Switching from Sole Trader to Limited Company

The structure you choose when setting up your business can impact everything, from how much tax you pay to how quickly you can grow. When starting out, it may make sense to keep it simple and set up as a sole trader, but transitioning to become a limited company may be more appealing as your business develops. Before doing this, it's essential to understand the difference between the two options and be sure that it's the right time to make the change.

What's the difference between a sole trader and a limited company? 

As a sole trader, you'll be self-employed and have full ownership of your business. Crucially your business is not a separate legal entity, which means you are entirely liable for any debts it may accrue. To become a sole trader, you must register using the government portal within three months of founding your business. Read our blog, How to Register as a Sole Trader, to learn more.

A limited company, on the other hand, is legally distinct from the owner. It has a unique company identity, which must be registered with Companies House, and because of this, there may be more than one owner or director. Directors will have limited liability — meaning their finances won't be affected should the business incur any losses or debts.

Pros and cons of being a sole trader

The most significant advantages of being a sole trader are the ease and low setup cost and the fact that you can keep all the profit you make. Getting started is simply a case of informing HMRC that you're a sole trader, you can be up and running in no time, and you don't need to spend ages filling in forms. You will also have complete control over your business, enabling quick decision-making and organisational flexibility. A sole trader's tax affairs will also be more straightforward, with the main requirement being submitting an annual tax return and ensuring you pay the required tax. You will need to register for VAT as a sole trader if you exceed the £85,000 threshold, adding to your responsibilities, but this will still be less than a limited company. 

The biggest potential drawback of being a sole trader, however, is the issue of unlimited liability, which means you are responsible personally for any debts and losses of the business. This structure can also impact your ability to secure finance. Lenders tend to be more wary of sole traders because of the unlimited liability aspect, so it can be harder to raise finance, and you may not be able to borrow as much as you could as a limited company.

It's also worth noting that while having sole decision-making responsibility can be a plus, being a sole trader means that you're responsible for every aspect of the running of your business, which can be daunting. A sole trader business structure also lacks some of the prestige of a limited company, so think about the market you're going to be working in and what the norm is here, as this will tell you what potential clients expect from the businesses they work with.

Pros and cons of operating as a limited company

Establishing a limited company will be more complex than operating as a sole trader; you must pay to be incorporated with Companies House, and your accounting requirements will be more complex and time-consuming. For example, a Confirmation Statement and annual accounts must be filed at Companies House each year, and a company tax return and annual accounts must be delivered to HMRC every year. Limited companies must also meet strict record-keeping requirements, including taking minutes of meetings and recording all decisions taken by directors and shareholders. 

Despite this added complexity, operating as a limited company offers several benefits. Limited liability protection is high on the list, particularly if you plan to provide high-value products or services that could lead to liability claims. There could also be some tax efficiency gains. For example, limited companies will pay corporation tax of 19% on profits, whereas sole traders pay 20-45% income tax on their profits over the £12,750 personal allowance.

It may also be the case that by setting up a company, you can reduce your income tax and National Insurance contributions by combining a salary and dividends. If directors' salaries are kept below the NIC primary threshold, you will not have to pay any income tax or employee Class 1 National Insurance on those earnings. 

As a limited company, you'll also be able to invest pre-tax trading income in a company pension scheme, as opposed to investing your money in a personal plan which will be done after the tax deduction.

How to become a limited company – and when? 

There's no right time to move from a sole trader to a limited company, so it's essential to take the time to ensure it's the right move for you. Usually, you'll use your time as a sole trader to see if your business model works, if there is demand for the service you're offering and to refine anything that hasn't worked as planned. Once you have this basis, you may start to think about growth and development, at which point becoming a limited company can be a sensible step. 

Once you're sure it is the best option for your business, you can begin to take the necessary steps that will enable you to register with Companies House. These include:

Choosing a name

While this may seem relatively straightforward, it's worth noting that you have to come up with an original name for your company, as two separate limited companies can't have the same name. Also, take the time to check that corresponding domain names and social media handles are available so prospective clients can find you easily.

Naming your directors

Every limited company needs at least one director, so either decide to go it alone or share the responsibility with others. As a director you'll be tasked with the overall running of the company. You'll also have specific responsibilities, such as keeping company records and reporting changes to Companies House and HMRC, making sure the company accounts are accurately maintained and filing tax returns. Now might also be a good time to find an accountant who can help with the tax side of running a business. 

3. Identifying people with significant control If anyone holds more than 25% of the shares in the company, more than 25% of voting rights, or has the right to appoint or remove the majority of the board of directors, these are likely to be classed as people with significant control, and you must tell Companies House about them on your PSC register.

4. Preparing a memorandum and articles of association The memorandum and articles of association are two separate documents that all limited companies are legally required to have when incorporated with Companies House.

The memorandum of association is the legal document that all your initial shareholders sign, agreeing to form the company. It's created automatically when registering your company online.

The articles of association are rules about running the company, agreed on by the directors and shareholders. You can find templates for both documents on the gov.UK website.

Once you have all this information, you're ready to register your company with Companies House. To do this, you'll need to have an official address and a Standard industrial classification (SIC) code that lets Companies House know the nature of your business.

If you're registering the company, the easiest and cheapest way is to do it directly online. The fee for this is £12, and you'll be registered for Corporation Tax at the same time. You'll need at least three pieces of personal information about yourself and your shareholders or guarantors, such as town of birth, mother's maiden name, National Insurance number, and passport number. Your company will usually be registered within 24 hours.

Will I earn more money as a limited company or sole trader? 

As mentioned above, there are potential tax advantages to operating as a limited company. But, as ever, the picture is not entirely clear. 

Setting up and running a limited company can be more expensive, with registration fees and the fact that you're more likely to call on the services of an accountant and pay to have a business bank account to meet your reporting requirements. This can make the sole trader option more appealing, particularly in the early days while you're working to establish yourself. Also, during this time, when profits may be low, you may not have to pay any tax if you're a sole trader. The trading allowance could mean you're exempt if you earn less than £1,000 a year in gross income. Once your income grows, you can choose between deducting the trading allowance from your business income or deducting actual expenses. Provided your profits, plus any other earnings, don't pass the £12,570 a year personal allowance, you won't have to pay income tax at all. 

Once you start bringing in enough to be liable for income tax and self-employed NICs, it can be time to consider the switch to a limited company, as you'll be paying 19% corporation tax rather than up to 45% in income tax. You can also claim a broader range of allowances and tax-deductible costs as a limited company, which all add to its financial appeal.

This is a complex area, so it's wise to speak to an accountant before making any decisions.