Articles - 27th August 2019

Status Anxiety: Sole Trader vs Limited Company?

Words by Joe Williams
Illustration by Léa Zhang

With the flexibility of freelancing comes a slipperiness of language: what exactly are you? Whether you call yourself a freelancer, a consultant, a contractor, or even a microbusiness, there are really just two kinds of self-employment: working as a sole trader or operating through your own limited company. But what do these terms mean, what are the differences between the two, and what are the options available to you and your business?

If you’re one of over 4.8 million self-employed people in the UK (ONS), you’re probably a sole trader – not least because that’s the default legal position if you’re completing paid work by yourself for a client or customer. As a sole trader, you and the businesses are one and the same: not only do you personally keep any profits, you’re also responsible for any debts or losses. Establishing yourself as a sole trader and registering online with HMRC is straightforward – and you only have to do so if your freelance work has earned you over £1000 in the previous tax year.

But the price you pay for that administrative ease is increased financial risk: if business is bad, you’re personally liable for any losses. The alternative is to instead operate through your own limited company, which would exist as a separate legal entity to you. In a limited company, the financial obligation or ‘liability’ of each shareholder is ‘limited’ to the amount they have invested. After establishing yourself as a company, you can make yourself the sole shareholder and set the price of your shares however you like. For example, I could set myself up as the single employee director of ‘Joe Journalism Ltd.’, allocate myself 500 shares, and set the price of shares at £1 – I could then earn as much profit as I like, but if the company went under, I’d only be liable for £500. In the third volume of Capital, Karl Marx called this model ‘capitalist production in its highest development’. 

Across all industries in the UK, there are far more sole traders than limited company contractors: according to the Government’s Business Population Estimates 2018, of the 5.7 million businesses in the UK, 3.1 million are sole traders working alone. For some, the possibility of limited company status just isn’t on their radar. I spoke to one successful freelance journalist who has written variously for the Guardian, the New York Times, and VICE, and they said they couldn’t tell me the difference between working as a sole trader and working through a limited company. They had never before heard that contracting as a limited company was even an option for them. 

According to the same Government report, between 2010 and 2018 the number of sole traders ‘grew by 594,000 (+22%) and the number of companies increased by 641,000 (+50%)’. Whilst it’s difficult to know for certain how many of those new businesses are freelancers, many of them will be: in 2018, ‘75% of all businesses did not employ anyone aside from their owner’, including 91% of all sole traders and 46% of actively trading companies. ‘The majority of [business] population growth since 2000 has been due to non-employing businesses, which accounted for 87% of the overall increase.’ (If these figures sound too large, remember that each of those freelance businesses is just one individual.)

Freelancing through a limited company is certainly on the rise. ‘It’s definitely an expanding client base,’ James Trowell, Accounting Lead at Coconut tells me. ‘More people are being made aware of the situation and the advantages to working through a limited company. The limited liability gives that element of protection, which quite a lot of people take comfort in.’

‘That was a big one for me,’ says Susannah Davda, director of The Shoe Consultant Ltd., who has never been a sole trader. ‘I weighed up whether to become a sole trader or a limited company and I thought it through a lot, I read a lot about it, and I got some advice. In the end, I thought it was a good idea to separate the business financially from myself personally so that I wasn’t going to be liable if there were issues within the business.

‘It was also about scalability, so although I am on my own at the moment and I use freelancers for aspects of my business that I need some extra help with, I have plans for the business to grow into an employer. I don’t have to worry about restructuring that aspect of the business at a later stage, and I’m able to be versatile.’ 

Being financially separated from your business can be reassuring for your clients, too. As Andy Chamberlain, Deputy Director of Policy and External Affairs at IPSE, explains: ‘Sometimes clients prefer to engage with a limited company contractor rather than a sole trader because it’s a much clearer legal relationship.

‘For example, if you don’t pay your taxes properly as a sole trader then the client can be made liable, but if you work through a limited company then it’s a much clearer relationship because the limited liability company is a well-understood legal entity. It gives the client a degree of assurance because they know they will not have any liabilities that extend beyond those which are spelled out in the contract. It’s a business-to-business relationship and everyone understands the legal parameters.’

The issue of liability is more important in some industries than others. It would be quite an achievement for Joe Journalism Ltd. to rack-up serious debts writing articles for magazines, but liability is a key concern in the IT industry. Paul Harding, director of Cotswold Apps Ltd, tells me that limited company status is important for his work: ‘I do not feel that IT companies and agents really believe in sole traders, especially when you’re talking high-paying clients.’ 

Partly this is due to liability, but it’s partly also a matter of appearances. Successfully running your own limited company can demonstrate that you know what you’re doing, you’re organised, and you understand your legal responsibilities. Andy Chamberlain explains: ‘many people feel that working through a limited company is a good thing for their professional image. It can make you appear more professional to clients if you have a company that makes a contract with another company.’

Leo, a freelance science consultant, is currently a sole trader. He plans to incorporate later in his career partly due to client perceptions: ‘I know that it helps to have everything going through a company, where everything is open and every transaction is on the record for the business. I think it’s very much a branding decision as well because the sort of jobs you get and the sort of people you work for depends on the way you present yourself.’ 

