Guest Post: Limited Company vs Sole Trader for Freelancers: 2016/2017
One of the trickiest decisions for many freelancers is whether to be run your business as a sole trader or as a limited company. Tax is a key factor here, but there are plenty of other non tax factors to consider as well.
Firstly, let’s outline what we mean by a sole trader and a limited company.
This is also referred to as being self-employed. When you’re a sole trader you and your business are the same entity, there is no legal separation. You might have a separate bank account for your business, but it’s still in your name. You might even have a brand name, but again, it’s still under your name – for example, Joe Bloggs trading as JB Design Services.
A limited company is a separate legal entity to you personally. It has to be registered at Companies House and will be allocated a unique company registration number. The shareholders own a company and they appoint directors to run the company on their behalf.
The directors are responsible for running the company properly and making sure accounts and returns are filed on time. With freelancers, the shareholders and directors are usually the same person(s), but it’s important to understand the difference between the two roles.
‘Limited’ refers to the fact that as long as the company is run properly in accordance with company law then the liability of the shareholder is limited to the initial share capital they paid in. This is an important point discussed further in the article.
A sole trader pays income tax and national insurance through their personal tax return which needs filing each year with HMRC.
Based on the 16/17 tax rates your first £11,000 of income (sole trader and any other income) will usually be tax free then between £11,000 and £43,000 you will pay 20% tax and above that the rate rises to 40% (there are other issues and tax rates to be aware of, but for most freelancers these are the main levels).
There are also two types of National Insurance to pay, Class 2 and Class 4.
A limited company is quite different – it pays corporation tax on it’s profits, which is currently at a rate of 20%. However, remember that you and the company are separate legal entities so although corporation tax deals with the companies profits, you then need to think about how you personally extract money from your company – the most tax efficient way of doing that is usually through a combination of a low salary and then dividends.
From 6th April 2016 there is a major change being brought in with regards to how dividends are taxed, we have written a detailed article on these dividend changes, but what it generally means is that the tax savings of a limited company compared to a sole trader are not as large as they previously were.
Based on 16/17 tax rates, assuming an optimum level of salary and dividends for a company and also factoring national insurance charges for a sole trader, here is a table comparing the two structures for different profit levels.
|Profits £ (excluding salary for limited company)||Sole Trader total tax and NI||Limited Company total tax||Savings of Limited Company|
As you can see, although there are tax savings, in our opinion they are not so considerable that the tax savings become a deciding factor. Especially when you factor in the additional accounting fees you are likely to need to pay for accounting services for a limited vs a sole trader (assume £1k extra as a rough guide).
One additional tax benefit of a limited company is if you are in a situation where you do not need to extract all of the profit from the company and are happy to build up some of the cash in the business. This is because although your company pays 20% tax on the profits generated in the period, you personally will only have some tax to pay on the salary / dividends you extract so if you choose to not extract all that you could, then you will save some tax.
When you’re a sole trader you pay your tax and NI on all of the profit generated, regardless of whether you need to use it or not.
A further consideration is that if you have a spouse there may be scope to give them some of the shares in your company to enable you to split some of the dividends with them – this will need to be discussed with your accountant further.
Non tax factors
There are plenty of non-tax factors to consider and these should be considered with as much merit as the tax differences outlined above.
A sole trader is much simpler to administer, you just need to keep a track of your income and expenses so that you can include them on your personal tax return when you file it with HMRC.
With a limited company you will need to file abbreviated accounts with Companies House and full accounts and corporation tax returns with HMRC, as well as doing your personal tax return to disclose your salary and dividends.
You will usually need an accountant to handle your limited company filings as they are more complicated than a personal tax return and you will need a book-keeping system in place to make sure you are on top of your companies cash, income and expenses. Your company will need to have a dedicated bank account in it’s own name.
You may not have a choice! If you freelance through agencies or with big corporate clients, they may tell you that you cannot be a sole trader and that you have to be a limited company if you want to work with them (this helps protect them from potential employment status issues).
IR35 is legislation around employment status and affects limited companies but not sole traders. We have an IR35 guide you can read here but it essentially means that if HMRC investigate the relationship between you and your end client and deem that it is actually one of employer and employee, rather than a real self-employed relationship, then HMRC can come after you for the lost national insurance, which can be substantial.
If you are concerned about IR35 then a sole trader can be more attractive, there are still potential employment status issues but HMRC would usually pursue the end client first rather than you.
The limited liability of a company can be attractive, depending on what kind of industry you operate in. If you’re concerned about potential legal issues then by trading through a limited company you are protecting your personal assets as it would be the company facing legal action, not you personally (assuming you had done everything above board and hadn’t signed any personal guarantees).
Reputation / appearance
Rightly or wrongly, some clients will view a limited company as being more official than a sole trader. This may or may not be an issue for many freelancers, you’ll need to assess the kind of clients you are working with.
As the tax savings of a limited company are not quite as large as they used to be you need to consider tax and the non-tax factors before working out if trading as a limited company is right for you or not. Take your time to make the right decision though, as it’s much easier to set a company up than close one down!
About the author:
This article has been written by John Falcon of JF Financial, accountants for freelancers, contractors and modern small businesses.
Disclaimer: The information provided in this article is of a general nature. It is not a substitute for specific advice in your own circumstances.
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