Sole Trader vs Limited Company: What Are The Differences?
The dream of every young entrepreneur is to scale up their business. It is cool to start the business as a sole trader till you eventually find your feet and become more established.
When you decide to start a business, you must choose which option to set up: Sole Trader Vs Limited Company. Your choice depends on the size (capital inclusive) and nature of the business.
Business structure influences the type of tax you will be required to pay and every other benefit of each legal entity.
This article will explore the differences between Sole Trader vs Limited Company to help business owners make informed decisions.
What is A Sole Trader?
A sole trader is also known as a sole proprietor who exclusively runs and manages a business. In sole trading, the business is owned by a single individual with no legal difference between the business and the individual running it.
This is the simplest and most popular business structure out there. Many business owners who started on a small scale began with this structure before incorporation.
In sole trading, the individual has limitless personal liability for all business debts and losses which can be considered a major drawback of this arrangement.
This means that if you can't pay off debts incurred by the business, you risk losing your assets and all of your money.
Characteristics of a Sole Trader
There are different characters through which sole trader business can be identified. These characteristics include:
1. Single membered
The business is managed by a single member who has total control over all business decisions.
2. Personal Liability
The single owner is responsible for all liabilities and debts of the company. The owner's assets, such as their home or vehicle, may be used to settle business debts if the company incurs debt or is sued.
3. No Legal Entity
There is no formal legal structure. The business and its owner operate as one.
4. Basic Structure
Sole trader business involves minimal paperwork and legal formalities. It often requires just registering the business name and obtaining any necessary licenses or permits.
5. Direct Income and Taxes
All profits made from the business belong to the sole trader and are considered personal income. This income is subject to personal income tax rates.
What Are The Advantages of Sole Trader
Here are some of the advantages of running a sole trader business:
1. Easy To Establish
Establishing a sole trader business is quick and less expensive to operate, unlike other types of business entities. An individual may generate a business idea and execute it within a short time frame depending on the size and type of business. It has fewer rules and regulations, thus, it is less complicated.
2. Minimum Capital Required
Most sole traders started businesses with personal funds, savings or funds gathered from relatives. You can use personal income to fund your small-scale business and watch it grow in the first few years before sourcing for a loan or huge capital.
3. Privacy
Unlike corporate organizations, sole traders do not need to publish financial statements or disclose business details publicly. No one demands business or sales accountability from a sole trader, all inventories are managed by their owners.
4. Complete Ownership
Sole traders have full autonomy over business decisions without needing to consult with partners or shareholders. He bears the responsibilities and consequences of any business decisions made by him.
What Are The Disadvantages of Sole Trader?
While the advantages of sole trader business can be amusing, the disadvantages are quite numerous. They include:
1. Limited Access to Capital
A sole trader's business is usually funded by personal savings or money obtained from relatives. Raising funds can be challenging as sole traders may have limited access to loans and investments compared to larger business structures.
2. Unlimited Liability
The owner is personally liable for all debts and legal actions against the business, which can pose a significant risk. If your business fails or runs into debt, you will lose your income and pay debt from personal funds and assets all by yourself.
3. Limited Growth Potential
Sole traders may face difficulties in sustaining growth, as the business's success is heavily reliant on the owner's skills and capacity. The growth rate might be slow because expansion may require more capital, labour and a well-defined business structure.
4. Credibility
Sole trader businesses do not have the required structures and documentation to prove their credibility. Clients and investors may view sole traders as less established or credible compared to companies.
5. Inefficient Tax
In sole trading, all profits made are liable to income tax and are considered less tax efficient. A limited company can maximize profits and avoid paying taxes with greater freedom.
What is a Limited Company?
A limited company (LC) is a type of business entity separate from its owners wherein the shareholders of the firm have limited liability. It is a multiple membered establishment which is usually managed by a director employed to oversee operations at the firm.
The 2006 Corporations Act and the company's articles of association apply to limited corporations. By law, limited corporations are required to submit information to corporations' houses regularly.
Types of Limited Company
Here are the types of limited companies you can find.
1. Private Limited Company by Shares
Ownership of this company is distributed by shares. The multiple members are referred to as shareholders who together put a substantial amount of shares to establish the company. Private limited companies do not offer shares to the general public.
2. Private Company limited by Guarantee
These are private companies limited by guarantee and are usually non-profits or charitable organizations. The guarantors contribute their percentage in situations like debt or bankruptcy. They appoint directors to manage and oversee operations in the firm.