There are many intricate differences in the tax-deductible expenses available to sole traders and limited companies, but perhaps the most attractive benefit of the limited company model is that it provides much more flexibility in terms of remuneration planning. As James Trowell tells me: ‘as a sole trader, the taxes are pretty fixed.’ Beyond their personal allowance, sole traders pay the 20% basic rate of tax and then the 40% higher rate according to how much they’ve earned (much the same as PAYE taxation), along with class 2 or class 4 National Insurance. 

But Trowell explains: ‘if they’re instead the director of their own limited company, they can pay their own salary as an allowable expense, which reduces their profit and therefore the amount of Corporation Tax they would pay. The funds remaining thereafter are what’s available for remuneration in the form of a dividend, which is taxed at a lower rate than PAYE taxation. Instead of 20% at the basic rate, they would pay 7.5% tax on the dividends. At the higher rate of tax, a sole trader would pay 40%, whereas the director of a limited company drawing dividends would pay 32.5%.’

And we could take this further, still. As single employee director of the newly-incorporated Joe Journalism Ltd., I could pay myself a salary that is below the National Minimum Wage and therefore below the personal allowance threshold, and in doing so not incur PAYE taxation or National Insurance contributions on that salary. After Corporation Tax, I could then draw the rest as dividends. Clearly, there is a very real financial advantage to working through a limited company. 

But that all seems like a lot of work. ‘The whole prospect of setting up a limited company seems quite daunting,’ says Leo. ‘I’m sure it’s not too difficult, and I’m sure it’s something that looking online and reading some information would be able to teach me, but it is daunting.’ 

Daunting, yes, but Leo’s right – the actual mechanism of setting up a limited company is really quite straightforward. As Andy Chamberlain tells me, ‘It’s quite simple to do. You can do it yourself online, although most people will go to an accountant to do it for a relatively small fee. Many accountants will have software packages and add-ons, and they can set you up with a business bank account, which is a good idea to maintain the separation from your personal finances.’

But running a limited company doesn’t end at incorporation – it takes constant work. IR35, for example, has been a thorn in the side of limited company contractors since 1999, but it doesn’t apply to sole traders. And the more time you’re wasting on the constant rumble of financial admin, the less time you’re spending concentrating on your own work and your own clients. ‘It’s really important to hire an accountant when you’re operating through a limited company,’ says Coconut’s James Trowell. ‘If you’re operating as a sole trader you have to register with HMRC, you have to keep the appropriate records so you know your income and expenses, and you have to report this at the end of the year in your self-assessment tax return.

‘Whereas if you’ve got a limited company, there’s various reporting and deadlines throughout the year that you need to be aware of. You’ll have returns on a quarterly basis, you’ll have to prepare annual accounts, company tax returns, and your self-assessment tax return. There are many more reporting requirements than if you were a sole trader, and that’s what an accountant is there for, to make you aware of those deadlines and to support you in filing everything on time and correctly. This is where we’re trying to bridge the gap.’

Coconut launched in January 2018, and their service makes the increased admin of limited company status far less off-putting than it would’ve been ten years ago. ‘Our mission is to free millions of people of business admin. People are wasting valuable time on things like tracking expenses or getting paid on time, and traditional online accounting packages and business accounts just haven’t kept up with the way things are changing.’ Their current account includes a book-keeping tool that categorises expenses and records VAT, thereby reducing the manual workload for freelancers and their accountants ahead of the self-assessment tax return. 

‘I think getting an accountant who is experienced with limited companies is important,’ says Susannah Davda. ‘I do rely heavily on my accountant, to make sure that I’m doing everything properly and everything is above board. A good accountant is well worth the fee, for the peace of mind that you’re doing everything properly, that everything is above board, and that you’re not going to have a surprise bill or any issues with HMRC.

‘I haven’t regretted setting up as a limited company, despite any extra complication in terms of accountancy. Having a limited company doesn’t cause me any issues or added work, and there’s nothing day-to-day that’s different from what a sole trader would do. Having a limited company isn’t anything to be scared of.’

But the appeal of the limited company model might soon tarnish. The Government is planning to introduce in April 2020 changes to IR35 that make it the client’s obligation to ensure that their contractors are inside IR35. This could discourage some clients from working with limited company contractors altogether. 

‘We think that this is very problematic,’ says Andy Chamberlain, ‘because clients are going to find it difficult to develop a good understanding of IR35 in what is a relatively short space of time. HMRC has lost five of the last six IR35 tribunals that have come to light, which suggests even it doesn’t understand the complex case law upon which status is determined. If the client and the contractor disagree on the IR35 assessment, projects will stall and that could be catastrophic for the private sector and the UK economy as a whole.’ These proposals would complicate the limited company model, but they are perhaps just as up-in-the-air as any other legislative change under the current Government. 

Working through your own limited company can provide financial security, a more professional appearance and increased client confidence – all of which can bolster your freelance career. There is more legislation to be aware of, so a good accountant is worth the money – and they’re tax-deductible, anyway.

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