Starting a business is an exciting venture, but it’s also one that presents some big decisions.
One of the most consequential decisions you’ll make is whether to operate as a sole trader or set up a limited company.
Now, there are many factors to weigh up here, but we’re going to assess taxation for company directors vs sole traders.
While you shouldn’t base your decision on which structure to opt for solely on tax, it’s still very important for those who run small businesses and rely on regular, stable salaries for their daily living.
Let’s dive in and figure out whether a sole trader or limited company is the way to go for you for tax and salaries.
Sole Trader Tax Structure: Simple and Cost-Effective
As a sole trader, your business profits are taxed as personal income via your Self Assessment, keeping your tax obligations straightforward and manageable. Here’s how it works for the 2024/25 tax year:
Personal Allowance: You can earn up to £12,570 tax-free each year. This allowance tapers once your income exceeds £100,000 and phases out entirely at £125,140.
Income Tax Rates:
- Basic Rate (20%): Profits between £12,571 and £50,270 are taxed at 20%.
- Higher Rate (40%): Profits between £50,271 and £125,140 are taxed at 40%.
- Additional Rate (45%): Profits exceeding £125,140 are taxed at 45%.
National Insurance Contributions (NICs):
- Class 2 NICs: For profits over £6,725, Class 2 NICs are automatically treated as paid, ensuring your National Insurance record is maintained. However, if your profits fall below £6,725, you can choose to pay Class 2 NICs voluntarily at £3.45 per week to protect your state pension entitlement.
- Class 4 NICs: The main Rate (6%) applies to profits between £12,570 and £50,270 are subject to 6%. Profits over £50,270 are subject to 2%.
The simplicity of the sole trader tax structure can be particularly appealing for small businesses with relatively low profits, as it often results in a lower overall tax burden compared to a limited company setup.
Limited Company Tax Structure: Flexibility and Tax Planning Opportunities
Operating as a limited company provides increased flexibility in how you extract profits. As a director, you have two primary options for taking income: salary and dividends.
Here’s a summary of the key tax elements as of the 2024/25 tax year:
- Corporation Tax: Limited companies are subject to Corporation Tax on their profits. For profits above £250,000, the main rate is 25%. A reduced rate of 19% applies to profits up to £50,000, with a tapered rate between £50,000 and £250,000.
- Salary: You can pay yourself a salary, which qualifies as a business expense and reduces the company’s taxable profits. However, this salary is subject to Income Tax and employee National Insurance Contributions (NICs).
- Dividends: You can also take profits as dividends, which are paid from the company’s post-tax profits. Dividend tax rates are generally lower than income tax rates, with rates of 8.75%, 33.75%, and 39.35%, depending on your income bracket. Additionally, the Dividend Allowance for the 2024/25 tax year is £500, meaning the first £500 of dividend income is tax-free.
The limited company structure opens up opportunities for strategic tax planning, allowing you to balance salary and dividends to optimise your overall tax liability.
However, as tax regulations change, consulting with tax professionals like us at Double Point can help ensure compliance and an effective tax strategy tailored to your specific situation.
Sole Trader vs. Limited Company: A Tax Comparison
To get a clearer picture of how taxes stack up between operating as a sole trader and a limited company director, we ran some calculations across different profit levels, specifically at £30,000 and £100,000.
Interestingly, the results show that the tax outcomes are fairly similar for both structures, although a limited company can offer a slight edge in certain scenarios.
For a profit of £30,000, a sole trader would face a total tax and National Insurance (NIC) liability of £5,234.10, while a limited company setup would incur a slightly lower tax burden of £4,459.55.
At £100,000 in profit, the numbers shift but remain close: a sole trader would pay £31,999.00 in tax and NICs, whereas a limited company would have a total tax cost of £30,750.38.
These differences may seem small, but they highlight just how sensitive tax outcomes can be to the structure chosen and the specific conditions, such as how income is taken.
For example, in a limited company setup, the director’s pay can be optimised by taking a modest salary and receiving the rest through dividends, which benefits from lower tax rates in the basic band.
The efficiency of this approach, however, depends on various factors like profit level, dividend tax rates, and personal allowances, meaning that small changes in these elements could shift the balance in favour of one structure or the other.
Moreover, you could benefit from Employment Allowance (EA), lowering your employer NICs bill when taking your director’s salary so you save even more tax.
But, we need to point out that the director’s salary + dividends is nuanced as your salary counts as a business expense (thus lowering your Corporation Tax bill) whereas dividends come out of your profits (meaning you paid Corporation Tax).
So, your director’s pay is already somewhat post-tax, meaning you’re generally paying more to HMRC overall than as a sole trader if you look solely at the topic from a tax perspective.
Ultimately, the decision between a sole trader and a limited company should consider these tax nuances alongside other factors, such as business goals, growth plans, and risk management.
While the tax savings alone might not be decisive at certain profit levels, the flexibility and protection offered by a limited company could make it the right choice for businesses focused on scaling up.
Why Choose a Limited Company? It’s Not Just About Taxes
While the tax comparison suggests that sole traders enjoy a tax advantage at lower profit levels, the decision to incorporate isn’t solely about tax savings.
There are several other important factors to consider when choosing between a sole trader and limited company structure:
- Limited Liability Protection: A limited company offers liability protection, shielding your personal assets from business debts and liabilities.
- Flexibility to Retain and Reinvest Profits: Limited companies allow profits to be retained within the business after paying corporation tax, without triggering dividend or income tax until they’re distributed.
- Tax-Efficient Pension Contributions: For directors looking to save for retirement, a limited company offers the option to make tax-deductible pension contributions directly from company funds.
- Income Splitting with Family Members: Limited companies offer opportunities for income splitting, where shares can be distributed to family members, allowing dividends to be spread across multiple individuals.
- Professional Image and Credibility: A limited company can lend credibility to your business, helping it appear more professional to clients, partners, and investors.
Seek Professional Guidance
The decision between a sole trader and a limited company comes down to your business goals, risk tolerance, and growth ambitions.
While the tax implications are an important consideration, there are many other factors that may be critical to the long-term success and stability of your venture.
At Double Point, our team of chartered accountants specialises in providing tailored guidance to help you navigate this important decision.
We can thoroughly analyse your specific circumstances, run the numbers, and recommend the optimal business structure and tax planning strategies to support your entrepreneurial journey.
Contact us today to schedule a free consultation and discover how we can help you make the most informed choice for your business.