3. Public Limited Company
Similarly to a private limited company, ownership of public limited companies is shareholders. Although public limited companies offer shares to the public which means the firm allows for numerous ownership according to the percentage of shares bought.
Characteristics of a Limited Company
Here are the characteristics of a limited company. Namely:
1. Limited Liability
Limited personal liability is one advantage shareholders enjoy from a limited company. In situations of debts or business closure, shareholders are only legally responsible to the extent of their investment in percentage. Their personal assets are protected from the company’s debts and legal actions.
2. Separate Legal Entity
The company is legally separated from its shareholders. This means the company can own property, incur debt, sue, and be sued in its own name. This separate legal entity provides the credibility the business needs to transact effectively.
3. Ownership and Shareholders
A limited company is owned by a minimum of two shareholders and a maximum of fifty shareholders. This permits a close-knit ownership structure while maintaining raising capital from multiple members. While a group of shareholders own a company, a director is hired to manage the activities of the firm.
4. Succession (Transferability)
In case of death of any member of shareholders, the company continues and there’s the advantage of transferring ownership of shares to another.
What Are The Advantages of a Limited Company?
Here are some of the advantages of a limited company.
1. Limited Liability Protection
Limited Company shareholders enjoy the protection of limited liability. This means their personal savings or assets are safe should the company experience debts or failure. This is why most entrepreneurs would love to run their business through a limited company, to detach personal funds from business-related issues.
2. Tax Efficiency
Limited companies enjoy the benefit of more favourable tax relief as compared to other entities. Additionally, this business entity offers greater opportunities for tax planning measures, especially compensation and business succession plans.
3. Capital Raising
Limited companies can raise capital faster than sole trader businesses. They possess the structure and transparency that investors desire. It is quite easy to get prospects part away with their funds due to their good reputation.
4. Separate Legal Entity
A limited company exists independently of its owners as a separate legal entity. The business operates as a single entity which allows for signing contracts, owning properties, and obtaining loans under its name. This gives room for easy business transactions, transparency and professionalism that other businesses might not offer.
5. Continuity
A limited company can continue for as long as possible even if shareholders leave or pass away. The ability of the business to still carry on after the death of its member provides stability and confidence to employees, customers, and suppliers.
6. Credibility
Limited companies are perceived as more credible and efficient to do the job effectively. This enhances business reputation and attracts more clients or investors. A limited company has structures and legal documentation that prospects and investors seek. Even customers will prefer to associate with a limited company.
What Are The Disadvantages of Limited Company
The advantages of a limited company are appealing, however, here are the disadvantages you should consider before choosing the business entity of your choice:
1. Public Disclosure
While a sole trader has the freedom to make decisions and manage inventory by themselves, a limited company must disclose certain information to the regulatory body and the public for inspection. Sensitive information such as financial statements, annual returns, and details of directors and shareholders are made accessible to the general public and this may include competitors as well.
2. Compliance Cost
A limited company is simply backed by certain compliance requirements which penalties are costly to bear if there’s a default. Compliance regulations are strict laws including maintaining proper records, conducting annual audits, and filing regular statutory returns.
3. Administrative burden
Meeting compliance regulations is an additional administrative burden. Due to the broad structure of a limited company, management of the company is usually burdened with overseeing activities in all sectors of the company, ensuring accurate inventory of the business is taken, filing annual returns, filing tax payments, and also providing professional assistance.
4. Cost of Establishment
Establishing a limited company is more expensive than a sole trader. The expenses vary from the cost of registration, annual accounting fees, and legal fees.
Key Differences: Sole Trader Vs Limited Company
How To Move My Business from Sole Trader to Limited Company
There are step-by-step guides to show you how to move your business from being a sole trader business to a limited company. Read the guide below:
1. Understand the benefits and Implications of Limited Company
A limited company has numerous advantages over a Sole trader business which include:
- Limited companies are perceived to be more credible by investors, banks and the public. Your business will be more recognised once you transfer from a Sole trader business to a limited company.
- Limited companies enjoy limited liability which protects shareholders' personal assets.
- Tax benefits: Tax rates are lesser in percentage. Usually 12.5% of profits. No personal income is taxed.
- Access to capital: Due to a rise in credibility, your company becomes eligible for loans, grants and other methods of obtaining funds.
The necessary documentation and structure needed to obtain a loan comes with setting up a limited company.
The implications also include the following:
- Increase in administrative responsibility: The limited company requires more teamwork and an equipped administrative body.
- Zero privacy: All accounts including annual returns, financial account statements, and shareholders details are made public. Before transitioning to a limited company, you should understand that the business isn't about you anymore, the company is now accountable to shareholders, regulatory authorities and the general public.
