Are you looking to start your own business? Irrespective of which industry you are choosing to go into, you need to select the type of company you’d want to work as. You have two options when it comes to that: you can either go for self-employment or a set up your business as a limited company.
For self-employment, you have two further options: you can set up your business with someone, in a partnership, or you can opt for a sole proprietorship.
Sole proprietorships and limited companies have their own unique benefits and drawbacks. First, you need to know and understand which one suits your needs. Remember that you’re in it for the long-term, and the route you take might seriously affect your decisions in the future.
So let’s see how a sole proprietorship and a limited company differ when it comes to taxes.
Tax Ramifications
If you opt for a sole proprietorship, your business and personal income get taxed under the self-assessment process. This means that you are not allowed to defer your profits to reduce the amount you have to pay for a particular year. A limited company is allowed to defer profits for later years however, and that does leave them with some leverage.
The last tax year (2023-2024) has a personal allowance limit of £12,570, which means that you don’t have to pay any income taxes on that amount. As for your annual profits, you could pay anywhere from 20% up to 45% depending on how large these profits were. The basic rate for taxable income between £12,571 and £50,270 is 20% and the rate for taxable income between £50,271 and £125,140 is 40%. The taxation rate of 45% is for income over £125,140.
National Insurance Contributions (NICs) are paid on top of these income taxes. The amount you pay in Class 2 NICs (applicable if your annual profits are £12,570 or higher) would be £3.45 per week. This rate for Class 2 NICs was valid till the last taxation year (2023-2024). As for class 4 NICs, His Majesty’s Revenue and Customs (HMRC) would determine the amount you must pay, based on your annual profits. You will pay 9% on profits between £12,570 and £50,270 and 2% on profits above £50,270. Both rates and thresholds are subject to HMRC regulations and can vary depending on your specific financial circumstances.
For the tax year 2023-2024, if you opt for a limited company, you’re required to pay corporation tax. The main rate for this period is 25%. It’s worth noting that unit trusts and open-ended investment companies have distinct rules that do not align with the standard corporation tax rates. Limited companies have the advantage of being able to retain their profits, unlike sole proprietorships. This offers flexibility in managing income tax on dividends, as dividends can be postponed in years following a profitable one, allowing the company to decide on dividend distributions strategically.
The Benefits
Sole proprietorships are fairly simple to set up compared to limited companies. You just inform HMRC that you want to set up your business as a sole proprietorship and can subsequently start your business. While limited companies may be a bit more challenging to set up, they do offer some advantages. For instance, your personal finances and your business finances are treated separately.
This means that you will not be responsible to pay for a claim lodged against the company from your personal finances. For sole proprietorships though, a settlement for a claim can eat away at personal finances.
As a limited company, you do have to maintain a balance sheet and income statement with accounts, and show those each year. This needs to be done punctually as it is an obligation. Limited company directors have a tax advantage, as discussed, that sole proprietorships don’t. They can pay higher dividends and lower the NICs they pay for that year (dividends aren’t liable for NICs).
What’s right?
There’s no particular right or wrong, it all depends on your personal (or partners’) preferences and needs. If you start out as a sole proprietorship but want to establish yourself as a limited company, you can do that too.