You have made the decision to leave the safety of employment to go it alone, congratulations! Not an easy decision to make, but at least now you know you will be self-employed. Or will you? Should you be a sole trader or use a limited company to trade through. Lots of people find it difficult to understand the difference between the two, so we will try to clarify it and give you some pointers to decide which one is right for you.

There are two key differences, the way you are taxed and the potential liability you have should things not work out. Getting the right advice and making the right decisions early on can be vital in making sure your new venture is successful.

Being taxed as a sole trader is relatively straight-forward. You take your income in the year to 5 April, reduce it by your business expenses to arrive at your profit for the year, your personal income. This is what you pay tax on. The first £11,500 is tax free, the next £33,500 is taxed at 20% and if you are lucky enough to have a profit over £45,000 it is taxed at 40%. This increases further if you get into 6 figures. You also have to pay national insurance of 9% on profits between £8,164 and £45,000, plus 2% on all profits over this amount.

If you trade through a limited company, you do a similar initial calculation to arrive at your profit. Only this is company profit, not your personal income. The company pays corporation tax, which is currently at 19%.  This does not increase depending on the amount of profit, all of it is taxed at 19%. (Comparing this to tax at 20% or 40%, there can be quite a saving to trading through a company rather than as a sole-trader).

However, at the moment you do not have any personal earnings, it is all in the company. The company then needs to pay you. A small amount will be as a salary (let’s try to keep those national insurance contributions ticking over just in case there is still a state pension in the future!) with the rest being dividends. This is what you get taxed on, there is no national insurance on dividends which is where a saving comes in. Again, you can have £11,500 tax free, then a further £5,000 of dividends tax free before you start to pay tax at 7.5% on other dividends, going up to 32.5% if you take out more than £45,000.

This ends up giving you saving of around £2,000-£2,500 per year, but only if your profit is at the right level.

The second tax benefit comes if you have a really good year thanks to a one-off job or contract. As a sole trader, this would force you into a higher tax bracket, losing 40% – 45% to HMRC. You have no choice, you pay tax in the year you make the profit.

For a company, the profit still falls into the one year but you pay tax at 19% regardless of the level of profit rather than the sole trade 40%/45%. This leaves a higher amount that you could take out in dividends. If you take it all, you will suffer tax at higher rates, 32.5% and higher. Alternatively, you could choose to limit your dividends to £45,000, minimising your personal tax charge. You can then take out the extra dividends in the following year/years, when perhaps you take a well-deserved holiday for working so hard the year before, so have less income and profit.

The second, and sometimes more important, consideration is what happens if something goes wrong. If you give advice or sell a product that your customer decides was wrong or faulty, there is a chance they will take legal action against you. Hopefully, you will have insurance in place which will cover any issues, but we all know how much insurance companies try not to pay out.

So what happens if the insurance does not pay out? As a sole-trader, the next step is to sue you, the individual sole-trader. This means that all assets of yours are at risk, houses, cars, savings etc.  It is not limited to your trading profits or sole-trade income.

As a company, it is the company that gets sued, not the individual. As a result, liability is limited to company assets. If you have been taking most of the profit out as dividends each year, there will be very little left in the company. Your house stays safe and, whilst it is not a nice process to lose a company you have started to build in this way, you can start again and your family still have security.

There are usually slightly higher running costs as a company, but this is minimal compared to the tax savings and the safety of not losing your house. If you are looking at moving away from the safety of employment or are not sure if staying as a sole-trader is the right thing for you, making an appointment to discuss it with an accountant should be top of your to-do list.

MumsWork Note: This article is provided by a third party and content is deemed to be correct at time of publication