Limited Company vs Sole Trader. Which is better?

One of the most common questions I get asked is, should I set up my business as a limited company or as a sole trader? On one hand, you might think that a limited company is the best option for you because it provides protection to your assets and means you can scale. On the other hand, you may believe that a sole trader is better because it's far less hassle to set up and it can mean you pay less in tax. Making the right decision can be one of the most important things you can do when starting out. So in this video, I'm going to be talking about the key differences between both of these structures, the advantages and disadvantages of each, and at what point you should consider switching from one to the other. If you're new here, I'm Nisha, I'm a qualified accountant and this channel is all about personal finance and building wealth and self-development. Let's get into it. When you first set up a business, you need to choose a structure and the two basic ones to choose between are sole trader and a limited company. So what's the difference? At the basic level, as a sole trader, you are the business. So say you are a personal trainer, you're doing one-to-one sessions with people and they pay you for it. This is you and this is also your business. It's an extension of yourself and your personal name represents your business. This means that all your business dealings, invoicing, contracts are done under your personal name. One of the advantages of setting up as a sole trader business is that the process is super simple and low cost. You just need to A, track your earnings and expenses over the year and B, at the end of the financial year, complete a self-assessment tax return. Quick, easy, and low cost. And so it's a very attractive option to start with in most cases. There are, however, some clear exceptions where this is absolutely not the way to go and I'll come to that in the tax part of the video. Now, a limited company is you operating under a separate legal entity from yourself. So this is you, a personal trainer, and you set up a company, Pilates Limited, let's call it, minus 10 points for lack of creativity. You register your company with company's house and that company or the business is very separate from you as an individual. You may own the company, so you can be a director or a shareholder in it, and you can have multiple directors and shareholders in it as part of the business, but it's a separate legal entity to you and the company does all the business. So the invoices, the contracts, all of that is under the company name. Setting up a company has also become very, very quick and very easy to do, but when it comes to the tax returns, that's when it gets more complex. You'll need to do a tax return both for your company and for you personally. And so the extra paperwork and the tax rules to follow that come with having a company come with an extra cost and it's a lot more expensive to do your accounts under a company than it is as a sole trader basis. Okay, so now we've covered the high level difference between a sole trader and a limited company and the difference in the structures. Now let's talk about the advantages and the disadvantages for each of these and when to use which one. Before I get into it, I want to give a quick mention to today's sponsor, Dropbox. As a business owner, managing different aspects of a business can be overwhelming. There are hundreds of moving parts and things to keep on top of no matter what industry you're in. For me, I had to make sure that the different people in my team were always aligned regardless of where in the world they're working from. I speak to loads of brands, I need to make sure that my lawyer has the latest version of an agreement, all the files were saved in the right place. We had so many apps and systems that we kept switching between. Then we came across Dropbox Business and Business Plus, which has simplified the entire process. Instead of paying for various subscriptions and tools, we just have Dropbox where we can handle everything in one centralized location. It's more cost effective and saves us a lot of time. I love the e-signatures capability, so being able to prepare, send, sign contracts, NDAs, and any other necessary paperwork from anywhere. My personal favorite Dropbox capability is replay. I can give it real-time, exact, time-stamped feedback, add markups, and leave comments for my editor to look at and amend straight away. By centralizing all of our most important tasks, we're no longer wasting time jumping from app to app. If you're looking for an all-in-one solution to organize your professional life, I'd highly recommend checking it out. You can click the link in the description to learn more about Dropbox Business. Now onto the tax implications. The way the tax is structured for a sole trader and a company can make all the difference in which one you choose. Let's use example of earning $100,000 after all your expenses. For a sole trader, this would be taxed just like income tax because you are the one getting paid. So you get your personal allowance and you can utilize that, assuming it isn't already used up through any of your other income sources. So the first $12,570 in this case at the current time is tax-free. The amount you earn above that is taxed at a progressive tax rate. So the amount you earn after $12,570 up until $50,270 is taxed at 20%. And then the remaining amount between $50,271 and $100,000 is taxed at 40%. I have a video linked over here that goes into the details of how the progressive tax system works in more detail. But you can also check that out after this video. But bear in mind, you also have to pay an eye on this as well. For corporation tax, it's structured slightly differently. And you might be thinking, how do I get paid? Well, the company earns money and then it can either pay you a monthly salary on which you have to pay income tax and national insurance. So the same rates that you had in the sole trader example, or you can get paid via dividends. Dividends are the payments the company makes to its shareholders, i.e. you, if it makes a profit. The tax rate for companies that have a profit of between $50,000 and $250,000 is 25% minus any marginal relief. So to keep this simple for the calculation and to be conservative, I'm going to keep the main rate at 25%. So you'll be paying $25,000 in corporation tax. As you can see, it might make sense to start off as a sole trader early on. So you can utilize the tax-free income allowance and the lower income tax brackets. But the tax bracket after a certain threshold very quickly becomes much higher for a sole trader than the highest bracket for a corporation tax. So with that in mind, it might make sense to consider switching because you could save a significant amount of taxes after a certain rate. The other thing to consider is as a sole trader, you get some other tax benefits. For instance, first year losses can be used to reduce any other tax that is due that year. So you might even get a refund. But at the same time, with a limited company, you can write off more things as expenses. So you're lowering your profit and subsequently lowering the tax that you owe. I'm not going to go into a lot of detail in this video because it's very case specific. But I did want to flag it as something that is important for you to look at when you're choosing between the two structures. Then let's move on to protection and privacy. When it comes to a sole trader, you and your business are considered the same legally. This means that you are responsible for all of your business's debt and liabilities. If the business can't pay its debts, your personal assets like your home or your car can be used to cover the costs and pay it off. In the same way, your business name is not protected either, which means that any other person can trade under the same name as you and you can't legally prevent them from using it in their business. So this isn't really a big deal when you're starting out. But as you get bigger and you scale, it can be an issue and you want to avoid, you don't want other customers mixing your and another business up with each other. So that is something to consider, although this is different to a registered trademark. If you want a registered trademark, you'll need to apply for that separately if it's relevant to your business. If you are operating as a company and the company is the legal entity, then you're splitting up your personal assets and your business assets. So if something happens to your business, they can't then go after your personal assets. Your car, your home, your personal assets, they're protected. Again, there are some exceptions in this case as well. For instance, if you have signed a personal guarantee for a business loan or if you fail to meet certain director duties, then you as an individual could still be held personally liable. So it's not a complete clear cut here. The drawback, however, of a limited company is that it comes with less privacy. If you have a limited company, you are required to file accounts and other relevant documents with Companies House. And then once these documents are filed, they become part of the public So everyone can access or can see how your company is doing, your financial performance, details about your company structure. It's all available to the public. And that might not be something that everyone wants when starting out. The final thing that I'd like to say is that after reaching a certain level, transitioning from a sole trader to a limited company becomes less of an option and more of a necessity. Because as you grow, operating as a company carries a specific brand image. It generally implies that the business is robust, it's stable, it's managed responsibly because there are specific rules and regulations that have to come into play when you're operating as a company. So that just gives confidence to customers. It gives confidence to suppliers and potentially investors as well if you're looking to scale and go down the funding route later on, which you can't do as a sole trader. So those are some of the key things to consider when deciding what to set up your business as. And in most cases, the sole trader way is the to go when you're starting out and then you want to transition to a limited company at the right time. If you enjoyed this video, you may also enjoy this video on how to pay less tax and legal loopholes you should be using whichever structure you're working in, even if you are employed. Thanks for watching. See you there.