Sole Trader or Limited Company, Which Best Suits Your Plumbing Business?
When starting your plumbing business, one of the first things to be decided is the legal structure used for the business.
It can either be a sole trader or partnership (if you have a business partner), or a limited company.
Whether you’re a one-man band or have employees lending a helping hand, businesses need the right legal structure to help them operate effectively.
But given that the legal structure you choose can impact everything from the tax you’ll pay to your take-home wage, working out what option is best for your business can be difficult.
Setting up as a sole trader is the most popular legal structure in the UK, with approximately 3.5 million sole proprietorships in 2019. Sole traders accounted for 60% of small businesses in the UK. There were also 1.9 million limited companies, making it the second most popular legal structure.
There are differences to each structure, particularly when it comes to tax issues. This article will help you understand each option and decide which is right for you: sole trader or limited company.
Which business structure is right for you?
A limited company is a separate legal entity that you can form to run your business – even if you’re a one-person business. As a director, you’re responsible for any legal and financial decisions the company makes. The company’s assets and liabilities are completely separate from your own personal finances.
If you decide to set up your own limited company, you’ll be a director and a shareholder of the business. You can be paid a salary and/or dividends from the company’s available profits. The company must make various annual returns and file annual accounts with statutory bodies such as Companies House and HMRC. It’s your responsibility as a director of the company to ensure this happens
If you’re a sole trader, you run your own business as an individual and are self-employed. You can keep all your business’ profits after you’ve paid tax on them. You’re personally responsible for any losses your business makes. You must also follow certain rules on running and naming your business.
Advantages of going limited
As the company is a separate legal entity, your personal assets are protected. If your company needs to close or experiences financial difficulties, your personal assets cannot be taken from you to pay company debts.
Potential for greater profitability
As a sole trader, all of the profits made by your business are taken as income. You’ll pay income tax and National Insurance Contributions (NIC) based on government thresholds.
Through operating as a limited company, you’ll pay Corporation Tax (currently at 19%) on your company profits, and can pay yourself through a combination of dividends and salary (usually set at the primary threshold for National Insurance). This will minimise your PAYE (tax you pay on your earnings throughout the year) and NIC outgoings. Any further payments you make to yourself will usually be taken as dividends.
Please read our article how to pay yourself as a director of a limited company
You can also normally claim more business expenses through your limited company than as a sole trader. It’s important you speak to an accountant about which expenses are allowable, as HMRC have strict rules about what can be claimed.
Any money you claim in expenses will be deducted from your company’s profit and will therefore not be taxed.
As a sole trader, you rely on your personal credit rating to borrow capital used to grow your business. A limited company can establish its own credit rating, which can support borrowing to invest in the business. This is good news for those individuals who don’t have the highest credit ratings.
Confidence is critical in business, and a limited company has a veneer of professionalism which instills such a confidence.
Some clients – large corporations and those in the financial sector especially – simply prefer to work exclusively with limited companies, but others flatly refuse to deal with unincorporated business. So, having a limited company can present new business opportunities that may not otherwise have existed.
Advantages of staying sole trader
Both sole traders and directors of limited companies are required to submit a personal Self Assessment to HMRC, but those operating a limited company must also submit extra paperwork to regulatory authorities (Corporation Tax, Annual Accounts, VAT returns if VAT registered). Failure to submit returns on time usually results in significant fines and penalties. As a sole trader, you’ll avoid the headache of these returns.
The accounting process is much simpler for sole traders – there’s less paperwork, fewer expenses to account for and often fewer clients. As such, if you do have an accountant at this stage, it’s often less expensive than it is for limited companies.
Legally, limited companies must be transparent and share certain information with the public, such as filing annual accounts and stating the names of directors and shareholders on public registers at Companies House. As a sole trader, you don’t have to provide this information to Companies House.
Will you pay less tax if you operate as a Limited Company?
When you’re a sole trader, you pay tax on any profits you make. Your profit is the difference between the sales you’ve made and the money you’ve spent. The taxman considers your profit as your income.
If you have £50,000 worth of income or profit in your first year of operation, you’ll pay 20% on any amount between £12,500 and £50,000 (£43,430 in Scotland). Above £50,000 (£43,430 in Scotland), you’ll pay 40%. The first £12,500 is not subject to income tax – this is your annual personal allowance.
There are also two different types of National Insurance to pay – Class 2 and Class 4.
For your Class 2 insurance, you’ll pay £156.00 over the year.
You’re also taxed with Class 4 and that’s based upon your profit/income. You’ll pay 9% on your profits between £8,164 and £50,000 this tax year and 2% on any amount over that.
So, out of your £50,000, what do you have left?
You’ll pay £7,500 in income tax, £156.00 in Class 2 National Insurance, and £3,723.12 in Class 4 National Insurance.
You’ll pay a total of £11,379.12 in tax, leaving you with £38,620.88.
When you operate as a limited company, you extract cash differently. There are two “incomes” which are taxed – the income the business makes (in corporation tax) and the income you make (in income tax, national insurance, and dividend tax).
For this instance, we’re going to assume that the business makes £50,000(some as the income of the sole trader above) in its first year and the shareholder/director of the business has no income from other sources.
