If you decide to run your business as a sole trader, rather than a limited company, then your tax obligations differ in several ways. Understanding your tax obligations can be a tricky matter. Let’s take a look at what you need to know.
Sole trader vs Limited Company: what’s the difference?
There are two main factors that differentiate sole traders from limited companies: the legal position of the personnel, and how the business pays tax.
In a limited company, the shareholders and directors are not ‘the company’, that is, they have limited liability and cannot easily be held accountable for anything the company does. By contrast, the sole trader is their business: they’re legally the owner which makes them responsible for all financial matters.
When it comes to tax, a sole trader will be taxed on their business profits (less expenses), whilst a limited company pays corporation tax on all of its taxable profits.
A sole trader is requires to pay Class 2 and 4 National Insurance on Income Tax on all taxable business profits, whereas the directors of a limited company will pay PAYE on their earnings. They may also be required to complete self assessment tax returns.
Sole traders may take cash from the business without being taxed, whilst the shareholders of a limited company have to pay income tax on dividends and other types of distribution made by the company. When a sole trader keeps a separate business bank account (as opposed to only using their personal bank account), they can claim tax relief against interests and charges.
When it comes to selling the business (or any assets), any monetary gain for a sole trader is taxed, and in a limited company the shareholders will pay a double tax charge, while the company must pay corporation tax on any profits.
Other differences may include: pension plan options (there are usually more within a limited company); responsibility for debts in the case of insolvency – sole traders have full responsibility for debts, whilst limited company shareholders do not; the legal requirements surrounding the preparation of accounts; working from home; the purchase of (eg) company cars and other assets.
In addition, tax free benefits and incentives are not applicable to sole traders, whilst limited companies have a range available to them.
Which is best for me – sole trader or limited company?
There are undeniable pros and cons to either option, but what it boils down to ultimately depends on the type of business you’re planning to run.
As a sole trader, whilst it’s an easy business structure to set up and involves limited amount of paperwork and other obligations, you may have difficulty accessing business finance. As outlined above, you will have no tax benefits or incentives available to you. You will have more control over your business, and whilst you keep all your post-tax profits, it’s prudent to remember that as already mentioned, you are liable for all debts – which could mean selling off your personal assets to cover.
A limited company is more complicated to set up and run but often looks more attractive to financial institutions, should you be looking at fundraising for the business. It will offer you more efficient tax schemes, however you have a lot less privacy. Your accounts, and any other documents filed with Companies House, are public record and can be accessed by anyone.
Paying Income Tax as a Sole Trader
Sole traders must pay income tax, which is calculated according to their profits for each tax year, which is calculated by deducting your business expenses from your self-employed income.
Reasonable expenses that you’ve incurred as part of your business, may include:
- Marketing and advertising expenses
- Overheads such as rent, phone line, internet, utility bills
- Stock and materials
- Travel expenses, or company car and fuel.
As mentioned above, Sole traders must also pay Class 2 and 4 National Insurance contributions – take a look at our previous blog about Tax and National insurance for the 2022-23 tax year for more information on this.
As a sole trader, you’ll be given a personal allowance by HMRC that you don’t pay tax on – this is the same amount as for employed people who pay their tax through PAYE. The difference here is that sole traders are responsible for declaring and paying their own tax.
When do I have to pay my tax?
Tax is paid on a yearly basis, and you have to pay tax on your profits for every year that you’re in business. The deadline for completing your self-assessment and paying any tax owed is the 31st January every year.
You’ll need to register with HMRC for self-assessment, and whilst you don’t legally have to do this until the October after the first year you started trading, we’d advise anyone to do it as soon as possible.
Whilst sole traders only need to pay tax if/when their profits exceed their personal tax allowance, remember that you must fill in your self-assessment form every year, even if you’ve made a loss or just a small profit.
Once you’ve completed your self-assessment, HMRC will let you know how much you need to pay – you may also be required to make some payments towards your next year’s bill, depending on the profits you have declared.
Can I switch from sole trader to limited company?
There may come a point on your business journey when you decide it makes better business sense to switch from sole trader to limited company. It may be that you wish to be more tax-efficient because your profits are increasing, you might want to raise funding for your business, it could be because you want to bring new personnel on board.
As we mentioned before, setting up a limited company is slightly more complicated and brings new rules and requirements with it, so you may find it useful to get some professional advice before you take the decision.
If this is something we can assist you with, or indeed with any of the points raised within this blog, get in touch: we’re here to help!