A key decision when starting a business is which legal structure do you choose when registering. The three most common options are sole trader, limited company and ordinary business partnership, although most people become a sole trader.
COVID-19 helped to push UK business start-up figures to new heights in 2020. According to the Centre for Entrepreneurs, annual year-on-year UK business formations in 2020 rocketed by 13% to 772,002.
A key decision when starting a business is which legal structure do you choose when registering. The three most common options are sole trader, limited company and ordinary business partnership, although most people become a sole trader. Sole traders make up about 59% (3.5m) of the total UK business population of 5.9m, and they include many freelancers, contractors and agency workers.
Ordinary business partnership members make up about 7% (405,000) and basically these are sole traders who go into business together. The UK also has about 2m (34%) active private limited companies. So, why do so many people in the UK who work for themselves operate as sole traders?
Here’s what we’ll cover
- What is a sole trader?
- How much tax do sole traders pay
- The key advantages of being a sole trader
- Sole trader v limited company: what’s more tax-efficient?
What is a sole trader?
Being a sole trader is the same as being self-employed. In law, you and your business are the same thing, which makes you personally responsible for your sole trader business debts. If you don’t build up large debts and your business is successful, this won’t be an issue, of course.
To become a sole trader, you must register for Self Assessment (SA), the system (UK tax authority) HMRC uses to collect tax from sole traders. You’ll then pay Income Tax on your profits during the tax year (20%, 40% or 45% depending on your income/earnings). You work out your profits by deducting your expenses and any allowances from your income/earnings/sales.
Sole trader NICs
Most self-employed people pay their National Insurance contributions (NICs) via SA:
- Class 2 if your profits are £6,515 or more a year (£3.05 a week) and
- Class 4 if your profits are £9,569 or more a year (9% on profits between £9,569 and £50,270 and 2% on profits over £50,270 – all figures quoted are for the 2021/22 tax year).
Declaring sole trader earnings and VAT
Sole traders aren’t required to submit annual accounts to HMRC, but they must maintain accurate financial records (which can be checked) and submit details of their income and business costs in their annual SA100 tax return, which must be filed each year.
If your VAT-taxable earnings/turnover goes over £85,000 a year (the current VAT threshold) or you know they will, you must register for VAT. You’ll then have to charge VAT, collect it and pay it to HMRC. This also applies to limited companies.
Need to know! The UK tax system is being fully digitised under Making Tax Digital, which means Self Assessment will be replaced come 2023.
The advantages of being a sole trader
It’s very easy to register online for Self Assessment so you can start your sole trader business. There are no costs and the process is very quick (minutes not hours or days). The tax admin is much easier when compared to a limited company, which means it can be done quicker. This saves cost, whether you do it yourself or pay an accountant to do it for you.
The paperwork and financial record-keeping requirements when you’re a sole trader are minimal; completing your SA tax return is more straightforward and any losses you make can be offset against other income.
Many customers won’t care whether you’re a sole trader or not, as long as your prices, products and/or services meet their expectations. In any case, you can easily change to a limited company structure later if you wish. And sole traders can employ others and their businesses can grow and prosper.
Being a sole trader can give you much more flexibility and control over your business, because you’re not answerable to shareholders – and you won’t have to share your profits with them either. You will enjoy more privacy, too, because the annual accounts of limited companies must be published on the Companies House website, which means anyone can view them. Sole traders do not have to publish their annual accounts.
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Sole trader v limited company: which is more tax-efficient?
Example 1
Sole trader profit = £50,000 Net income = £38,717
Ltd co profit = £50,000 Net income = £40,109
Difference = £1,392
Example 2
Sole trader profit = £100,000 Net income = £67,752
Ltd co profit = £100,000 Net income = £69,469
Difference = £1,717
Example 3
Sole trader profit = £150,000 Net income = £91,723
Ltd co profit = £150,000 Net income = £92,057
Difference = £334
These examples assume that all profits are extracted from the business, salary up to Secondary National Insurance threshold (£8,840) is taken and the remainder paid as dividends (2021/22 rates).
Conclusion
As the above examples show, operating as a limited company can reduce your tax bill. However, if you need to pay an accountant each month to look after your tax admin and complete your annual accounts and Corporation Tax returns, in reality, any financial advantage as the director of a limited company can be minimal or non-existent.
Each year, hundreds of thousands of people in the UK who decide to work for themselves register as a sole trader and many go on to establish and grow highly successful small businesses. In many ways, being a sole trader is the easier and cheaper choice and it need not hamper your business or your ambitions.
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