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  • Writer's pictureMatthew Hunt

How to choose the right legal structure for your business

Updated: Oct 10, 2023

When starting a business, one of the critical decisions you need to make is choosing the right legal structure. Two popular options are operating as a sole trader/freelancer, which is essentially operating in your own name, or incorporating a limited company.


Each structure comes with its advantages and disadvantages and understanding their differences is crucial for making an informed choice.


In this blog post, we will explore some of the differences between sole traders/freelancers and limited companies, helping you determine which option aligns best with your business goals.


Legal entity

Sole trader/freelancer: operates as an individual, which means there is no legal distinction between the business and its owner. Consequently, the owner assumes all financial and legal responsibilities.


Limited company: a distinct legal entity that exists independently of its shareholders. This means that the company's finances and liabilities are separate from those of the owners. The company can own assets, enter into contracts and sue or be sued in its own name.


It’s important to remember that if you’re operating as a limited company the company money is separate from your own personal funds so there needs to be some discipline with running a company.


Liability

Sole trader/freelancer: one significant element of being a sole trader is that you have unlimited liability. This means that if your business incurs debts or faces legal issues, your personal assets are at risk because your personal finances and business finances are intertwined.


Limited company: unlike sole traders, the liability of shareholders in a limited company is usually confined to their investment in the company. Personal assets are shielded from business debts and legal actions, except in cases of fraud or illegal activities.


Depending on your own clients and the level of risk you’re working with, you may choose to operate as a limited company to protect your personal assets in the event your business fails, perhaps because a large client fails to pay an invoice.


Complexity

Sole trader/freelancer: this is the simplest and most common form of business ownership. As a sole trader, you are the single owner of your business with full control over decision-making and profits. You only have to file a personal tax return each year with income and expenses.


Limited company: this is a more formalised structure, with directors responsible for the day-to-day operations and shareholders having voting rights on major decisions. Limited companies involve legal requirements for maintaining company records and filing annual financial statements. You will also need to file corporation tax returns alongside personal tax returns for money withdrawn from the business.


In our experience, unless your profits are over £35,000 a year you’re best off remaining as a sole trader/freelancer as the small tax saving of incorporating a limited company is outweighed by increased accountancy costs and administration burden.


Tax savings

Tax savings are the main reason people incorporate limited companies. Everyone's situation is unique and it’s worth getting advice around your exact position. Below we’ve explained some of the factors we often consider.


Do you have an employed role and is this a second starter business to leave your main job?

If so and you earn over £50,270 in your main role you would be paying 40% tax and potentially 9.73% Class 4 National Insurance Contributions [NIC] on any profit made regardless of whether this money was in a bank account and you didn’t need the extra funds.


If, however, you were a limited company this would be taxed initially at 19% corporation tax, and the money after tax could then be taken from the company as needed. In this case, you would be paying 33.75% dividend tax.


However, if you could store money in the company until you gave up your employed role knowing you had a pot of money to cover living costs, this could be taxed as low as 8.75% dividend tax.


Are you buying a property anytime soon or requiring a mortgage?

A change of circumstances from sole trader to a limited company will often require a couple of years to settle in and lenders don’t like changes. Sometimes, it’s worth paying more tax in the short term while the mortgage hurdle is overcome and making a plan around this.


Do you have a partner or someone you trust who could work for you to take a wage or split the profits as a shareholder?

As a sole trader you can’t split income, it's all taxed on the individual.


However, if you are a limited company you could give shares to a partner for them to take income at the cheaper rates of tax. We do this a lot for families where child benefit is concerned. A family earning £50,000 each gets all their child benefit whereas a sole parent who earns £100k with a partner who didn’t work would get no child benefit.


When is the right time to switch from a sole trader/freelancer to a limited company?

Our normal advice is to keep things simple until your profits are around £35k a year, then move to a limited company part way through a year. This takes advantage of a few factors in the switchover year:

  • An £11,908 Class 4 NI band as a sole trader worth a saving of 9.73% = £1,158.64

  • You would then get another NI band via the company as a salary so another £11,908 instead of dividends at 8.75% = £1,041.95

Payments on account

As a sole trader/freelancer, you have to make payments on account towards your tax. This can often be a cashflow burden although once explained it’s not actually the case.


However, moving to a limited company can reduce payments on account and allow some of the tax that would have been paid to be used for cash flow purposes or to invest in the business’ further expansion or growth.


Limited companies don’t have to provide payments on account.


Case study

Jane is a freelancer who has left her 9-5 role to become her own boss.


