Choosing between operating as a sole trader or a limited company is one of the first major decisions for anyone starting a business in the UK. Both structures have their benefits and drawbacks, and the choice often depends on your business goals and financial situation. In this article, we'll explore the differences, benefits and disadvantages of each structure. Plus, we'll guide you through the full process of transitioning to a limited company.
What is a sole trader?
A sole trader is a self-employed individual who runs their business as an individual entity. It’s the most straightforward business structure in the UK, making it popular among freelancers, contractors and small business owners.
Key features
You are the sole owner of the business.
You are personally liable for debts, meaning there’s no legal distinction between you and the business.
You pay income tax on your profits through a Self Assessment tax return.
It’s simple to set up and has minimal ongoing administrative requirements.
Common sole trader business types
Freelancers
Tradespeople
Small retail shops or food vendors
Professionals like tutors, fitness trainers or consultants
What is a limited company?
A limited company is a separate legal entity from its owners. It's owned by shareholders and managed by directors (who can be the same person in smaller businesses).
Key features:
Owners are only responsible for business debts up to the value of their shares, protecting personal assets
It must be registered with Companies House and comply with stricter regulations
Corporation tax is paid on profits, and directors may pay additional income tax and national insurance on their earnings
Financial information, such as annual accounts, must be made publicly available
What is the difference between a sole trader and a limited company?
Feature | Sole Trader | Limited Company |
|---|---|---|
Legal entity | Not separate from the owner | Separate legal entity |
Liability | Unlimited personal liability | Limited liability for shareholders |
Taxation | Income tax on profits | Corporation tax, plus director's tax on salary/dividends |
Setup complexity | Simple and quick | Requires registration with Companies House |
Administrative burden | Minimal | Higher due to legal and accounting requirements |
Public visibility | Private financial records | Publicly accessible financial records |
💡Editor's tip: "I find lots of small business owners and new sole traders aren't aware of trading allowances (sometimes known as a hobby allowance). This is a tax exemption of up to £1,000 a year that may apply to you if you're starting out."
Benefits of being a limited company over a sole trader
Operating as a limited company has many advantages that can appeal to a growing business:
Limited liability: Your personal assets, such as your home and savings, are protected from business debts, reducing financial risk.
Tax efficiency: Limited companies often pay less tax on profits compared to sole traders. Directors can also optimise their income through a mix of salary and dividends, which can reduce personal tax liability.
Professional image: Being a limited company can enhance your credibility with clients, suppliers and investors, as it demonstrates stability and professionalism.
Access to funding: Limited companies can issue shares to raise capital, making it easier to attract investors and expand the business.
Business continuity: A limited company exists as a separate entity, meaning it can continue operating even if ownership changes.
Disadvantages of being a limited company over a sole trader
Despite its benefits, operating as a limited company also has a few key drawbacks to consider.
Increased administrative burden: Running a limited company requires regular filing of accounts, annual returns and compliance with strict regulations.
Public financial information: As a limited company, certain financial details must be made publicly available, which some business owners may find intrusive.
Higher setup costs: Setting up a limited company involves registration fees and may require professional advice, increasing initial expenses.
Complex tax requirements: While tax efficiency is a benefit, limited companies face more complex tax obligations, requiring careful management or professional assistance.
More difficult to withdraw funds: Directors cannot withdraw profits freely, as funds are tied to salary or dividends, which must be accounted for in the company’s financial planning.
When to change to a limited company
Many sole traders eventually reach a point where transitioning to a limited company makes sense. Here are some common scenarios:
Growing profits: If your business profits reach a level where the tax savings of a limited company outweigh the administrative costs, it may be time to make the switch.
Liability concerns: If your business involves higher financial risk or potential liabilities, limited liability offers peace of mind.
Credibility needs: If clients or investors are more likely to trust a limited company, transitioning can improve your business reputation.
Expansion plans: When seeking funding, taking on shareholders, or entering into larger contracts, a limited company structure is often essential.
How to change to a limited company
Transitioning from a sole trader to a limited company is easier than it sounds. Here are the key steps involved - you can learn more in our comprehensive guide to how to open a limited company.
1. Choose a company name
Ensure your chosen name is unique and complies with Companies House naming rules.
2. Register with Companies House
File your incorporation documents online including the memorandum of association, details of directors, shareholders, and the registered office address.
3. Inform HMRC
Notify HMRC that you are ceasing to operate as a sole trader and provide details of your new limited company.
4. Open a business bank account
Set up a dedicated bank account for the limited company to keep finances separate.
5. Transfer business assets and contracts
If you own equipment, stock, or have supplier agreements, transfer them to the new company. This may involve legal documentation.
6. Register for VAT and PAYE (if applicable)
If your business turnover exceeds the VAT threshold or you employ staff, ensure you register for VAT and PAYE.
7. Hire an accountant
Engage a professional to help manage the increased administrative and tax requirements of a limited company.
FAQs
What is the difference between a sole trader and a limited company?
The primary difference lies in liability and structure. Sole traders are personally liable for all debts, whereas limited companies provide limited liability protection. Additionally, limited companies face more regulations but offer tax benefits and enhanced credibility.
Which is better: sole trader or limited company?
It depends on your business needs. Sole traders benefit from simplicity and flexibility, while limited companies are ideal for those seeking liability protection, tax savings, and growth opportunities. You may also want to consider the pros and cons of a private limited company too.
Can I switch from sole trader to limited company?
Yes, transitioning from sole trader to limited company is common as businesses grow. It involves registering with Companies House, notifying HMRC, and transferring business assets.
Are sole traders taxed differently from limited companies?
Yes, sole traders pay income tax on their profits, while limited companies pay corporation tax. Directors of limited companies may also pay personal tax on their salary and dividends.
Final thoughts
Choosing between a sole trader and a limited company is a critical decision that can significantly impact your business’s finances, liability and growth potential. While sole traders enjoy simplicity and flexibility, limited companies offer tax efficiency, credibility, and access to funding.
Transitioning to a limited company is a natural progression for many sole traders seeking to expand or protect their personal assets. By weighing the pros and cons and understanding the differences, you can select the business structure that aligns best with your goals.
If you have a legal business concern, we're here to help. Get a free quote today and see how our small business solicitors can be of service.
References
Set up a business from Gov.UK
Become a sole trader from Gov.UK
Corporation tax from Gov.UK
Disclaimer: This article only provides general information and does not constitute professional advice. For any specific questions, consult a qualified accountant. Bear in mind that tax rules can change and will differ based on your circumstances.