Most shareholding directors pay income tax. They also have a personal tax allowance every year of £12,500.
Limited company shareholding directors do not pay Class 2 or Class 4 National Insurance. They are classed as company employees so they pay Class 1 National Insurance.
For many shareholding directors, the majority of their pay is made up from a “dividend”. A dividend is a payment related to their shareholding in the business and the profit that business has made.
So, back to your limited company which has made £50,000 profit in its first trading year.
We would recommend that you pay yourself £8,632 in salary. This is the maximum amount of salary you can take home without paying any income tax or National Insurance.
Cost saver note:
As you’re an employee, your limited company is liable to pay National Insurance Employers’ Contribution on your salary. However, by paying yourself £8,632, your Employers’ Contribution bill will be £0.
Your salary is considered a business cost so you can take the £8,632 you’re paid in salary from your profits. You’ll pay 19% corporation tax on what’s left. So, on the remaining £41,368 (£50,000 minus £8,632), your company tax bill will be £7,859.92.
Minus your salary and minus corporation tax, you’re left with £33,508.08.
You still have £3,868 of your personal allowance left for the year (that’s the £12,500 personal allowance you have minus the £8,632 you’ve taken in salary) which you can take off the £33,508.08, leaving you with £29,640.08.
You can pay yourself this £29,640.08 as a dividend. Your first £2,000 of dividends are tax free and, given the size of your salary and dividend in this example, you’ll pay 7.5% tax on the £27,650.08 not covered by your annual dividend allowance.
Your dividend tax bill for the year will be £2,073.01.
Cost saver note:
Anything you pay yourself in salary reduces your profits. Anything you pay yourself in dividends does not affect your profits.
So, what’s remaining?
From your £50,000, you paid £8,632 in corporation tax and £2,073.01 in dividend tax, leaving you with take-home pay of £40, 067.07
In this example a limited company wins.
A sole trader would keep £38,620.88 of his or her £50,000 income/profit. A shareholding director would take home £40,067.07. That’s a difference of £1,447.07 that stays in the shareholding director’s bank account.
From purely a taxation point of view, in most cases, it’s better, even for small, one-person companies, to run as a limited company than be a sole trader. But, the higher you earn, the picture flips the other way.
These would be what a sole trader takes home at these levels
|Class 2 NICs||£156.00||£156.00||£156.00||£156.00||£156.00||£156.00|
|Class 4 NICs||£165.24||£2,823.12||£4,123.12||£4,723.12||£6,723.12||£8,723.12|
For a shareholding director, this is how we’d split the same figures…
|Tax on Dividend||£0||£1,465.51||£5,373.03||£13,270.53||£43,774.47||£74,635.47|
Other Major comparisons of Sole Trader or partnership vs Limited Company
|Sole trader or partnership||Limited company: you are director & shareholder|
|You are the business.||The business is a separate legal entity.|
|You are the owner.||You are a shareholder and hold all or a proportion of the company’s share capital.|
|the manager or proprietor.||Serve the company as its officer as a director (a company secretary is an officer too).|
|In the event of any legal dispute, you will be sued personally unless you have suitable insurance e.g. products and services liability, professional indemnity, employer’s liability etc.|
In the event of any legal dispute, the company will be sued unless it has suitable insurance cover. It is exceptionally difficult and rare under UK law for anyone to sue a director personally for a company’s wrongdoing. There are exceptions where the ‘corporate veil’ may be pierced and a director may be held personally accountable e.g:
– In general law, where the director has perpetrated fraud.
– Where the director has committed specific offences such as corporate manslaughter, or under health and safety, environmental acts, companies acts and listing rules.
– In tax, in cases of fraud by the directors and for penalties involving deliberate concealment and offences by Senior Accounting Officers of large companies.
– You are self-employed; you cannot be your own employee.
– In difficult times, such as the COVID-19 crisis in 2020 as you are self-employed government support is likely to be based on your trading profits.
– From April 2014 the members of a Limited Liability Partnership who are on fixed profit / no risk arrangements may be automatically classed as employees under proposed anti-avoidance provisions
– A director is an office holder, this does not automatically make you an employee in terms of employment law, the National Minimum Wage or for Tax Credits.
– For Income Tax and National Insurance purposes company officers are treated as employees.
-In difficult times, such as the COVID-19 crisis in 2020 as you are an employee government support is likely to be based on your payroll salary.
-You can offset your trading losses against your other income as an individual.
-The company can offset its trading losses against its other income, but not against your income as an individual.
-If the business fails you will be personally (or jointly with your partners) liable for its debts. You may go bankrupt.
-If the company fails, your liability is limited to the amount unpaid on your shares (if any) unless you have made a personal guarantee for the company’s borrowing (which is often required by banks).
-As a director, you can be held personally accountable if you continue trading when your company is insolvent and this causes financial loss to creditors. This could result in your personal bankruptcy.
– When you die your business ceases. You can pass all or part of it down to the next generation.
– When you die the company lives on: it is a separate legal entity.
When it comes to deciding whether or not to incorporate your business, it’s not a clear-cut choice. The best choice for your business will depend on your own circumstances and should be discussed with your accountant.
If you need some more help, please give us a call on +44 01234 712840.
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