Self employed vs limited company: which is right for you?

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One perennial question for freelancers is whether to stay self employed as a sole trader or move to a limited company.

For me personally, it’s an issue of liability.

Because I write for US clients, it’s impossible for me to get suitable indemnity insurance. Trust me, I’ve tried! But the answer has always been “we don’t have a product for you”.

This is especially worrying when many US contracts contain indemnity clauses that essentially puts all of the liability on me as the supplier.

One of the ways to get around this is to set up a limited company and supply my work that way. This protects my personal assets as, in the unfortunate event that I get sued, it’ll be my company that takes on the lawsuit.

But of course there are also tax implications of being a limited company, both positive and negative.

So I spoke to two chartered accountants from Optionis, a professional services provider, about some of the things to consider when you’re deciding whether to stay self employed or start a limited company.

Joanne Harris​ is the company’s head of technical, compliance and payroll while Joanne Thorne is its technical compliance manager.

Pros and cons of being self employed

When it comes to working for yourself, being self employed is the easiest way to go.

All you need to do is tell HMRC that you’re working as a sole trader and register for tax self assessment. And then of course, you’ll need to fill in your tax return every year.

There are other benefits too.

Fewer reporting requirements, more privacy

Harris explained: “As a sole trader, you have fewer reporting obligations. There’s no obligation for sole traders to prepare and file annual company accounts. You just have the self assessment tax return that you need to do at the end of the financial year.

“There’s also more privacy because the information about the company doesn’t have to be stored anywhere publicly, unlike a limited company.”

This second bit is worth bearing in mind – as a limited company, details of your earnings and your registered address are both in the public domain. The latter can be particularly problematic if that address is your home.

It is possible to pay a bit more to register your business address as that of your accountant (if they offer the service) or an virtual office address such as those offered by Tide*, but people would still be able to look up how much you’ve made.

More liability and limits on growth

In terms of cons, it’s not just about liability.

Harris said: “There’s no division between your business and yourself – you are the business – which can be which can be difficult, particularly if you are wanting to expand or secure finance.”

Depending on the sector you work in, being a sole trader can also impact how easy it is for you to secure work.

Harris explained: “If you are working as a sole trader, you might find it difficult to get contracts with recruitment agencies, because agency rules [which turn you into their employee] would significantly put them off from doing it. So you’ve got to consider who your clients are.”

Those working in IT consultancy will find that most of their work will come through recruitment agencies, for example.

The tax implications

There are also pros and cons when it comes to the tax.

“Depending on the level of turnover, it can be more tax efficient to operate through a limited company,” says Harris. “When you’re a sole trader, everything you earn is taxed within that tax year.”

This might mean, for example, that you get pushed into a higher tax bracket because you’ve had a great year.

You can reduce your tax burden by paying into your pension, but you can’t save that money for the following year, when you might not be making as much money.

Pros and cons of being a limited company

Many of the cons associated with being a self employed sole trader are what makes being a limited company so attractive.

Limited company equals limited liability

Among the top of the list of benefits is liability.

Thorne explained: “The company is a separate legal entity. Although you can be the sole owner of the business, you are legally separated, so the money that you earn through the business and its liabilities belong to the business.

“That’s attractive to some people because it means if you’re a sole trader and something happens, your personal assets may be used to settle liabilities. With a limited company, as long as you haven’t misused and abused the company, it’s unlikely for that to happen.”

Better brand protection

Having a limited company can also be a great way to establish and protect your brand, says Thorne, as it’ll be registered with Companies House.

She added: “As a sole trader, although you can assign a company name, you don’t really have the same level of protection because it’s not always registered.”

Increased professionalism

Another benefit of a limited company is that it might make your business look more professional, which can in turn attract more customers.

If you’re working as a tradesperson for example, your potential customer might be more comfortable knowing that you’re a registered and verifiable business.

More tax efficiency

One of the main benefits of a limited company is that it’s more tax efficient.

Thorne explained: “Most of our company directors will take the smallest salary. They can set it at a level that’s still absolutely legally tax compliant, but at a level where perhaps they’re not paying as much or any tax on it. They’re also getting tax relief through their limited company on that salary – because that salary is classed as an expense.

“And the remaining money – the profit that they make – is then available to draw down as dividends, which are taxed at a lower rate. There’s also a £2,000 tax free dividend allowance for everybody in the UK, so the first £2,000 that they take out in the year is completely tax free, irrespective of what they earn.”

Money left in the company can be used to contribute towards a pension for the director, which will also benefit from the corresponding tax relief. Alternatively it can be left in the bank to be redistributed in the following year.

This ability to decide when to withdraw your profits can be particularly helpful if there are significant income variations from year to year.

Affected by different political policies

This tax efficiency does have its downside, however.

Harris said: “It’s interesting to think about this in the context of the Covid support schemes. Limited company directors didn’t get a lot of support, whereas the self employed got more help through the Self Employment Income Support Scheme.”

Obviously it’s impossible to plan for something like the coronavirus pandemic, but policy implications like these might just affect how many people incorporate their business and how they structure their finances.

Cost and complexity of running a company

The biggest drawback of a limited company, however, is the additional cost and complexities of running the business.

Depending on your situation, you may end up having to complete paperwork for your company, your personal tax self assessment as well as PAYE paperwork.

There may be additional accountancy costs and taxes associated with those, and higher penalties if you fail to meet the regular deadline for filing returns and paying taxes.

When should you switch to a limited company?

When it comes to transitioning from self employment to a limited company, there isn’t a clear income threshold, because you might have other considerations to factor into the equation.

However, from both an admin and tax standpoint, it’s just not worth making that leap until you’re consistently earning a good income as you might actually end up paying more tax otherwise.

Thorne explained: “When you have a limited company, there’s something called a double bite of tax. So you will pay corporation tax on the money you earn through the company before it becomes available as profit for you to withdraw as a dividend. When you take those dividends, you’re personally taxed as well.”

A good measure for that threshold might be when your self employment income is consistently nudging or over the higher tax bracket, or there’s a large gap between your income and what you need to live on. You should also factor in income from other sources, such as property or pension.

It’s worth considering how long you intend to continue trading as well. Anything less than six months is just not worth it, says Thorne, as you won’t have enough time to take advantage of the tax efficiencies.

This is particularly relevant for those regularly working contracts within IR35 rules, where they may not earn enough income as part of their company to achieve tax efficiency.

In this case, temporarily working through an umbrella company might offer the best of both worlds.

Should you stay self employed or become a limited company?

The best way to assess whether you should make the switch is by asking an accountant who specialises in accounts for contractors.

Some accountants offer a free projection tool that you can use to assess your circumstances, but they’ll certainly be able to answer more detailed questions about tax benefits tailored to your situation.

The Freelancer and Contractor Services Association (FCSA) is a good place to find a specialist accountant.

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