Sole Trader vs Company – When to Incorporate Your Business
The legal status of your business—whether company, limited liability partnership, or sole owner/trader—has implications for your tax situation and how your income is assessed. It also has an effect on the liability you face if you are sued or challenged in any way, or your business goes bust. It is therefore worth considering carefully.
This page is designed to explain some of the issues, and help you to think the situation through. It is always worth taking legal and financial (for example, from an accountant) advice about your status before making any final decision.
A challenging question
The tax and employment structures in many countries offer several options to small businesses. Most provide, for example, for businesses to be limited companies (or incorporated). Many also have an option to declare that you are working single-handed with no employees. In the UK, this is called being a sole trader. You can also often form a partnership, such as a limited liability partnership, which may be particularly appropriate for professional services such as accountancy or law.
Many freelancers and small business owners find themselves struggling with one particular business question:
When is the right moment to incorporate?
In other words, when, if at all, should you switch from being a single-handed business to trading as a company? For some businesses, this is obvious: for example, if you are setting up a shop, and you are definitely going to be employing staff, you will need to be a company. For many freelancers and skilled traders such as builders or plumbers, the situation is less obvious, and there are advantages and disadvantages to balance.
The Pros and Cons of Incorporating
As you would expect, there are a number of advantages and disadvantages of moving from being a sole trader to a limited company.
The three main advantages are:
Being a limited company is likely to be more tax-efficient, especially when your income is higher.
Corporation tax and personal income tax are often at different rates and with different bands. Dividends and salary are also taxed differently. Other taxes such as National Insurance in the UK also vary. It may therefore be possible to earn more money as a whole by taking a small salary and topping it up with dividends from the company. This option is not open to sole traders. There are also issues about expenses and costs that may vary.
There is likely to be a threshold at which being a company becomes more tax-efficient, although it does depend on the country and the business. It is worth taking advice from an accountant on this.
Being a limited company protects you from liability if the business goes bust owing money.
You and the business are separate legal entities if it is a limited company. When you are a sole trader, there is no distinction.
If your business is a company, therefore, you are only liable for the amount that you put into the business in the first place. As a sole trader, your other assets (house, car, and savings, for example) could be at risk if your business goes bust owing money.
Your business will have a separate credit rating, so it can be easier to obtain loans.
There are generally more loan opportunities available to small companies than individuals. It is, for example, easier for banks to lend to them, and the collateral demanded may be less extreme than for sole traders. Your business will also be able to build up its own credit rating—and any problems, such as the business going bust, will not affect your own credit rating in future.
There are also disadvantages.
The requirement to file accounts
In the UK, sole traders do not need to keep formal, audited accounts. The only requirement is to complete your Tax Self-Assessment each year. As a small company, however, you will need to file formal accounts with Companies House each year. Similar requirements are likely to exist in other countries, so it would be a good idea to check this out before making your decision. This requirement to file accounts means that you will probably need to employ an accountant.
Company directors have formal legal duties and responsibilities
The regulations and law about sole traders are generally fairly light. Company directors, however, have some formal legal duties and responsibilities. You will need to be sure that you understand these, and are complying with them at all times, or you may be prosecuted. It is worth taking good legal advice on this issue.
There is less privacy available as a limited company
Limited companies are required to register (in the UK this is with Companies House), and provide details of directors, including their names and addresses. This information is publicly available. You therefore need to be comfortable with that level of disclosure, as it is one of the first search items that comes up with Google.
Finding the Balance
The decision about whether to operate as a sole trader or a limited company is often a question of balance. You need to decide whether the additional duties and responsibilities—and the level of both stress and cost that these may provide—are outweighed by the financial benefits of incorporating.
A question of customers?
The decision on whether to incorporate may also be driven by your customers.
Some businesses and organisations have rules that prevent them from contracting with sole traders, or even anyone except a limited company. This is particularly true of public sector organisations in the UK (for example, NHS Trusts).
If you expect or hope that these organisations will become major clients, for example, because of your business or your area of expertise, then you will have to incorporate.
This is likely to emerge from your market research for particular sectors, but it is a question that is worth asking of any potential client.
Generally speaking, as your income increases, so will the financial benefits, meaning that you can pay someone to manage your accounts more comfortably. However, it is a balancing exercise, and only you can determine your personal balance point.