Should I be a Sole Trader or run a Limited Company?
For the last few years it has been far more popular to start a Limited Company than to set up as a Sole Trader. With the introduction of Dividend Tax is it still better to form a Company?
Which is better for tax purposes? Limited Company or Sole Trader?
In almost all circumstances it is still better to form a Limited Company.
A Sole Trader has the same £11,000 Personal Allowance as the Company Director, but once this tax-free amount has been exceeded tax is payable at 20% for the next £32,000, and then 40%.
In addition to this a Sole Trader will pay Class 2 National Insurance of £2.80 per week, and Class 4 National Insurance at 9% on profits between £8,060 and £43,000, then 2% on profits over £43,000.
The Company Director will usually take a salary of £11,000 to utilise the tax-free personal allowance, but above this will take dividends. The first £5,000 of dividends will be free of personal tax (although it will be after the 20% corporation tax paid by the company). Above this, the company will continue to pay corporation tax of 20%, and the Director will pay dividend tax of 7.5%.
Because the company pays 20% corporation tax on the profits earned, the dividends drawn will only represent 80% of the profits, so the Director will not personally reach the £43,000 upper limit on the basic rate tax band until the point where the Sole Trader has an income of £51,000, and has already been paying 40% higher rate tax on £8,000.
The Company Director also pays far less National Insurance, paying Class 1 NIC at 12% on earnings between £8,060 and £11,000, but no other NI contributions. This is assuming that enough of the £3,000 “Employment Allowance” is available, so that Employer’s National Insurance is not due at 13.8%, and if extra staff were taken on and this allowance was used up by them, then the Director’s Remuneration would be reduced to £8,060 to avoid NI completely.
In addition to the above, the proposed reductions in Corporation Tax rates to 19% for 2017/18, and to 18% for 2020/21, means that the tax advantage or the Company Director should be even greater.
Are there any other tax advantages for the Company Director?
Yes. A Sole Trader pays tax on their profit for the year, whereas the Company Director pays tax on their salary and dividends which do not have to be all of the profit earned.
If the Sole Trader has a particularly good year, and reaches higher rates, then they cannot avoid paying 40% tax. The Company Director has the flexibility to take less dividends to avoid higher rate tax, and to “carry forward” the retained profits for another year when it is more tax effective to draw those dividends.
So, when is a Sole Trader a better option?
When a business is likely to make a loss in its early years being a Sole Trader is a better option than forming a company.
A Company can only carry the losses forward to use against future profits. However, a Sole Trader is able to set off losses against other income in the same year, or to carry back losses in the first four years against income from the previous three years and to obtain a tax refund.
What’s the bottom line?
So, the bottom line is that for most businesses it is almost always better to form a Company, but if the venture is either expected to make a loss early on, or needs a lot of initial investment in capital items, then a Sole Trader may be a better choice for tax purposes.