You are thinking of setting up a new business and are unsure of the correct trading structure. This is a very common question and there is not a straightforward answer.
Most small businesses are operated through two different types of trading structures:
This is an incorporated entity and you will be company director and/or employee of your company. The company will pay corporation tax and the director/employee will withdraw earnings through salary and dividends.
You will not be incorporated and are self employed. You will pay tax & NIC’s on the business profit, regardless of how much you draw, so the accounting side of the business is easier.
Operating as a sole trader is more straightforward than a limited company because there is less paperwork but it is worth considering other key aspects:
Earnings (NIC’s & PAYE)
As a sole trader you will pay income tax on your business profit irrespective of drawings. This will be at the full income tax rates. Sole traders as self employed will pay Class 2 NICs (paid monthly or 6 monthly) and Class 4 NICs (paid with self assessment).
As a limited company you will be an employee and will pay income tax on your salary. You will also be subject to employees NICs (Class 1) and the company will have to pay employers NICs. The limited company has an advantage where you can amend the salary/dividend. This facilitates tax planning to optimise the total remuneration.
As a sole trader you are not distinct from your business and you will have personal liability for any debts arising from the business. This is fine if your clients do not mind working with an unincorporated business and your activities are unlikely to put your personal assets at risk.
A limited company is a distinct legal entity in its own right. Provided the Director(s) have not acted negligently the personal assets are protected against corporate debts.
Accounts & record keeping
Accounts and record keeping for a sole trader are simpler. Accounts for each financial year will need to be prepared and a self assessment return completed. The sole trader will need to retain records of income and expenditure for 5 years after the 31st January tax return deadline.
A limited company has more rules and regulations than an unincorporated business. There are a number of returns that will need to be completed:
- Monthly payroll (RTI) submissions
- Year end payroll returns and P11Ds (return of taxable benefits and expenses) for each director/employee
- Company accounts
- Company corporation tax computation
- Annual return to Companies House
- Personal tax returns (SA100) for the company directors
This costs a bit more than the unincorporated business, but the corporate structure allows more control over when and how you pay tax which can result in legitimate savings. The limited company will need to retain accounting records for 6 years after the end of corporation tax accounting period.
Both sole traders and limited companies will have to register for VAT in the event their turnover exceeds the VAT threshold. There may be benefits of early VAT registration but this would need to considered on a case by case basis and you should consult with a qualified accountant.
If you are intending to be in business for greater than a year and your profits are likely to exceed £20k it may be worth considering a limited company set up. Whichever path is chosen, it’s important to understand that your decision isn’t final. It is always possible to change at a later date. A lot of small businesses start as sole traders and they convert to a limited company when they start to get bigger.