Sole trader vs limited company: which is best for freelancing?
When looking to undertake freelance work, there are various trading formats through which individuals could provide their services.
Two of the most common formats are sole tradership and limited company directorship.
Here, exclusively for FreelanceUK, I will pit these two very different business structures against each other, ahead of exploring the take-home pay of both structures, which freelancing in the UK is invariably undertaken via, writes chartered accountant Graham Jenner of tax advisory Jenner & Co.
Do I have a free choice when it comes to sole trader vs limited company?
In theory, yes you do have a free choice - but in practice, no, you might not!
End-clients, whether a company or public sector organisation, offer work on a freelance basis because they do not want the commitment of taking on an employee, or are looking for a more flexible working arrangement than would be available with an employee.
However, not all clients will be automatically agreeable to the sole trader and limited company routes!
In fact, some clients may not entertain the idea of engaging a sole trader for the freelance work which they want done, if they feel it might leave them exposed to the risk that the freelancer could be regarded as their employee -- either for tax purposes or in law.
IR35 may deter clients from engaging you for your freelance services
Other clients (also known as ‘engagers’ or ‘end-users’) may not be prepared to get involved with a limited company, due to obligations on them under April 2021’s revised IR35 rules.
At the time of writing, it is fortunately the cases that there are no such obligations where the client is not in the public sector and is regarded as a ‘small’ company. There are also no such obligations (arising from the April 2021 off-payroll framework) where the end-client has no connections with the UK.
If I do have a choice of sole trader or limited, which is best?
There are legal and taxation differences between the two structures, and the key differences are set out below.
If you are or become a sole trader, there is no separate legal entity – in other words, you are the business and the business is you!
Therefore, you are personally liable for all the debts of the business, which is unincorporated.
There is no formal process to setting up as a sole trader, other than registering with HMRC for self-employment.
If you are or become a limited company (often called a ‘PSC’ – Personal Services Company), the company – which you set up and form -- is a separate legal entity.
You will be the shareholder (i.e. owner) of the company. You will register with HMRC for self-employment and register the company on Companies House.
You will be the director of the company (a role which carries certain responsibilities), which is an incorporated business.
You work for the company.
You are not personally liable for the debts of the company. (N.B. For most freelancers, the largest debt will be taxes. As long as you keep on top of the tax due by the company there should be no risk of personal liability for the company’s debts). This protection (limited liability) is the main reason people incorporate, according to a 2014 study by HMRC.
The company will have a contract with the end-client.
There are a few formalities to deal with to set up a company.
To ensure those formalities are adhered to properly, a chartered accountant should be your first port of call, as such advisers can assist comprehensively in this area.
Tax and National Insurance (NI) is payable for each tax year
It is based on the profits of the basis period for that year, (usually the 12 months accounting period ending in the year)
You pay tax and NI on the profits in the basis period, even if you don’t take all of the profit out of the business.
Subject to certain allowances and the level of profit, tax is payable at rates of 20%, 40% and 45% and national insurance at 10.25% -- on profits between £11,909 and £50, 270, and 3.25% -- on profits over £50,270.
The take-home pay of a sole trader will be covered in part two.
Tax is payable for an ‘accounting period’ not a tax year
An accounting period is usually the 12 month period ending on the company’s year-end date, so that the accounting period for tax is the same as the accounts period.
The rate of corporation tax is 19% ((N.B this rate of tax is set to rise from April 2023 for companies with profits over £50,000).
So-called ‘taxable profit’ is what you are left with after deducting your salary as the director (usually a small sum, below the NI threshold).
The profit after tax is available to be paid as a dividend to the individual (in their capacity as a shareholder).
There is no national insurance to pay on dividends.
There is tax to pay on dividends once £2,000 in dividend income is taken, and the rates payable to HMRC are viewable here.
But interestingly, there is the flexibility to explore with an accountant of only paying out some of the available profits as dividends, to reduce an individual’s tax liability for the year. It may be possible to pay these in a later year, with less tax being due.
The take-home pay of a limited company freelancer will be covered in part two.
But be aware before you commit to a particular set-up for freelancing, a limited company is a more tax and NI-efficient way of working than a sole trader, provided IR35 does not apply.
Does going through a recruitment agency make any difference?
There is no significant take-home pay difference if you work through your own limited company and use an agency to source work, but you are unlikely to be able to operate as a sole trader if you work through such a temporary employment agency, as they will, generally, not make this option available.
What if my client refuses to engage me as a limited company or sole trader?
If the end-client won’t allow the sole trader route or use of your own company, they may ask you to operate through an umbrella company.
A bonafide umbrella company employs you, extends to you employment rights, and pays you under PAYE, minus a fee you pay to the company (their ‘margin’).
But in take-home pay terms, be aware that for the same amount paid by the end-client, you will be worse off than under a sole trader or your own limited company.
Finally, discuss the options with your customer
If you decide you would prefer to work through your own limited company, don’t be afraid to discuss this option with the end-client when negotiating the contract or work. Some end-clients, particularly smaller ones, may previously have only dealt with sole trader freelancers. But due to the ever-changing tax landscape, corporate customers themselves may have shifted their engagement policies, so it’s definitely worth leading with the freelancing structure that suits you and your business best!