Sole Trader or Limited Company?
Making the Right Tax Choice for Your Contracting Business
There’s a lot of decisions that need to be made as a contractor, ranging from how to market yourself and which services to offer, to how to handle your finances and how to continually become more successful. But, one of the most important decisions is to do with tax, and it’s not a ‘one size fits all’ approach for everyone.
At Go Limited, we know that contractors need to decide between being sole traders and limited companies, and tax works differently for both. To make sure that you’re making the right choice for your business, you need to weigh up the pros and cons of each, especially when it comes to being as tax-efficient as possible.
Sole Trader vs. Limited Company Tax Comparison
There are a number of differences between being a sole trader and someone who’s contracting through a limited company, but the main thing that sets them apart is the way in which tax is handled. If you are a sole trader, you pay income tax on your profits, and this is done via HMRC’s self-assessment system. National Insurance is also paid in the same way. This is a relatively simple and straightforward process, which is hugely appealing to contractors. After all, who wants to navigate a complex self-assessment system? But, this ease is balanced by the fact that the tax rates can be higher than those of a limited company, especially if you’re earning a lot.
When you contract through a limited company, you are a separate legal entity to your business, meaning that the business has to pay corporation tax on all profits. Currently, the rate of corporation tax is no more than 25%, and that’s paid by the business. As a company director, you need to pay income tax on your earnings, but you can take these earnings in a combination of salary and dividends. This is usually more tax-efficient, as dividends are taxed at a lower rate than salaries. The best approach to tax will depend on your business’ size, profits and growth.
Guidelines for Limited Company Contractors
When you have a limited company for contractors, you need to understand the ins and outs of paying tax. For example, you need to be aware of IR35 legislation, which determines whether or not you are operating as a business, or if you’re effectively working as an employee of your client. If you fall inside IR35, you’ll have higher tax liabilities than if you were a limited company contractor.
The majority of contractors working through a limited company take their earnings as a combination of salary and dividends. If you take a small salary - but a salary that’s still high enough to meet National Insurance thresholds, as you don’t want to miss out on your state pension - and the rest in dividends, you’ll benefit from lower tax rates. Plus, as a director, you are also required to maintain accurate records, file annual accounts and comply with Companies House regulations. This is a legal requirement, and failing to do so can lead to fines and penalties.
What is the Tax Calculation for a Contractor with a Limited Company?
There’s a few things that go into tax for a limited company, so you need to understand the tax calculation for contractors and what needs to be included. This will help you to plan ahead - you don’t want to get to the end of the tax year and then be blindsided by a hefty bill you weren’t expecting - put money aside for tax and submit everything without any errors.
Corporation Tax
Your limited company will need to pay corporation tax at a rate of no more than 25% on all profits, after allowable expenses have been deducted.
Dividend Tax
After paying corporation tax, you can withdraw profits as dividends. You’ll pay a tax rate of 8.75% on dividends if you’re a basic rate taxpayer, rising to 33.75% if you’re a higher rate taxpayer. You don’t have to pay tax on any dividend income that falls within your Personal Allowance, which is the amount of income you can earn each year without paying tax.
Income Tax and NICs
Income tax and National Insurance (NICs) need to be paid on your salary, which is why a lot of contractors with limited companies keep their salary low to minimise tax liabilities.
When you’re planning for tax, you need to factor in the cost of all of the above. You then need to make sure you’re keeping enough money aside to cover the bill. It doesn’t matter if you’re a sole trader or limited company, planning ahead and understanding your tax responsibilities is key.
Limited Company VAT Rates for Contractors
If your limited company’s turnover goes above £90,000* in a 12 month period, you’ll need to be VAT registered. This is mandatory and is the case regardless of business size, type and industry. There are a few different ways to approach limited company VAT as a contractor, either by using a standard VAT scheme or a flat rate VAT scheme. With a standard VAT scheme, you charge VAT on invoices and reclaim VAT on purchases. With a flat rate VAT scheme, you pay a fixed percentage of your turnover, keeping any difference as profit. This approach simplifies administration, but it’s not always the most cost-effective.
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Tax Deductible Expenses for a Limited Company
As a limited company, you can reduce your tax bill with tax deductible expenses. These are allowable expenses for limited company contractors, and by claiming them you reduce your taxable profits. When the time comes to pay your business’ tax, there’s less to budget for. There’s a whole host of allowable expenses for limited company contractors, but not all of your costs are tax deductible. For example, office costs - including rent, utilities and office supplies - are all allowed, as these are exclusively for business purposes. The same can be said for professional fees, equipment, software and training courses related to your industry. You can also claim for travel, including public transport costs and mileage, as long as you were travelling for work purposes.
