and 2021, the UK business population increased by 2.1 million (61%). The highest rate of increase occurred between 2013 and 2014 at 6.8%, and between 2003 and 2004 at 6.7%. Predictably, the business population decreased during the first year of the Coronavirus pandemic; specifically, between 2020 and 2021, the total business population fell by 390,000 (6.5%).

According to the FSB, the Federation of Small Businesses, sole traders are the most popular business model in the UK, accounting for approximately 3.2 million businesses. There are currently just over 2 million limited companies active at Companies House. Close to 96% are SMEs with less than ten employees. 

Out of the estimated 5.5 million private sector businesses (mostly sole traders, partnerships, and limited companies), 4.2 million had no employees. This substantial number suggests that most UK firms exist to generate income for the owner alone.

Despite the high number of single-person operations, many choose to take on limited company status. It may indicate that running a limited company might not be as demanding or complex as thought. Even if it's just a one-person company with you as the sole director and employee, compliance with the law and tax regime isn't as daunting or time-consuming.

What are the important differences between sole traders and limited companies?

The significant difference between a sole trader and a limited company is the ultimate ownership. A sole trader business is owned and controlled by one person with unlimited personal liability. In comparison, a limited company's ownership is limited by shares.

The shareholders of limited companies have "limited liability" for the company, meaning there is less personal monetary risk involved when setting up your business as an Ltd.

In short, when you conduct business as a limited company, your liability doesn't typically extend beyond whatever guarantees are attached to that company. Your creditors can't hold you personally liable for the conduct of the business unless you offer personal guarantees.

For example, if your company fails in the ordinary course of business, you're not liable for the losses. The company as a legal entity is responsible. There are apparent caveats, such as having used your home as collateral to a bank for a loan etc.

Technically, you could be liable for debts if you have run a business outside of the accepted parameters and exacting standards demanded by the authorities such as HMRC and Companies House.

However, most people choose limited company status because their liability only extends to the activities and assets within the company. If you run your company ethically and legally and attend to all the compliance, you wouldn't be penalised for its failure.

What is a sole trader?

Sole traders are individual business owners with 100% responsibility for their operations. Sole traders aren't single-person businesses only, they still hire staff, but they own and control the company.

In legal terms, you and your business will be looked upon as the same entity if you're a sole trader. So, you're personally liable if your business incurs any losses or debts, a crucial factor to consider when deciding to register as a sole trader or run a limited company.

As a sole trader, you keep all profits after tax. Typically, those who offer hairdressing, heating engineers, plumbing, or copywriting services operate as sole traders (among others).

You employ yourself and pay yourself because you become self-employed. You have the responsibility to pay other staff members if you take them on. More official government information about your responsibilities if you want to set up as a sole trader is available here.

What is a limited company?

Limited companies are private entities that can operate with multiple owners and shareholders or with a minimum of one director and shareholder. The business exists separately from its owners. As a limited company director, your liability for your business' debts or losses is limited.

When you register a limited company at Companies House, it becomes a separate legal entity to your personal affairs. The responsibility for paying debts and liabilities lies with the company and not you as a person, assuming the company runs legally and conducts its duties correctly.

What are the advantages of being a limited company?

·      Tax-efficient

Limited company owners can pay themselves a combination of dividends and salary. Company dividends have a lower tax threshold, allowing you to be more efficient with tax than paying yourself a salary.

For example, you could pay yourself a low salary, instead taking due compensation from annual or quarterly dividends that are not subject to PAYE tax rates. It would be best to get advice from an accountant as the thresholds can change depending on government rules and annual Budget changes.

·      Selling up or moving on can be a more straightforward process

If you look to sell your limited company business, prospective buyers might prefer to buy a company. Their accountants can forensically analyse the performance based on accounts filed at Companies House. All the assets and liabilities of the company will be visible, as will any charges against the company's assets.

Similarly, suppose you're a limited company director with several directors and shareholders, you can resign and move on, and theoretically, that's where your ownership and liability will end.

·      Debts and losses are not personal issues

The losses incurred and the debts are not your responsibility, assuming you discharge your duties as a director according to the rules and law. Bear in mind that running a limited company doesn't excuse reckless or illegal behaviour. Although only a tiny number of directors are banned each year (around 1,000-1,500), the risk is still there should you consistently flout the rules and violate company law.

·      Limited liability

Suppose your business fails, perhaps due to a recession or change in the business climate. In this case, your liability is limited to that company's assets and not your assets unless you've offered up personal guarantees to creditors or your bank. 

