What is the best business structure for freelancers?
When you’re starting your business as a freelancer, one key point you’ll need to address is what business structure you want to use.
The most common structure is sole trader, and a close second, limited company, but there are others too, notably an LLP -- Limited Liability Partnership.
Here, exclusively for FreelanceUK, Emily Coltman FCA, chief accountant to online accounting software provider FreeAgent, looks at the advantages and disadvantages of trading through a limited company compared to being a sole trader.
As well as providing nuggets of wisdom throughout, she also explains the less usual business structure for the aspiring self-employed to consider.
Want to set up a company for your freelance services? Think of it like a car!
When you’re a sole trader, you and your business are legally one and the same. But if you’re running your business through a limited company, the company is a separate legal entity from you. You will most likely be a director of the company (you run it), and also a shareholder in the company (which means you own all or part of it), but you won’t actually be the company.
Think of the company a bit like your car. You own it, you decide where it’s going to go, but you don’t actually become the car when you drive it!
Legal separation between you and your business impacts on a lot of what we’re about to explore.
Quick jargon buster
Turning your business into a limited company is called “incorporation”. So if your business is “incorporated” it is a limited company.
Advantages of incorporation
1. Tax savings
You may be able to save tax overall if you run your business through a limited company, plus small companies do not have to make tax ‘payments on account.’
Any savings would come about because, as a sole trader, you pay income tax at 20%, 40% or 45% on your profits (different rates apply in Scotland), and also Class 4 National Insurance at 9% or 2% (in both cases the rates change as your profits increase).
But a limited company pays corporation tax on those profits at a lower rate -- 19%, and there is no National Insurance to pay. You can take money out of the company as dividends, so long as the company has enough profit to cover those dividends, and again, you’ll pay no National Insurance on those dividends.
Yet as your dividend income increases, you pay more tax on it and the rates of income tax on dividend income are higher than that on the rest of your income. So beware of taking too much income as a dividend!
However, depending on your other income, as a sole trader you may have a personal allowance to put against your business’s profits. Limited companies are not entitled to a personal allowance.
It’s important to discuss potential tax savings carefully with an accountant and ask them to crunch the numbers for you to quantify what you could save, as your situation will be different depending on whether you have any other income, where in the UK you are based, and how much profit you make.
2. Limited liability
Because the company is a separate legal entity from you, it can own equipment, incur debts, and pay bills in its own right.
That means that, if the company is sued, your own personal assets, such as your house and car, cannot be seized to pay the debt, unless you have given a personal guarantee to a company creditor (say if the company borrowed money from the bank and you undertook to pay the loan back if the company couldn’t).
If you are a sole trader, on the other hand, your own assets could be seized to pay a business debt, because you and the business are legally the same entity.
3. Some costs attract more tax relief
When you’re running your freelance business through a limited company, certain costs are given more tax relief. For example, a limited company can pay for food and drink for its employees when they’re out and about – and you yourself, as its director, would be an employee of the company.
But for a sole trader, the rules are more restricted. You can only claim tax relief on the cost of food and drink when you’re travelling ‘on business’ if the journey involves an overnight stay, or it’s outside your normal working pattern, or your business is by nature itinerant – that is, you spend time on different client sites and not too long at any of them. For example, you are a jobbing gardener, or chimney-sweep.
4. More attractive for inward investment
Potential suppliers and investors may well view your business as more commercial and serious if you run it through a limited company. If you are a sole trader, there is no way anyone else can buy into your business unless you turn it into a partnership, but it is fairly easy to sell shares in a limited company to an investor.
Disadvantages of incorporation
It’s very important not to risk incorporating without seeing the full picture.
Here are the key disadvantages of running your business through a limited company.
1. Potential tax costs
Because the company is a separate legal entity from you, you can’t draw money out of its bank account freely, unlike when you are a sole trader.
There are only three ways that a company can legally pay you money. It can pay you a salary for the work you do; if it has enough profit to do so, it can pay dividends on the shares you own; and it can pay you back for any expenses you personally incur on its behalf, such as if you buy a train ticket on your own credit card to visit a client.
If you take money out of the company over and above these three options, then you could have extra tax to pay.
Also, if you are a sole trader and your business makes a loss, you may well be able to use that loss to save tax on your other income. When a company makes a loss, it can only use that loss against its own profits.
So if you have a job as well as your business, and your business makes a loss, then if that business is a sole trader, you may be able to get back some of the tax you’ve paid on your salary. You won’t be able to do that if your business is a limited company.
2. Limited liability protection may not be absolute
Be aware, you may still have to give your own ‘personal guarantee’ on borrowing, even if you borrow the money in the company’s name.
In some circumstances, for example “wrongful trading” (where the company goes on trading even though its directors know it will be unable to keep doing so, and then goes into liquidation), creditors can force the company’s directors to make good the company’s debts -- personally.
3. Legal responsibilities as a director
Company directors have legal responsibilities they must fulfil, for example to safeguard the company’s assets, and not to keep trading when they know the company can’t survive. If you fail in your legal responsibilities as a director, you could be fined or go to prison.
4. More paperwork
One of your legal responsibilities as a director is to file the company’s paperwork on time.
As a sole trader you only have one document to file with government bodies each year – your tax return. But a limited company with one director will have, between them, at least four documents to file.
The company must file a set of accounts and a document called a confirmation statement (formerly known as an Annual Return) each year, with Companies House.
The confirmation statement is a list of the company’s directors and shareholders and anyone else involved in the running of the company, and shows the company’s registered office address. The company must also file a corporation tax return with HMRC, and each director almost inevitably has to file a personal tax return.
As you will almost certainly be an employee of the company and take a salary, you will have to register the company as an employer and it will need to operate a payroll for you -- reporting to HMRC every time you take a salary out.
All this means that either you will have to spend more time preparing and filing the paperwork yourself, or that your accountancy fees will be a good deal higher after incorporation.
5. Lack of privacy
The company’s accounts and confirmation statement, once they’re filed at Companies House, are in the public domain and available for anyone to see -- free of charge.
This means that not only are your figures visible, but also the company’s registered office address – though that could be at your accountant’s office rather than at your own home.
What other business structures can would-be freelancers use?
Feeling enterprising, but not convinced about a limited company or a sole trader business? Well, you might instead look at setting up either a partnership or a Limited Liability Partnership (LLP) if there are other people involved in running your business.
A partnership is much like a sole trader except that there is more than one of you. The advantages and disadvantages of trading as a partnership are pretty much the same as those of being a sole trader, except that with two or more of you, the partners are also “jointly and severally liable” for the business’s debts.
That means that should one partner abscond with the business’s money, the other partner must make good anything the business owes. We strongly recommend drawing up a ‘partnership agreement,’ even if your partner is your best friend or your spouse, to cover all eventualities such as the break-up of a business or the death of one partner.
An LLP combines the tax approach of a partnership (each partner paying income tax and National Insurance on their share of the profits), with the limited liability of a company. This can make them attractive for early-years loss-making businesses, but again the paperwork can be complicated.
Final thought -- It's horses for courses
There is definitely no one best structure for a new freelancer, and no one-size-fits-all answer to the question of what set-up is best to become self-employed. Sole tradership is by far the simplest option, but it’s not without its drawbacks. It’s important to fully weigh up the pros and cons and to discuss them in detail with an accountant before you decide to commit to a particular structure.