There are positives and negatives to operating as either a sole trader, or a limited company. While it’s possible to switch at a later date, this can be expensive and time-consuming. And you’ll just have to put up with any additional costs you’ve incurred in the meantime.

• What is a sole trader?
• What is a limited company?
• Other types of company structure
• What are the advantages of becoming a sole trader?
• What are the disadvantages for sole traders?
• What are the advantages of becoming a limited company?
• What are the disadvantages of becoming a limited company?
• Making the right choice

Setting up a limited company means that your business becomes a separate legal entity, with its own financial and legal reporting requirements. Whether you’re the sole director or not, it means you’ll have a limited liability for any losses and debts.

There are more regulations applied to limited companies, which mean you can’t just dip into business profits when you want to. And you’ll need to file more paperwork, including company accounts and corporation tax returns. This is before you also file your personal taxes and pay any amounts due on your individual income from both wages and dividends. You can find more information in our guide on how to pay yourself as a limited company director.

There are other options available when you want to become self-employed, including working for an Umbrella company as a contractor, Partnerships, Limited Liability Partnerships, Charities, or Social enterprises (including co-operatives, credit unions, and employee-owned businesses).

Broadly speaking, a partnership will be closer to operating as a sole trader alongside one or more other individuals, while a Limited Liability Partnership (LLP) is more akin to a limited company, requiring incorporation and registration with Companies House, annual accounts, and profit-sharing agreements.

The main downside of being self-employed as a sole trader will be the increases in tax as your income grows. For income in 2022/2023 that’s a Basic Income Tax rate of 20% on income up to £50,270, 40% on income between £50,271 and £150,000, and 45% on anything over £150,000.

You’ll need to pay both Class 2 and Class 4 National Insurance Contributions (NICs), along with registering for VAT if you have a turnover more than £85,000 over a 12-month period.

You’re also not able to leave money in your business and pay yourself more in the next tax year, as you could with a limited company.

The other big issue is that you’re subject to unlimited liability for any business debts or losses, putting your personal finances and assets at potential risk over any unpaid costs or bills. That’s less of an issue if you’re working alone with a modest number of smaller clients, but can be a big problem if you’re liable for things such as office rents, equipment costs and employees.

Some clients may see sole traders as less credible than limited companies, or even require you to have limited company status before working with them. And lenders tend to be more wary about financing for sole traders, meaning you can borrow less and face higher rates of interest.

As a sole trader, you’re also not able to protect your business name, meaning that competitors or unrelated companies can operate under a similar or identical title.

Finally, it’s more complicated for sole traders to pass on their business or sell it to new owners. As it’s not legally separate, you’ll need to organise a transfer of assets. This is also the process if you decide to become a limited company, and usually requires the help of an accountant or financial specialist to make sure it goes smoothly.

In summary, the main disadvantages of setting up as a sole trader are:

• Potentially higher tax liabilities with less options to defer income
• Unlimited liability for debts or losses, risking personal finances and assets
• No protection if you’re trading under a business name
• Some clients may see sole traders as less credible
• Securing finance can be more difficult
• Selling or transferring your business is more complicated

The main reason most people would give for becoming a limited company is that you’re not held personally liable for any debts. While this is true in most cases, you may still be asked to give a personal guarantee if the business is accessing loans or other financial products, and it doesn’t remove the need for relevant insurance.

Another major benefit is that there are more tax efficiencies available as a limited company, particularly if your profits are above certain thresholds. From 2023, profits under £50,000 incur a Corporation Tax rate of 19%, with percentages rising up to a main rate of 25% for profits of £250,00 and above. But as a director and shareholder, you’re able to choose the best combination of salary and dividends for your individual circumstances.

You can also choose to potentially leave profits in your business if you prefer, rather than incurring additional tax in a financial year. And Director Loans are available if money is needed at short notice, although they will need to be paid back promptly to avoid any personal tax implications.

While the allowable expenses are only slightly wider than those for sole traders, you’re able to claim them back from your business, rather than having to pay them from your personal income and profits. There are also more potential options for tax relief and deductions available for limited companies, such as Research and Development incentives in qualifying industries.

As part of setting up a limited company, your business name will be registered with Companies House preventing others from choosing an identical title. This provides some legal protection, although the use of trading names can still cause confusion unless you also apply for relevant trademarks.

You’re also likely to be seen as a more credible and professional business, and be given greater access to financial products due to the legal status and tax benefits available. It’s also potentially easier to bring in other people as directors and shareholders, or to transfer and sell your business in the future.

In summary, the main advantages of setting up as a limited company are:

• No personal liability for business debts (unless you sign any personal guarantees)
• Potential for personal tax efficiencies using salaries and dividends
• Offers the option to leave profits in the business rather than taxable income
• More opportunities for tax relief and funding
• Some protection for your registered company name
• Greater credibility in some industries
• Easier to sell and transfer your business, or bring in additional shareholders

Choosing to become a sole trader or limited company is a decision which depends a lot on your personal circumstances, and your plans for the business. Investing in some specialist advice when you’re starting out can save you time and money over the first few years of self-employment.

In very general terms, if you’re intending to work part or full-time as a small business with a modest client portfolio and income, then becoming a sole trader may be the most suitable. Although you’ll typically pay more tax, managing your own accounts and admin can offset some of that cost.

If your business is growing quickly, or you’re planning to expand in the near future, then the benefits of a limited company will probably outweigh the increased complexity and costs of the additional responsibilities. Outsourcing the work to an accountant will lower the burden, although company directors will remain legally responsible for all aspects of the business, so it’s important to check and double check all paperwork.

Whichever option you choose, it’s always possible to incorporate a company having previously operated as a sole trader, which is relatively common, or to wind up your existing business and move in the opposite direction (which is more unusual).

Self-employment provides you with the freedom to choose exactly what kind of business you want to run, and the freedom to change it to suit your current circumstances or future ambitions.