·      Image

Limited company models can provide more of a professional image than sole trader. Not an issue if you're a one-person business that invoices for your services. Still, when pitching for clients, you might want to afford your venture the added polish that an Ltd status can provide.

Disadvantages of operating as a limited company

·      You Must Prepare Annual Accounts

You must prepare annual accounts that get filed at Companies House. A sole trader doesn't have an obligation to prepare statements and reports.

·      Financial Administration

You'll need to file a corporation tax return, annual accounts, and a confirmation statement. Each limited company director will usually need to file their self-assessment tax return.

·      Less privacy

You have less privacy as a limited company owner than a sole trader. Your company's registered address and specific financial figures will become visible to the public. However, you can shield your home address for a fee.

·      Taxation

Any limited company losses are offset against the company's profits; the company's net profits get taxed. Whereas, if you're a self-employed sole trader, you might be able to compensate for only some loss to reduce your overall income tax. It will help if you take specialist advice on tax from an advisory professional, such as an accountant.

· Less freedom

Any planning or strategy will need permission from all directors and a shareholder majority decision. It could take longer to implement new policies and plans.

What are the advantages of being a sole trader?

·      Profits are yours after tax

As the single owner of your business, you'll get to keep 100% of your after-tax profits.

·      Easy start-up process

There are fewer rules and regulations to be aware of as a self-employed sole trader. You register for a self-assessment tax return online. You get a unique tax reference (UTR) number and pay your taxes annually.

· You're the ultimate decision-maker

Being a sole trader provides you ultimate control and decision making; you won't have to run an idea through anyone else before making it a reality.

·      Less admin needed

You're legally required to submit your year-end self-assessment tax return, and that's it. You can use many of the accountancy software packages available to take care of this tax. You also won't have to prepare and file accounts anywhere.

·      Easier decision making

As previously mentioned, you're the boss. You make the calls, and you don't have to answer to other directors or shareholders. If you want to make a decision, you do it unilaterally. Whether it's new premises, taking on debt, or radically altering your business, you can implement changes without interference.

Disadvantages of running your business as a sole trader

·      Unlimited liability

You become personally liable for your business debts. In the event of failure, you're on the hook for all the debts and losses. You could lose your home, savings or any other assets.

·      Complete responsibility

If you're a one-person business operating a simple model, the responsibility isn't overwhelming. However, as a sole trader, your responsibilities will grow if you employ people and expand. You're hands-on regarding every aspect of the business, and you manage tax, employment rules, customers, planning, strategy, etc.

·      A challenge raising capital

Sole traders usually begin with savings or funding from family, and they might get a personal bank loan. Suppose the loan is above a certain amount or you have limited experience. In this case, a lender might ask for your home as collateral for security.

Sole traders are close to impossible to scale, and you don't have the option to sell company equity to raise funds.

Which is better, sole trader or limited company?

The pros and cons are listed above, and your decision comes down to your preferences, ambitions and options. There's no right or wrong decision. If you're one of the millions in the UK who operate a single person operation, either choice can make sense.

However, there are two valid reasons why most small businesses prefer to be incorporated as companies, even if they employ one person. Those reasons are taxes and liability.

·      Taxation

Tax is a critical aspect, and as a sole trader, you might pay the highest tax rate on your profits. But as a limited company, you could structure your income below £12,500, the ceiling by which you have to pay personal tax and then pay tax on any dividend you receive.

·      Liability

It's crucial to concentrate on the word limited regarding the term "limited company". Your liability is limited. Suppose your limited company has offered no personal guarantees, and you've put nothing up as collateral to provide a lender with security. In that case, you can run your business free of risk in the knowledge that if it fails, you don't go down with it.

Just one last point, don't be put off by the supposed compliance concerning running a company versus sole trader status. Filing basic filleted accounts and annual statements at Companies House and filing a tax return isn't time-consuming, complicated or expensive. And there are many software products on the market which can help with the process.

Whatever choice you make and whatever stage your business is at, you might need to address your funding requirements. At Funding Options, we've assembled a dedicated team of business finance specialists who can offer advice on your route forward. Or, if you're ready to apply and know what you're after, you can begin the process by clicking here.

Find funding

Joe Morley
Joe Morley

Head of Unsecured Lending

Joe has worked in the alternative lending space since 2015. During this time he has helped hundreds of SMEs access millions in essential funding ranging from long-term asset-backed lending to short-term unsecured revolving credit lines and beyond. In his role, Joe manages and supports a large team of Credit Finance specialists.

Subscribe to our newsletter today

Sign up for the best of Funding Options sent straight to your inbox.