- Massive cost: Limited companies are costly to establish. It requires higher costs, paying more talents to get the job done and every other expense to keep the business running.
2. Incorporate your business
The first obvious step to changing business structure is to register your business to your desired structure. To register your business as a limited company, here are a few important things you will need:
- A business name: You can decide if you want to continue with your previous business name or choose a new one.
- A registered office address
- At Least a director and a secretary.
- Details of company shares and shareholders.
The service of an accountant or lawyer may be required during the process of incorporation.
Contact our team for business advice on how to go about transitioning from Sole Trader to Limited company.
3. Inform HRMC or any tax authority
Inform HMRC of your business change after three months of new business activities. They are responsible for VAT registration and any other tax filing.
4. Transfer business assets to the new company
Sole trader business assets are also considered as personal income. In the process of transitioning from Sole trader to limited company, you need to consult your lawyer before moving any business assets, to avoid mix up and irregularities in account.
5. Set up a business bank account
Now, the business is no longer a sole trader business, you need to set up a business bank account which will be distinct from your personal or stakeholders account.
Open up a bank account in your company's name.
6. Notify all stakeholders about the new business structure
Stakeholders include shareholders, partners, investors, clients and suppliers. Notify them of all of the changes in your business structure.
7. Hire an accountant to restructure new accounting records
Hire an accountant to monitor and manage records going forward.
What Are Their Tax Rates?
Understanding the tax rate and differences between sole trader businesses and limited companies will help you make informed decisions before transitioning.
Sole Trader Tax
As a sole trader, there are key taxes you need to be aware of: Income Tax and National Insurance contributions (NICs).
Income Tax
- Personal allowance: The first £12,570 of your profit for the year is tax-free.
- Basic rate: Profits between £12,571 - £50,270 are charged at 20% tax rate.
- Higher rate: Profit between £50,271 - £125,140 will be charged at 40% tax rate.
- Additional tax rate: Any profit exceeding £125,140 will be charged a 45% tax rate.
National Insurance Contributions (NICs)
Sole traders pay two types of NIC tax:
- Class 2 NICs
£3.45 per week if your profits are £12,570 or more yearly.
2. Class 4 NICs
- 9% on profits between £12,570 and £50,270.
- 2% on profits over £50,270.
Limited Company
Limited companies are subject to corporation tax, directors salary and dividends.
- Corporation tax: 19 - 25% depending on profits.
- Directors salary as taxed through PAYE
- Lower tax rates (8.75%, 33.75%, 39.35%) than income tax rates.
Do I need business insurance for the limited company?
Obtaining insurance for a limited company is highly recommended. Several types of insurance should be incorporated into a limited company, some of which include Employer’s liability insurance, Professional Indemnity insurance, Public Liability insurance, Directors and officers insurance, and Cyber Insurance.
1. Employer’s Liability Insurance
If you have employees, even just one, you are legally required to have employers' liability insurance. When an employee encounters an incident or is made ill through work, the employer’s liability insurance covers health costs.
2. Professional Indemnity Insurance
Professions such as accounting, medicine, aesthetics and consulting are required to have professional indemnity insurance. This insurance covers claims for professional negligence, errors, or omissions in the services you provide.
3. Public Liability insurance
If your business requires interaction with the general public, public liability insurance is strongly recommended. Usually, businesses with physical locations use this coverage for injury or property damage caused by business activities done within the premises.
4. Directors and Officers' insurance
While limited companies have a limited liability advantage, the director and officer have an unlimited liability. This means that in the case of mistakes or errors, the general public, competitors or clients can charge the directors to court, separate from the company itself. The D&O insurance covers personal liability for directors and protects their assets against legal claims.
5. Cyber Insurance
This insurance covers financial losses and legal costs associated with cyber-attacks, data breaches, and other cyber incidents.
Form Your Company with Incorpuk Today
At Incorpuk, we will help you through the company formation process and file your confirmation statements to help your business stay compliant. Whether you're a UK resident or a non-UK resident, our team is ready to provide guidance and help you establish your company in the UK. Contact us here today.
Conclusion
After reading the difference between a Sole Trader vs Limited Company, you will agree that establishing a limited company is more economically and legally preferable to a sole trader business. A business owner should think long-term before embarking on entrepreneurship. If you want sustainable growth for your business, a limited company has what it takes to bring your dream to reality.
While you’re left with the best decision to make based on the differences between a sole trader and Limited company, kindly, contact one of Incorpuk’s experts here.