There are a number of reasons why people choose to trade through an incorporated entity (such as a limited company) or an unincorporated entity (such as a sole trader or partnership), and the right answer will depend on your individual circumstances. But it’s likely that business taxation will play a big part in that decision.
Taxes for a sole trader are relatively straightforward: broadly speaking, you simply pay income tax and national insurance on how much profit your business makes in a given tax year.
There is no legal distinction between ‘you’ and ‘your business’ as a sole trader. You may have a separate business bank account, and you may leave a proportion of your profits in that bank account in order to help the business expand or to manage its day-to-day cash flow, but this has no effect on your taxes.
Your income tax and national insurance will still be calculated on the business profits, not on your drawings from the business. The ‘business’ itself does not pay tax, because the ‘business’ and ‘you’ are one and the same for tax purposes.
The same logic applies to partnerships, the only difference being that the profits will be split between the partners.
Conversely, a limited company is its own distinct legal entity. It pays corporation tax on its taxable profits, with no minimum profit threshold.
Because of this, you cannot just ‘take’ money from it the same way you might just take money from a business bank account as a sole trader. Instead, the money must make its way to you in the same form as it would for any company you work for or have shares in – via salaries and dividends.
As the owner or partial owner of a limited company, you will likely be both a director of the company (entitling you to a salary) and a shareholder (entitling you to dividends). As you will be liable for personal tax and national insurance on the salary and dividends you withdraw from the company, it is important that your mix of income is managed in the right way.
On the face of it, acting as a sole trader appears a lot simpler from a taxation point of view, and to a certain extent it is. There is no separation between you and your business, the flow of money between any business and personal bank accounts is irrelevant; you just pay your taxes based on how much profit the business makes.
However, this simplity comes with rigidity. Whilst a limited company has little leeway when it comes to corporation tax, from a personal point of view you do have flexibility, given that you can decide how and when you wish to take money from the company.
There can be tax advantages to this structure: for example, if you personally have introduced funds into the company to help with working capital then it may be tax efficient to be paid interest on this loan, and having an electric company car can also be beneficial.
If it seems as though you are paying tax twice through a limited company (corporation tax, then personal taxes), then it’s because you are - which is why it is important to manage it correctly.
It’s worth pointing out that VAT rules are not specific to sole traders or limited companies – they apply across the board, however you have structured your business.
Tax is just one of the factors – albeit a major one – in deciding what structure your business should take. It is vital to consider all of those factors and take professional advice, because getting it wrong can be costly down the line.