The tax imbalance and disparity of financial security between different types of self-employed workers and small business owners in the UK leads many people to consider the benefits of converting from sole trader to limited company.
To help you to make an informed decision, we discuss the key differences between these two popular business structures.
What is a Sole Trader?
A sole trader business is owned and controlled by one self-employed individual. There is no legal distinction between you and the business – you are one and the same in the eyes of the law. This is hugely significant because it means that, as a sole trader, you have unlimited personal liability for any and all business debts, losses, and legal claims.
Consequently, your personal finances and assets, including your home and savings, are at risk if you are unable to pay business-related debts, or if you are sued during the course of running your business. In a worst-case scenario, this could result in personal bankruptcy.
What is a Limited Company?
A limited company is owned by one or more shareholders and managed by one or more directors. The same person can be a shareholder and a director, so you have the option to own and control the business by yourself (just like you do as a sole trader) or jointly with other people.
A limited company has its own legal identity and is liable for its own debts, losses, and any claims brought against the business. This means that the finances, liabilities, and actions of the company are completely separate from those of its shareholder(s) and director(s).
As a result, company owners enjoy limited liability. Beyond what they invest in the company, or agree to contribute, their personal finances and assets are protected if the business can’t pay its bills, or if it is sued.
Limited liability is reason enough for many self-employed people and small business owners to set up a limited company from the get-go or convert from sole trader to limited company at a later stage. However, there are many more benefits, which we highlight below.
Sole Trader vs Limited Company: the key differences
Sole trader and limited company business structures are the most popular options for people who want to work for themselves, but there are significant differences between the two.
Setting up as a sole trader is the go-to business structure for many self-employed individuals in the UK because it’s a straightforward way to start and run a business. That being said, a limited company is the most secure and tax-efficient option for almost all types and sizes of businesses, offering far greater benefits than operating as a sole trader.
If you are thinking about converting from sole trader to limited company, it will be helpful to understand these key differences, as well as the advantages and disadvantages of both structures.
1. Registration and internal business structure
|Sole Trader||Limited company|
|Registered through HMRC||Registered (incorporated) at Companies House|
|No cost to register a sole trader business||Small incorporation fee payable to Companies House|
|You can trade using your own name or another name. There is no need for this name to be registered.||A unique company name must be registered at Companies House during the incorporation process
Stricter rules and requirements apply to company names
|No legal distinction between owner and business – you are the business; the business is you||A company is a distinct legal ‘person’ that is separate from its owner(s)|
|Unlimited liability – you are held personally responsible for business debts and legal disputes
If your business fails, you are at risk of personal bankruptcy
|Limited liability – the company is held responsible for business debts and legal disputes (limited exceptions apply)
If the business fails, the company is at risk of insolvency (i.e. corporate ‘bankruptcy’), not the shareholder(s) or director(s)
|Owned by one person only||Can be owned by one or more people, who are known as ‘members’ or ‘shareholders’
Managed by one or more people, who are known as ‘directors’
Shareholders and directors can be the same people
|You are self-employed
During the COVID-19 crisis, some sole traders are eligible for government support based on their average declared trading profits over the past 3 tax years
|You are employed by the company as a director, which means that you may be eligible for certain employee benefits
During the COVID-19 crisis, some directors were eligible for furlough and government support based on their PAYE salary (but not dividend income)
|Must provide HMRC with a business contact address. This is not available to the public unless you include it on business stationery or other forms of communication or marketing material||The company must have a registered office address in the country of incorporation
Every director and shareholder must provide a service (‘correspondence’) address.
Both of these addresses are a matter of public record
|If a sole trader dies, the business ceases to exist||If the sole shareholder and director of a company die, the company still exists in its own right. This is known as ‘perpetual succession’|
|As a rule, a number of industries and agencies will not work with self-employed freelancers or sole traders||Depending on the industry in which you operate, you may find that having limited liability protection offers a greater choice of clients and contracts|
2. Business income and taxation
|Sole Trader||Limited company|
|All business income belongs to you||Business income belongs to the company until it is transferred to you as:
• a director’s salary
• shareholder dividends
• a director’s loan
|You pay Income Tax (20-45%) and National Insurance contributions (Class 2 and Class 4) through Self Assessment on all declared business profits above your tax-free Personal Allowance (PA)
|You pay Income Tax and Class 1 National Insurance contributions (NIC) through PAYE on your director’s salary (above your PA)
You pay dividend tax (7.5%-38.1%) and NIC (Class 2 and Class 4) through Self Assessment on dividend income above your PA and the £2,000 tax-free Dividend Allowance. These tax rates are lower than Income Tax rates
The company pays a flat rate of 19% Corporation Tax on all taxable profits. This is lower than Income Tax rates.
