Should I be a Sole Trader or run a Limited Company?
For the last few years it has been more popular to start a limited company than to set up as a sole trader.
You may be wondering, with the introduction of dividend tax if it is 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 a company director, but once this tax-free amount has been exceeded, tax for a sole trader is payable at 20% for the next £32,000, and then 40% thereafter, known as ‘higher rate’ tax.
In addition, a sole trader pays 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.
In comparison, a company director will usually take a salary of £11,000 to utilise their tax-free personal allowance, and above this level takes dividends. The first £5,000 of dividends taken will be ‘dividend tax’ free. Above this, company directors pay dividend tax of 7.5% up to the level of the basic rate tax band.
Because the company pays 20% corporation tax on the profits earned, the dividends drawn 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 a sole trader will have earned the equivalent income of £51,000 (and will have been paying 40% higher rate tax on the £8,000 difference).
A company director also pays less National Insurance; paying Class 1 NIC at 12% on earnings between £8,060 and £11,000, but no other NI contributions for Directors with at least one other employee, who is over the NI threshold via the Employment Allowance. This is an allowance up to £3,000 which can be deducted from N.I. amounts payable to HMRC. Employers National Insurance is 13.8%, so this is quite a saving.
If the employers allowance was used up by staff employers NI, 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 all of their profit for the year, whereas a company director pays tax on their salary and chooses the amount of dividends to take, which do not have to be all of the profit, if it does not suit them. Some profit can remain within the company, this is known as ‘retained profit’.
If a sole trader has a particularly good year, and reaches higher rates, then they simply cannot avoid paying 40% tax, whereas a company director has the flexibility to take less in dividends to avoid higher rate tax, and to “carry forward” the retained profits for another year when it may be more tax effective to draw the 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 sole trader is able to offset losses against other income earned in the same year, (for instance through P.A.Y.E), or to carry back losses in the first four years against income from the previous three years and to obtain a tax refund.
A company can only carry the losses forward to use against future profits, so therefore claiming a tax refund the same way as a sole tradre is not possible.
What’s the bottom line?
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.