Changing from Sole Trader to Limited Company? What to Know Before You Switch

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It comes at a time when a business needs to change structure due to growth or tap into other benefits. As much as a sole trader structure has absolute control over its business, assets, and profits after tax, a limited company has tax benefits and financial security.

In a limited company, debts incurred by the business are generally not the personal responsibility of the owner or director unlike in the case of sole proprietorship where individuals are personally liable for all that their business does including taxes. To help you determine whether it is worth switching from being a sole trader to forming a limited company, this article seeks to discuss some of the contrasting features and advantages between the two types of structures.

How does a sole trader operate their business?

Also known as a sole proprietor, a sole trader owns the business exclusively and makes all the decisions. All the dimensions of doing business like profits, losses, and debts fall under his or her areas of jurisdiction.

Sole traders report and file their taxes with business earnings and expenses alongside other income. They are expected to declare and send tax due on business earnings via the annual Self-Assessment.

Two kinds of National Insurance Contributions (NICs) need to be paid by sole proprietors:

Class 2 NICs: These apply if your earnings surpass some level (currently £6,725 annually).

Class 4 NICs: Paid on profits over £12,570 per year.

If your business turnover exceeds the VAT threshold (currently £90,000), you must register for VAT and charge it on your sales.

Sole traders also have a personal allowance, which is the amount of income you can earn each year tax-free. The 12,5703 was approved for use in the 2023/24 tax year. 

 

Advantages of sole proprietorships

Fewer overheads

Full autonomy in conducting one’s business means that there are limited requirements for administration hence making it less difficult to administer decisions. This can also be an advantage with respect to the amount spent as there will be minimal overhead expenses.

No barriers to entry

No entry barrier exists for sole traders making it an easy and accessible option for entrepreneurs. The process of setting up as a sole trader is both quick and uncomplicated, given that there is no necessity to register a company with Companies House. However, you must still inform HMRC that you are self-employed and operate your business as a sole trader.

Use your personal bank account

As a sole trader, you are not legally required to open a business bank account making it okay to use your personal bank account for business transactions and manage your expenses and finances.

Save on annual company fee

Sole proprietors are exempted from the obligation of paying annual company filing fees and are not required to adhere to the statutory filing regulations that apply to limited companies. Furthermore, they are not subject to corporation tax on their profits.

Perk savings

As a sole trader, you can keep all profits after tax and get a tax allowance if you earn £12,000.

Additionally, if you need to purchase office equipment to operate your business, you may be able to claim capital allowances.

Individuals may be more inclined to engage in business with sole traders rather than larger corporations. This preference can be attributed to the personalised service and direct communication that sole traders typically offer.

Sole traders may build stronger customer relationships due to familiarity and direct communication.

Disadvantage of a sole trader

Pay more tax than you need to if you expand

You may face an increased tax obligation when your business starts expanding. As a company develops, both its net income and profits rise, resulting in higher personal income tax rates upon surpassing the threshold limit. Investment expenditure associated with expansion can also add on more taxes than anticipated.

Increased difficulty in separating personal and business transactions can result

Confusing business transactions make it difficult to keep track of your expenses when you use personal accounts for businesses hence appearing unprofessional.

Hard to attract new customers

Many clients may prefer to deal with larger companies due to workmanship. Some clients may believe that large entities will get work done faster since they have a team or employees.

Limited reach and visibility in the market can be another factor that may contribute to the difficulty in attracting new customers as a sole trader. A weak online presence on social media and networking channels could restrict your potential to draw in new clientele.

Employing staff can be hard

As a sole trader, employing staff can be challenging especially when dealing with Pay As You Earn (PAYE) tax regulations. You will be individually accountable for adhering to employment regulations and managing payroll tax obligations.

Before employing staff, you must register as an employer with the HMRC and then register for PAYE to start paying your staff. Once you become an employer, you must take out an employer’s liability insurance policy which protects you if an employee becomes ill or injured because of their work. Every day employ someone without this policy, you can be fined an extra £2,500.

This task may prove to be difficult, as it needs considerable effort, time, and resources that an individual entrepreneur might lack.

Hard to get government incentives

Government incentives may require formal structures making it difficult for sole traders to qualify for certain incentives or programs that are typically available for larger entities. Operating with restricted resources, sole traders may struggle to effectively operate through the complex application process.

Hard to get a loan from banks

It can be difficult for sole traders to get a bank loan to expand their business. Banks may be unwilling to lend large sums of money to sole traders because they may not have collateral or assets in exchange for the investment.

Lenders may be cautious about providing loans to sole traders, primarily due to the increased risk they associate with smaller business operations.

When is the right time to change to a limited company?

The appropriate time for a business to transition to a limited company differs among various companies. Certain businesses may opt to change from sole proprietorships to limited companies when they secure substantial contracts or experience revenue increases. When your earnings start to pick up, it becomes more economical to move to a limited company protecting you from tax obligations. However, you will have certain costs as a limited company that you don’t have as a sole trader.

Furthermore, a suitable time to transition to a limited company could be when there is a need for enhanced financial support. The structure of a limited company facilitates the acquisition of business loans and investments, as it ensures that the company’s finances are distinct from personal assets.

If you want to protect your assets, transitioning to a limited company may be prudent. In contrast to sole traders, debts accumulated with a limited company will not affect your assets. In the case of buying or owning properties, you may benefit from stamp duty charges and greater taxation since it won’t be in your name.

When trying to win a potential client or secure new contracts, you will have to shift to a limited company which will increase your professional image.

Steps to take to switch your business from sole trader to limited company?

Register your limited company: Choose a unique name and register your company with the relevant authorities (e.g., Companies House in the UK).

Inform HMRC: Notify HM Revenue and Customs (HMRC) that you are changing your business structure.

Transfer assets and liabilities: Move your business assets and liabilities from your sole trader account to your new limited company.

Open a business bank account: Set up a new bank account in your company’s name.

Update stakeholders: Inform clients, suppliers, and other stakeholders about the change.

Register for taxes: Ensure your new company is registered for Corporation Tax, VAT (if applicable), and PAYE for employees

Benefits of changing to a limited company

Limited liability: Your personal assets are protected as the company is a separate legal entity.

Tax efficiency: Potentially lower tax rates and more opportunities for tax planning.

Professional image: Being a limited company can enhance your business’s credibility.

Considerations

Administrative Responsibilities: More paperwork and regulatory requirements.

Costs: Initial setup costs and ongoing compliance costs.

At what point should one consider shifting from a sole trader status to forming a limited company? Well, a quick answer to that is that time may differ for each business. Transitioning from a sole trader to a limited company can support many aspects of your business, however, it is important to weigh out your options properly.

Want to register your business? Icon Offices can help you incorporate your business seamlessly. We have different company formation and virtual office packages to help you get started. Our virtual office comes with a business address that will help you keep your personal address private.

We help with additional ongoing services such as filing statutory documents, corporate tax, VAT, and EORI number registration, UK bank accounts, and 24/7 call answering services.

For more information, contact us at [email protected].