Sole trader vs Limited company: What is the difference?

The first question that’ll come to mind as a business owner is – How many business-setup structures are there anyway? To give a quick answer, there are 5 namely – sole proprietorship, partnership, limited liability company, cooperative, and corporation. There are many variants of the latter 4 but built on the same general principle.

In this article, we’ll endeavour to shed light on the broad principles underlying the sole proprietorship (sole trader) and limited company (limited liability company).

Who is a sole trader?

A sole trader is a self-employed small-scale business owner who is the sole controller and decision-maker of his business. As a sole trader, you could work alone or employ other people to work with you. Either way, you and your business are seen as one and the same (one entity). Everything the business owns is yours and vice versa, meaning that every profit the business makes is yours after filing tax returns. This also means that, in case of debt or lawsuit, your business’ assets and yours are fair game.

What is a limited company?

The case of a limited liability company is different from that of a sole trader. Here, even though a single person can be the sole director and shareholder of the company, the business or company is a separate entity from its owner(s). A limited company can either be limited by share or guarantee. In the case of a company limited by shares, the shareholders get paid dividends monthly or yearly and the rest of the profit made after payment of corporation tax goes back into the company. Unlike the case of the sole trader, the company’s assets are its own and different from those of its director(s) or owner(s). What this means is that in case of any liability, insolvency, or legal action against the company, it’s only the company’s assets that can be liquidated or taken over.

So, what differentiates both structures of business setup?

As earlier mentioned, the sole trader is solely responsible for his business’ profits and liabilities while that of a limited liability company is borne by the company itself. There are other differences such as –

1. The sole trader does not need to register with HM Revenue and Customs (HMRC) for Self-Assessment to start the business. He would only have to when he hits the threshold limit of £1000 income after starting business in which case he must compulsorily register. Otherwise, he can voluntarily register to have access to benefits like proof of self-employment to set up tax-free childcare or benefit from the voluntary Class 2 National Insurance scheme.
    
2. The limited liability company, however, whether limited by shares or guarantee, private or public limited, must first be registered with Companies House and with HMRC for corporation tax before commencing business. This is what is called company incorporation or formation.
    
3. The sole trader does not need to register with Companies House while the limited company must be registered with Companies House and HMRC before the commencement of business.
    
4. Accounting for the sole trader is often straightforward except when the business becomes large and the expertise of an accountant is needed. The limited liability company however has a more elaborate accounting which compulsorily needs the expertise of an accountant especially for making tax filing easy.
    
5. The cost of running the business for the sole trader is not as expensive because he can choose to do the business alone without keeping any employee on the payroll. He would just need to occasionally outsource some jobs if need be. The limited liability company on the other hand is more expensive to run because of the number of people that have to come on board (director(s), shareholder(s), persons of significant interest, etc.) before it becomes functional.
    
6. The limited liability company must compulsorily make available its account book for the tax year and confirmation statement to the Companies House every year while the sole trader does not need to do this at all. The sole trader only needs to file his tax returns to HMRC by the end of the tax year.
    
7. The sole proprietorship is more suitable for small and start-up businesses while the limited company structure is good for companies with large initial capitals or established ones.

Now, the next question on your mind should be, “how do I choose between these two?”. The answer is not as straightforward as you may think because it all depends on your business’ needs and capacity. 

Let’s take a brief look at the advantages and disadvantages of both.

Sole trader advantages

• Easy formation.
• You are the don of your business
• You get to keep all profits after tax.
• You don’t have to register before you begin working until you have earned up to £1000 since starting business.
• Information regarding your business is private since you are not registering with Companies House which makes all information of companies registered with them become public knowledge.
• Accounting is straightforward. Can be done through the traditional method.
• You are the sole decision-maker which is especially useful when time is of the essence.
• You can upscale to become a limited company as your financial status improves.

Sole trader disadvantages

• Unlimited liability. You are responsible for every liability the company has.
• Higher tax payment if you earn more than £25,000 yearly.

Limited company advantages

• Limited liability. In case of insolvency or loss, the company bears its own liabilities, not the directors or shareholders.
• Reduced tax payment.
• Your business becomes more credible for access to loans and investors feel more secure.
• The business does not go into extinction just because a shareholder dies.

Limited company disadvantages

• Formation or incorporation is more elaborate and tedious.
• You only get your salary and dividend payments. All other profits go back into the company.
• You must register with Companies House before commencing business.
• Accounting is more elaborate.
• Your financial and business information becomes public knowledge.
• It is not easy to downscale if the company falls on hard times.

Therefore, with the above pros and cons of both the sole trader and limited liability company, it is safe to say that choosing between setting up as a sole trader or limited company is as much a matter of choice as it is a matter of financial strength and capability. 

The sole proprietorship structure is more suitable for freelancers, small businesses, and start-ups. Whereas, the limited company is suitable for larger corporations to enable them to maximise profit in terms of reduced tax payments and VATs. As a sole trader, it is possible to register for VAT voluntarily, but it may not be wise if you make less than £85,000 per annum.

Conclusion

The choice between sole proprietorship and the limited company depends on so many things and it is better to know those before starting up.