You can minimise your personal tax and NIC liabilities by taking a lower salary and higher dividends
|You cannot pay a spouse or partner through the business unless it is commercially justified||If your spouse or partner is a basic rate taxpayer or is not in receipt of any income, you could avoid higher tax bands by making your spouse or partner a shareholder|
|The deadline for paying your Income Tax and NIC liabilities on your sole trader income is 9 months after the end of the tax year||Income Tax and NIC are deducted from your salary immediately through PAYE
You do not have to pay tax or NIC on your dividends until 9 months after the end of the tax year
|You cannot keep profits in the business in order to defer tax until a future tax year||You can defer tax on profits by leaving surplus income in the company to withdraw in a future tax year
This is a great option if withdrawing all profits in one year would result in paying a higher rate of personal tax
|Your ability to borrow capital for business purposes is based on your personal credit rating
You are personally liable for business loans; therefore, your own credit rating will be impacted if you default on a business loan or are unable to pay it back
|A company can establish its own credit profile and borrow capital in its own name
The company will be liable for business loans taken out in its name; therefore, it is the company’s credit profile that will be adversely affected if it defaults on a business loan or fails to pay it back
3. Accounting, reporting, and record-keeping requirements
|Sole trader||Limited company|
|No information about you or your business is made available to the public by HMRC||Company information is a matter of public record, including accounts and certain details relating to directors and shareholders|
|No annual filing or maintenance fees||A Confirmation Statement must be sent to Companies House every year to confirm/update certain company details. This costs £13|
|No legal requirement to keep or submit accounts, though it is beneficial to do so||It is a legal requirement to prepare annual accounts for Companies House and HMRC|
|Must register for Self Assessment
Must report your self-employed income by sending a Self Assessment tax return to HMRC every year
|The company must register as an employer and set up PAYE, even if you (the director) are the only employee
The company must operate payroll to pay, record, and report your director’s salary
A Company Tax Return must be delivered to HMRC each year
If you are a shareholder as well as a director, you must register for Self Assessment and send a personal tax return to HMRC every year to report your total annual income from all sources (salary, dividends, any other earnings)
|Keep records of all sales and expenses||Keep accounting records and company records, including a number of statutory registers that must be made available for public inspection|
4. Expenses and benefits
|Sole trader||Limited company|
|Not eligible for Statutory Sick Pay (SSP)||Company directors may be able to claim Statutory Sick Pay (SSP)|
|Only eligible for a personal pension scheme||Access to more favourable, tax-efficient, and customisable pension scheme options through a company|
|You can claim capital allowances on your car, but you must disallow a proportion for the private use of the vehicle||Companies are eligible for full capital allowances on cars, regardless of any private use|
|Tax relief on mobile phones and computers will be apportioned according to business and private use – an add-back of capital allowances will apply||Mobile phones and computers are tax-free if they are purchased by the company
More tax-free benefits available through a company, including parking charges, public transport, travel costs, health checks, eye tests and prescription eyewear, childcare, and school fees
|You can’t charge yourself rent for the use of your home for business purposes||You can charge rent to the company for the use of your home for business purposes, which will enable you to offset a proportion of your mortgage interest and council tax|
How much does it cost to set up and maintain a limited company?
Companies House charges a small incorporation fee to set up a limited company. At 1st Formations, we offer online company formation from just £12.99, which includes:
- A ready-to-trade limited company incorporated at Companies House within 3-6 business hours (subject to Companies House workload)
- Expert help and guidance throughout the company formation process and beyond
- All company registration documents, including a Certificate of Incorporation, Share Certificates, a Memorandum of Association, and Articles of Association
- Statutory Company Registers, which are a legal requirement
- Free business bank account
- Optional services, including company address services, VAT registration, Confirmation Statement service, and much more
The only statutory cost of maintaining a limited company is £13/ year, which you must pay when you file an annual Confirmation Statement at Companies House.
Whilst there are no filing fees to pay, you may wish to use an accountant, particularly if you are not confident with bookkeeping and accounting, or if your business finances are complex.
The typical cost of using an accountant ranges from £750 to £1,500 a year for the preparation of accounts and tax returns.
This may seem like a significant sum, but for many business owners, it’s a small price to pay for financial peace of mind, in addition to the prestige, tax advantages, and limited liability protection of a limited company.
Converting your business from Sole Trader to Limited Company
If you decide to convert your existing small business from sole trader to limited company, you will need to take the following steps:
1. Register a limited company
The first step is to register a limited by shares company. The most popular and inexpensive way to set up a company is through an approved company formation agent. The procedure is incredibly straightforward and is done entirely online, with most applications processed and approved by Companies House in a few working hours.
To register a limited company online, you will need:
- a unique company name
- a registered office address
- at least one director
- at least one shareholder
- a service address for each director and shareholder
- Standard Industrial Classification (SIC) code(s) to describe the nature of your business activities
See also: Information Required to Set Up a Company
Limited company names are subject to more rules and restrictions than sole trader names. If you wish to register your existing business name as a company name, you can use our free company name checker to find out if it is available before you begin the application process.
