Historically, businesses would set out as sole traders and would then ‘graduate’ to limited companies as growth graphs climbed. Until not too long ago, the limited company was perceived by creditors and investors to be a more ‘credible’ structure than the sole trader one. However, the ‘contractors’ revolution of the 21st century changed all that upside down. Millions of limited companies sprang up and disappeared overnight, having got incorporated in hours and ‘struck off’ after three months of inactivity! To some extent the business-friendly provisions within the Companies Act too have helped, as much as the tax advantages offered by the incorporated form. In short, the private limited company is indeed the most favoured business structure for today’s budding entrepreneurs looking to set up a business.
There are, in fact, significant differences between the two forms of businesses and we have tried to put together an overview of the main differences here below.
Setting up
Setting it up is fairly straightforward in either case but setting up a company is more formal in terms of paperwork. Any one could do it online these days for a fee of under £20 though!
|
Sole Trader |
Private Limited Company |
|
| Registration | No formal registration required. For tax purposes you will need to let HMRC know that you’re now in business | Formal registration with companies house required |
| Business name | No prior approval required – but general restrictions apply | Prior approval required before setting up |
| One-man band | Indeed it’s a one-man band | One-man company (single shareholder/director) allowed |
| Ownership | You (only you) are the owner | You, the shareholder, is the owner. Joint ownership with others shareholders allowed |
| Constitution | No constitution required | You should follow a model constitution or have a bespoke constitution, which is not in violation (ultra vires) of the company laws. |
| Non-resident ownership | Possible, though unusual | Allowed |
Legal status and governance
This is where the real difference begins. An incorporated company is a separate legal entity (person) from you. It can own land, property and other assets and can borrow in its own name. As a sole trader all the business debts are personal to you whereas the debts of the company are the company’s debts and the owners (shareholders) are not personally liable for the debts of the company except where the management (the director) has personally guaranteed the loans or it is apparent that s/he has continued to trade and incur liabilities in the name of the company when it was insolvent.
|
Sole Trader |
Private Limited Company |
|
| Legal status | The individual is the business | The company is a separate legal entity |
| Governing law | No specific law | The company laws (The Companies Act) |
| Ownership | The individual owns the assets and property | The company owns the assets and the property |
| Liability – general | All liabilities are personal | All liabilities are the company’s |
| Management | The individual is the manager and the proprietor. No difference between the owner and the management | The director(s) manage(s) the company. Whilst the law does distinguish between the ownership and the management the same person can be director and the shareholder |
| Liability – Compliance | You are personally liable | The directors are liable for the compliance |
| Transparency | Business details are not known the public | Business details available on the public register maintained at the Companies House |
| Annual updation of ownership and changes | Not required | Required to be filed with the companies house |
| Event-driven returns | Not required | Required for changes to the management, business address etc |
| Initial capital | Not required; purely business-driven | Required, negligible though |
| Withdrawal of capital | As easy as writing a cheque! | Subject to restrictions and tax consequences |
Employment status
As the business expands you take people on, and from being a self-employed you become a business. A sole trader is personally liable for complying with the employment laws whereas in the case of a company all the liabilities are on the company, which is legally a separate entity from you. So, in that sense, if your business is likely to employ people a company structure is preferable to being a sole trader.
|
Sole Trader |
Private limited Company |
|
| Employer | You can’t be your own employer | Your company can be your employer. Being a director of your own company doesn’t result in employment laws or minimum wage or tax credits applying though. |
| Employment laws | You are liable for all the compliance if you employ people. The employment contract is between you and the employed | The company is liable for all the compliance. The employment contract is between the company and the employed |
| Liability | Paying wages is your personal liability. | Paying wages is the liability of the company. Your wealth is unaffected even where the company can’t pay wages. |
Taxation
Taxation is one of the key reasons why a company structure is preferred over a sole trader one. Detailed differences apart, very broadly, if your cash withdrawals from the business in a year are not likely to go over c £40,000 then it may well be advantageous to operate a through a company structure. That does not automatically mean that over that level, the sole trader structure offers great tax advantages. What it means is that limited company businesses (subject to the small profits rate) could retain profits within the business by paying tax at 20% which could then be withdrawn during rainy days without paying any tax.
