When you start out in business it is difficult to know whether to be a sole trader (self-employed) or a limited company. And many will wonder what the difference is and whether there are advantages of one over the other.
A few years ago it was said that it was more tax efficient to be a limited company but these days there really isn't much difference in tax savings between the two.
So how do you decide?
The choice has to be based on the type of business you are starting and only you and an accountant really know which is the best option for you.
My experience working with small businesses is that generally it is better to start as a sole trader.
Advantages of being a sole trader
1. You can start trading straight away in your own name.
2. You can open a business bank account more easily than you can if you are a limited company.
3. You don't have to register with HMRC until 5 October in your second year of trading. However you must register by then to avoid a fine and to ensure you receive a self-assessment tax return to complete. You only need to register if you earned more than £1,000 in the tax year.
4. Accountancy fees for preparing and submitting self-assessment tax returns are a lot less than preparing and submitting limited company accounts. And you could even do the tax return online yourself to save on costs.
5. Your accounting period will generally run from 1 April to 31 March in line with HMRC tax year making it easier to prepare your accounts.
6. If the business doesn't take off you can just stop and as long as you submit your final self-assessment tax return declaring your income and expenses for that year you don't need to do anything else.
7. Tax is payable on the profits of your business before deduction of any drawings you may have taken and is payable by you personally and not the business as the profit is your income.
But you may decide because of the type of business you are starting that you want to be a limited company. The reasons for choosing this entity may be so that you give the impression of being a larger business and for the protection it gives you personally if the business fails.
Disadvantages of being a limited company
1. Accountancy fees will be significantly more to prepare and submit limited company accounts and corporation tax returns to HMRC and Companies House.
2. There will be initial set up costs when purchasing limited company status. This can be done online fairly cheaply but will cost more if set up is done by an accountant.
3. It can be more involved to obtain a business bank account and often takes longer before it is available to use.
4. There will be further accounting costs to shut down your company if things don't work out.
5. You will be an employee of your company and will therefore need to set up and run a payroll and file returns on time.
6. You have significant responsibilities as a director of a limited company. Read more about Director responsibilities here.
Advantages of being a limited company
1. You can take a smaller salary but still receive the benefit of National Insurance contributions.
2. If you take a larger salary your business will pay employer's National Insurance contributions for you which will reduce the profit of the business.
3. Your business can make a pension contribution on your behalf reducing the profit of the business.
4. If your business makes a profit after corporation tax has been accounted for you can take dividends.
5. Corporation tax is payable on your profit before dividends and is paid by the company although is not classed as a business expense.
Whichever entity you choose for your business you will need to keep accurate accounting records and register for VAT when you reach the VAT registration threshold of £85,000.