However, it’s important to avoid claiming for anything that’s not considered an allowable expense, and not everything is. For example, unless clothing is protective or branded for your business, you can’t claim the cost as tax deductible. You also can’t claim the costs associated with entertaining clients - for example, taking them out for a meal or giving them gifts - or personal expenses, such as purchases that aren’t for your business or commuting costs. If you do claim expenses for things that aren’t tax deductible, you could be fined by HMRC.
Can I Claim for Lunch and Coffee as a Limited Company Contractor?
One of the most common questions we’re asked is whether or not limited company contractors can claim for lunch and coffee, and there’s not a ‘one size fits all’ answer. The ability to claim lunch and coffee expenses depends on the circumstances. If you’re working away from your usual business location, you can claim reasonable subsistence costs, including lunch and coffee. But, meals eaten at your normal place of work are not tax-deductible because they are considered personal expenses. If you do want to claim for lunch and coffee, you need to keep detailed receipts.
The Importance of Using the Best Accounting Software for Limited Company Contractors
Once you have decided whether to approach working as a sole trader or a limited company, you need to make sure that your tax is in order. It’s a lot easier to do this when you have accounting software on hand to help. Accounting software can simplify managing your business’ finances, giving you more time to focus on other aspects of running a business. Using accounting software for limited company contractors helps with invoicing and expense tracking, by automating routine tasks and making sure your records are accurate. It also helps to streamline compliance and reduce errors in VAT and tax calculations.
FAQ
What is the difference between a sole trader and a limited company?
A sole trader operates as an individual, meaning there is no legal distinction between personal and business finances. A limited company is a separate legal entity, offering liability protection and potential tax benefits.
What are the tax differences between a sole trader and a limited company?
Sole traders pay Income Tax and National Insurance on their profits. Limited companies pay Corporation Tax on profits, and directors may take salaries and dividends, which can be more tax-efficient.
Which structure is more tax-efficient?
For lower earnings, a sole trader structure may be simpler and more tax-efficient. As profits grow, a limited company often provides better tax benefits due to lower Corporation Tax rates and dividend allowances.
Do I need to register for VAT?
Both sole traders and limited companies must register for VAT if their turnover exceeds £90,000 per year (as of 2024). Voluntary registration can also be beneficial for reclaiming VAT on expenses.
What are the legal responsibilities of a sole trader vs. a limited company?
Sole traders have fewer legal obligations, mainly self-assessment tax returns and record-keeping. Limited companies must file annual accounts, Corporation Tax returns, and comply with Companies House regulations.
Which structure offers better liability protection?
A limited company protects personal assets, as liability is limited to the company’s finances. A sole trader is personally liable for business debts, meaning personal assets could be at risk.
Can I switch from a sole trader to a limited company later?
Yes, many businesses start as sole traders and incorporate later when it becomes more tax-efficient or when liability protection is needed.
How does each structure affect my ability to get business funding?
Limited companies may find it easier to secure loans and attract investors, as they appear more stable and credible. Sole traders may rely more on personal credit.
How much does it cost to set up and run each structure?
Setting up as a sole trader is free and has lower ongoing costs. A limited company requires registration fees, annual filings, and potentially higher accounting costs.
What is the best option for a small business just starting out?
For simplicity and lower admin, a sole trader structure is often best for new businesses. If you expect high profits, want liability protection, or need funding, a limited company may be better.
How do I register as a sole trader or a limited company?
- Sole traders register with HMRC for self-assessment.
- Limited companies register with Companies House and set up for Corporation Tax with HMRC.
Where can I get more advice on choosing the right structure?
Consult an accountant, visit HMRC’s website, or seek advice from business support organisations for tailored guidance.
*Please note: Any rates and thresholds mentioned in this article are correct at the time of publishing and may be subject to change.
The Verdict: Sole Trader or Limited Company?
As you can see, there are benefits that come with being both a sole trader and a limited company contractor, especially when it comes to tax. Being a sole trader keeps your tax simple and straightforward, which is ideal if you’re relatively new to handling your own tax, can’t quite afford an accountant at the moment or you want to focus on the day-to-day running of your business for now. But, contracting through a limited company is more tax-efficient, helping you to keep more of your income as take-home pay. It’s what a lot of contractors end up transitioning to, simply because it tends to be the right tax choice.
There’s a lot of help for limited company contractors out there, including at Go Limited, so you won’t have to navigate limited company tax alone. With our knowledge and insight, you’ll have everything you need to know to run your business in the most tax-efficient way.
*Please note: Any rates and thresholds mentioned in this article are correct at the time of publishing and may be subject to change.
