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When is the best time to turn a sole trader business into a limited company?

There comes a time for many sole traders when the prospect of running their business as a limited company seems more practicable and appropriate for their needs. 

The truth is, no business is ever too new or too small to be registered as a company, but it is a particularly beneficial legal structure if you’re planning to grow an existing sole trader business, start trading further afield and/or your profits are likely to be at least £20,000 per year. As business profits increase, so too does the potential to employ a more tax-efficient strategy with a limited company structure. What’s more, the added prestige and financial protection of ‘limited' status can be extremely advantageous on both a professional and personal level.

What’s so great about limited companies?

Oh where to begin. Limited companies are ideal for all sorts of businesses, big or small, commercial or non-profit. Whether you’re a one-man (or woman) band or you want to set up in business with other people, incorporating a company is a viable option if you’re at least 16 years old and are not currently an undischarged bankrupt or a disqualified director of another company.

1.     Financial liability

As a sole trader, you are your business. There is no legal distinction between the two, so you are fully liable for business debts. This is not the case with a limited company. By incorporating a company, your business will become its own legal entity; an individual ‘person’ that is separate from you. Consequently, the company will be responsible for business liabilities, not you.

As a company director and shareholder, you will only be personally responsible for the nominal value of your share(s) and any guarantee you choose to put in place, rather than the full sum of any liabilities that may arise. This financial protection is referred to as ‘limited liability’ and it is one of the most effective ways to protect your own finances and assets, such as your house and savings, in the event of insolvency.

If you want to compete on a level playing field for high-value contracts, or your products or services have the potential to attract liability claims for damages, you would be wise to protect yourself by trading through a company.

2.     Tax efficiency

As a sole trader, you will currently be paying Income Tax and National Insurance Contributions (NIC) through Self-Assessment. Depending on how much you earn through your business and from other sources of income, you will be paying between 20-45% Income Tax on your annual profits, in addition to Class 2 and Class 9 NICs. If your total profits in a year are likely to exceed £20,000, you could reduce your personal tax liability by switching your sole trader business to a limited company.

This can be achieved by paying yourself a salary through PAYE and taking additional income as dividends. By doing so, there is the potential to save upwards of £700/year in tax. Your company will pay 20% Corporation Tax on profits up to £300,000, which is a much higher threshold than the 20% Basic rate Income Tax allowance of £32,000 (2016-17 tax year).

3.     Professional appeal

Whilst the ownership structure and nature of your business may remain completely unchanged, company incorporation will likely have a significant impact on the way you and your business are perceived by other people and other organisations. It is often easier for companies to obtain finance and investment; larger clients and suppliers tend to favour limited liability businesses over sole traders; and, people in general are more likely to trust an incorporated business over a sole trader one because they are required to adhere to strict reporting and public disclosure regulations.

4.     Protecting a business name

By changing your sole trader business into a limited company, you have the opportunity to protect your existing business name by registering it as your company name (as long as no one else has beat you to it). No two company names can be the same, or even too similar that they are likely to cause confusion, so you can prevent other people from using your business name by setting up a company.

Alternatively, you can ditch your existing sole trader name and register a completely different name for your company. This may be a good option if you’re looking to rebrand, start afresh, or your current name is not particularly appropriate, appealing or memorable.

What’s not so great about companies?

Nothing good is without its drawbacks. There are a few nuisance aspects of running a limited company, namely:

  • Additional administration, filing requirements and reporting obligations
  • More complicated bookkeeping and accounting
  • Lack of privacy
  • Strict procedures for removing money from the business

At first glance, a company may appear more hassle than it’s worth. For some sole traders, this is absolutely the case. But for the vast majority, these seemingly major drawbacks pale in comparison to the huge potential benefits.

I would always advise speaking to an independent business advisor or accountant before setting up a company or converting a sole trader business. It’s a very inexpensive and simple process to incorporate a company, but the decision should not be taken without careful consideration and a full understanding of the legal duties involved.

About the Author

Rachel Craig is a content writer for 1st Formations Limited, the UK’s leading company formation agency. She specialises in private limited company formation, statutory compliance and corporate taxation. 

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