She has a number of clients and is now regularly making an income of £70,000 a year. Her expenses are minimal as she works from home and meetings are mostly over Zoom.


She claims for her mobile phone, insurance, £6 per week allowance to cover the incremental cost of working from home along with some stationery costs. Jane drives and travels to some client meetings too. In total, her expenses come to £5,000 a year leaving her with a profit of £65,000.


Jane has a family with two children and a partner who earns £36,000 a year PAYE employed. They continue to be paid child benefit for their two children.


Below, we’ve outlined how the tax situation could look different depending on the legal structure of the business, taking into account the most common factors.


Jane started her business in April 2022 and has just finished her first full year as a sole trader. She expects profits for the next tax year to be the same due to her retainer contracts.


Sole trader position

Profit - £65,000


Tax

Income Tax rate Tax due

£12,570 0% (Personal Allowance) £0

£12,570 - £50,270 (£37,700) 20% £7,540

£50,270 - £65,000 (£14,730) 40% £5,892

Total tax due £13,432


National Insurance (NI)

Income NI rate NI

Class 2 NIC £3.15 a week £163.80

£11,908 0% £0

£11,909 - £50,270 (£38,362) 9.73% £3,732.62

£50,270 - £65,000 (£14,730) 2.73% £4,298.54

Total NI due £4,298.54


Child benefit to repay £1,885


Total tax, National Insurance and child benefit - £19,615.54


Tax forecast payments

31 January 2024 Tax due for 22/23 £19,615.51

1st payment on account for 23/24

(£19,615.84 tax tax due less £163.80

Class 2 NIC x 50%) £9,725.80

Total tax due £29,341.41

31 July 2024 2nd payment on account for 23/24 £9,725.80

Total tax due £9,725.80


Now, most people think HMRC is asking for tax upfront and this is not fair. However, this isn’t actually the case. Being a sole trader is very favourable, with tax payments being delayed, although they ultimately catch up with you.


Jane has worked 12 months from April 2022 to March 2023 and her tax bill is £19,615.54.


However, by the time she comes to pay this tax in January 2024, she would have worked another 10 months from April 2023 to January 2024.


So when the tax in January 2024 is due HMRC should have been paid 22 months but they are in fact only actually being paid 18 months' worth of tax: the year's tax plus 50% on account.


Therefore, you are never actually paying in advance. However, this large balance of tax due can catch clients out.


If Jane’s profits had gone down in her second year or she incorporated a limited company, the estimated tax can be amended. This is where our advice and expertise can help.


If Jane continues to earn £65k every year and the tax rates don’t change she would just pay £9,725.87 every 6 months after this initial catch-up period.


Limited company

Now, let’s say Jane was operating a limited company for the same period.


We would recommend a salary from the business of £12,570 to transfer her personal allowance to the company. This comes with an employer's NI cost of £478.86.


Company profit £65,000

Salary £12,570

Employer’s NI on salary £478.86

Taxable profit £51,951.14

Corporation tax at 19% £9,500

Corporation tax at marginal rate 26.5% £50k plus £517.05

Total tax due £10,017.05

Net profit for dividends £41,934.09

Jane’s dividend £37,430

Jane’s partner’s dividend £4,504.09


Jane’s personal tax


Income Tax rate Tax due

£12,570 0% (Personal Allowance) £0

£12,570-£13,570

tax-free dividend

allowance 0% £0

£13,570-£50,000

(£36,430) 8.75% £3,187.62

Total tax due £3,187.62


Jane’s partner’s personal tax


Income Tax rate Tax due

£12,570 0% (Personal Allowance) £0 as taxed via PAYE

£36,000-£37,000

tax-free dividend

allowance 0% £0 as taxed via PAYE

£37,000-£40,504.09

(£3,504.09) 8.75% £306.60

Total tax due £306.60


So from a limited company perspective, the total tax due is:


Corporation tax £10,017.05

Employer’s NI £478.86

Jane’s personal tax £3,187.62

Jane’s partner’s personal tax £306.60

Total tax £13,990.13


Therefore, the tax implications are:


Sole trader £19,615.51

Limited company £13,990.13

Tax saved £5,625.38


In summary, a limited company does have some tax benefits which are worth the administration burden. If the financial numbers used in this case study were to increase, the savings associated with being a limited company would continue to grow too.


Everyone’s situation is unique and requires careful planning. At Digivolve Accountants, we take an overall view as a tax saving in one area may give a tax burden in another area. Therefore, it’s important to make sure that each small saving works overall. There isn’t often one large tax reduction strategy: it’s normally a combination of a small bit here and there that adds up.


Matthew Hunt, Digivolve Accountants




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