2. Tell HMRC that you have decided to stop being a sole trader
When your new company has been incorporated and you are ready to start trading through this business structure, you will need to tell HMRC that you are stopping self-employment and will cease running your business as a sole trader. To do this you must complete an online form with the following details:
- The date on which you stopped being self-employed
- Unique Taxpayer Reference (UTR)
- National Insurance Number
- Date of birth
- Nature of trade
You will need to send a final Self Assessment tax return as a sole trader by 31st January after the end of the tax year. The income reported on the return should include your self-employed earnings and tax liability up to the date on which you stopped being a sole trader. You may also need to include:
- allowable expenses, including any costs involved in converting your business structure
- capital allowances on any sole trader assets transferred to your limited company
- Capital Gains Tax (CGT) on any business assets transferred to the company
3. Transfer your sole trader business to the company
Depending on the nature of your sole trader business, you may need to transfer your existing business assets (such as property, machinery, equipment, inventory, etc.) to your new limited company.
Naturally, your new company is unlikely to have available funds to pay for these assets. In this situation, the most common approach is to create a director’s loan account whereby the company will pay you (the director) for the transferred business assets over time.
Transferring certain assets may trigger Capital Gains Tax (CGT) liability, which will be based on the market value of the assets.
Depending on your specific circumstances, you may be able to reduce or defer CGT by claiming some form of tax relief, such as Incorporation Relief, Business Asset Disposal Relief (formerly Entrepreneurs’ Relief), or ‘Hold-over’ Relief.
Transferring assets can be a complex matter for some businesses, so we advise speaking to an accountant for expert help and advice.
4. Set up a business bank account in your company name
There is no legal requirement for sole traders and limited companies to operate business bank accounts. However, it is advisable to keep your business finances separate from your personal finances.
Aside from making bookkeeping and accounting easier, you will avoid the risk of taking money out of the company illegally.
1st Formations have partnered with several of the leading names in UK banking to offer our customers an excellent selection of business bank accounts, including Barclays, Cardone, TSB, CountingUp, Mettle, ANNA, Revolut, and Cashplus. These accounts are available to customers during the online company formation process.
5. Notify stakeholders about the change of business structure
Regardless of whether you register a new company name or continue using your existing business name, you will need to inform a number of parties that you have changed the legal structure of your business and will now be operating through a limited company.
The stakeholders that you will have to notify include (where applicable):
- Employees and contractors
- Customers and clients
- Suppliers and service providers
- Banks, lenders, and other finance providers
By informing all interested parties, you are keeping everyone abreast of important changes to your business, minimising any risk of confusion or voiding contractual agreements, and ensuring all paperwork and invoices contain the correct details.
You may also need to provide your new business bank account details to certain parties.
6. Register your limited company for tax and PAYE
When your new company has been incorporated, Companies House will inform HMRC. You will receive a letter from HMRC at your company’s registered office address within approximately 2 weeks of company formation.
This will contain information about your tax and reporting obligations, as well as your company’s 10-digit Unique Taxpayer Reference (UTR).
You must register your company for Corporation Tax online within 3 months of starting to trade through this new structure. To do so, you will need your company UTR and Company Registration Number to hand.
If you expect your VAT taxable turnover to be more than £85,000 within a 12-month period, you must register the company for VAT.
Alternatively, you may wish to voluntarily register for VAT to improve the tax efficiency and status of your company. If your sole trader business is registered for VAT, you should cancel this existing registration within 30 days of changing your business structure.
To receive a director’s salary and pay employees (if you have any), you will need to register as an employer and set up Pay As You Earn (PAYE) before the first payday. You can choose to operate PAYE yourself using payroll software, or you can appoint a payroll provider to take care of this for you.
Take-home pay comparison: Sole Trader vs Limited Company
Compared to the sole trader structure, a limited company provides the opportunity for many freelancers and small business owners to reduce their tax and NIC liabilities, providing them with a higher take-home pay. Below is a simple example, based on a trading income of £50,000 for the current 2021/22 tax year.
|Sole Trader||Limited Company|
|Income Tax = £7,486
National Insurance = £3,797.48
|Take a director’s salary of £8,840/year (the NIC secondary threshold). This salary is also within your tax-free Personal Allowance (PA)
Corporation Tax = £7,820.40
Take gross dividends of £33,339.60
Dividend Tax = £2,070.72
|Take-home pay = £38,716.52||Take-home pay = £40,108.88|
By trading through a limited company, a tax saving of £1,392.36 can be achieved on a £50,000 trading income – and that’s without factoring in any tax-deductible costs and expenses of running the business.
However, bear in mind that you may have to pay accountancy fees if you are not confident dealing with company bookkeeping and accounting requirements yourself.
Is it worthwhile converting from sole trader to limited company?
There are some great benefits to setting up a limited company, which we’ve highlighted above, making it a worthwhile decision for many people. However, it is not a one-size-fits-all structure, nor is there a set point at which converting to a limited company is a necessity.
More often than not, converting from sole trader to limited company is simply a matter of personal preference. Ask yourself:
- Will I pay less tax and receive a higher take-home pay through a limited company?
- Will the prestige of a limited company help me to attract more clients and grow my business?
- Could I benefit from my personal assets being protected, should my business fail?
- Do I want to bring in business partners or attract investment?
- Are these benefits worth the extra administration and filing requirements?
Your choice of business structure very much depends on your circumstances and what you are comfortable with. If you are unsure about the best course of action, you should seek tailored, professional advice from a reputable accountant, many of whom offer a free initial meeting.