The major differences are as follows:
|
Sole Trader |
Private limited Company |
|
| Taxation of profits | ||
| Tax profits | From 20% to 45% | Currently 20% up to £300,000 profit |
| Tax free profit | £10,000 (2014-15) provided the total income doesn’t exceed £100,000 | No tax free limit; tax payable even on a £1 profit |
| Class 2 NIC | £2.75 per week (2014-15) | Not applicable |
| Class 4 NIC | 9% on profits between £7,956 and £41,865, and 2% thereafter | Not applicable |
| Extracting money out of the business | ||
| General | No tax consequence regardless of whatever the nature and level of extraction | There are tax consequences for the shareholder/director |
| Salary | Not applicable | Salary (alone) up to £ 7,956 (2014-15) in a year suffers no tax and NIC in the hands of the director. Salary allowed as a deduction from the business profits |
| Dividend | Not applicable | Dividend (alone) up to £ 38,678 (2014-15) suffers no further tax in the hands of the director |
| Salary + dividend | Not applicable | Salary of £7,956 + dividend of £30,518 (2014-15) suffers no further tax in the hands of the director |
| Loans from the business | No tax | Loans taken out of the business by the owner when not refunded in 9 months after the accounting year-end is over, suffers additional tax at 25%. Interest-free loans from the company subject to a benefit in kind charge for the director |
| Growth and expansion | ||
| Expenses | Expenses incurred ‘wholly and exclusively for the business allowed as a deduction. Personal expenses of the sole trader are disallowed. | Expenses incurred ‘wholly and exclusively for the business allowed as a deduction. Personal expenses of the director are taxed as ‘earnings’ of the director and deemed ‘distributions’ if incurred for the shareholder. |
| Assets used | Capital allowance on cars used for private use split according to business and personal use. Mobile phones costs are also split according to business and personal use. | Full capital allowance allowed where the car is owned by the company even if used by the director for personal use. Mobile phone costs allowed as a deduction where the contract is in the name of the company. |
| Use of home for business | A sole trader can’t obviously charge a rent to himself! | The director/shareholder can charge the company for use of home for business subject to elaborate rules |
| Pension contribution | Not allowed as a business deduction | Allowed as a deduction subject to lifetime limit. Opportunity for setting up SSAS, SIPP schemes. |
| Employment taxes | No separate tax unless you employ people. | Employment taxes apply even whey you’re paid salary as a director. These include PAYE and the employer and employee NICs. From 06 April 2014 employer’s NIC up to £2,000 is waived off. |
| Goodwill on acquisition | Not allowed as a deduction | Allowed as a deduction subject to rules |
| Investment from external sources | No flexibility in terms of structuring the funding | Great flexibility in terms of structuring the funding in to debts and equity |
| Personal loan to the business | No tax relief on interest paid | Tax relief can be claimed by the director on interest received from the company on the loan to the company in certain circumstances |
| Loss offset | Loss offset against personal general income including employment income allowed subject to limit of £50,000 or 25% of adjusted net income | Not allowed against the owners’ personal income |
| Diluting ownership with spouse | Not possible unless the structure becomes a partnership | Possible subject to careful paperwork, and in effect can save on tax |
| Exiting the business | ||
| Capital gains | Gains arising on sale of the business or the business assets are taxed at your personal tax rates, which could either be 18% or 28% (in most cases).Entrepreneurs’ relief may apply in which case 10% tax applies | Gains arising on the sale of business or business assets may be taxed at the company level and at the shareholder level. To avoid this shares in the company are transferred.Entrepreneurs’ relief may apply in which case 10% tax applies |
| Inheritance tax | Business Property Relief may apply if it is a qualifying trade | Business Property Relief may apply on the company shares subject to rules |
Accounting
Sole trader accounts can be quite simple to make unlike the company one which is more detailed and needs to comply with various legal requirements. It thus follows that the accountant’s fees can be higher too in the case of companies.
|
Sole trader |
Private limited company |
|
| Basis | Both cash basis and accrual basis allowed | Only accrual basis allowed |
| Accounting period | Usually tied to the tax year which runs from 6 April to 5 April next year | The first accounting year ends on the last day of the anniversary month with yearly periods starting the next day, unless changed by the directors |
| Deadline | No deadline, except that accounting information may be needed to fill in the tax return | First accounts to be prepared and submitted within 21 months of incorporation. Second year on, within 9 months after accounting year is over. |
| Formal accounts | No need to prepare formal accounts. However, adequate records are required to support tax claims | a) Formal accounts required in compliance with the company laws and accounting standards.b) IXBRL accounts required for tax return purposes |
Closing down the business
Again, a company having come in to existence by the operation of law can end its life only by the operation of law. This means more form filling, filing returns and complying with the laws.
|
Sole Trader |
Private Limited Company |
|
| Formal closing down | No formal requirement. Should notify HMRC to avoid having to file tax returns | Either the company will need to be liquidated or struck off. Specific rules apply with regard to dissolution of the company |
| Assets and liabilities on closing down | All yours | All belongs to the company. There are complex tax consequences upon distribution of the dissolution proceeds depending upon whether it is a capital or a revenue receipt |
| Death | The business ceases with owner’s death | The owner’s death doesn’t automatically end the company’s life |
So in sum if you’re in to some serious enterprise go limited!!
