Self-employment or working as a Sole Trader has become increasingly popular in recent years, and due to the changes in the labour market, there are currently in the UK 4,3 million self–employed. The number is growing as this type of business attracts working-age and some above retirement who wish to stay active.
This so-called smallest type of business, when individuals work solo, take risks and enjoy the benefits, is legally considered as business entity.
The Self-employed may or may not have starting capital, such as tools and equipment. As the business grows, they may purchase some for the trade and claim expenses as tax-allowable. For accounting purposes, they must separate their business and private matters and some self-employed open business bank accounts for this purpose. However, there is no legal obligation for them.
Self-employed and business owners, such as partners and company directors, submit their tax returns annually to declare their income and benefits (form P11D for company directors who are typically taxed at source – PAYE).
After taking off the Personal Allowance (£12,570- 2023/23), Self-employed income is taxed according to their income bracket, that is at @20%, with the pay up to £37,700, 40% if their income is between £37,700 and £125,140, and 45% if the income is above £125,140. Completion of the SA Tax Return is a legal requirement.
Sometimes, self-employed may employ staff or subcontract some work. However, the business is small, and its income level makes this frame best suited considering tax liability.
Certain decisive factors outweigh the decision to change from trading solo or in a partnership to set up a limited company, which is crucial to benefit the business.
Typically, this happens when the estimated or realised profits hit around the higher income bracket – £37,700 – £40,000. Any earnings above £37,700 would invite tax at a higher rate of 40%, and if the self-employed made business investments, those would have to be from his private profits. However, these are tax-deductible annual investment expenses and are taken off from tax liability calculation upon claiming.
With an income of £37,000, a limited company could pay a director a minimum salary up to the Personal Allowance, and the remaining profits would then be taxed under the Corporation tax at 25% (from April 2023′). Let’s look at the example below.
SME income – £37,000 after the deduction of Personal Alowance and Tax allowable expenses (for this example 1,000) is left with £23,430 which is taxed @ 20%.
At an income of £37,000, a limited company, after paying the director’s salary up to a Personal Allowance of £12,570 (assuming only he is on the Payroll), similarly as self-employed, is left with the amount of around £24,430, which after deduction of liabilities and tax allowable expenses is taxed at 25%—leaving in the business around £17,000- £18,000 (depending on the amount of the expenses). This amount is available for redistribution among the shareholders and reinvested in the business.
Let’s look at the example when there is more income; which will be more financially viable? Self-employed or a Limited company?
With the income of £57,000 the self-employed would be taxed as follows: After the deduction of £12,570 PA, he will pay tax at 20% on the £37,700 (£7,540) and 40% on the £6,730 – (£2,692). This altogether make his tax liability £10,232 leaving in the business around £46,000 (not considering business expenses)
At £57,000 income, a limited company is taxed at a steady rate of 25% on the income after the payment of the director and employees’ salaries, debts and liabilities. Assuming the director is paid the minimum wage to Personal Allowance (£12,570) and tax allowable business expenses are 1,000 – the amount of £43,430 is subject to ‘25% Corporation Tax, equal to the tax liability of £10,877, thus leaving in the business similarly as self-employed around £46,000 for distribution amongst the shareholders and reinvestment.
How profit grows when self-employed and running a limited company can be best illustrated in a graph
The director is taxed separately under PAYE according to his income bracket.
Company directors are separate from the business they run. When borrowing money to and from the company, they enter into a legal agreement under the Director’s Loan Account rules.
Limited Company director can decide how much he pays himself in wages. • He can utilise Personal Allowance and draw a salary to this amount, thus safeguarding his Pension, but he would have to start paying NI contributions if his income reaches £242 per week or £1048 per month (£9,100 per year) • He may decide to pay himself a wage based on his specific needs. • Or he may pay himself a higher salary per the company’s growing income.
A company director may additionally pay himself in the form of dividends. Currently (2023/24) the tax-free dividend allowance is at £1,000. Above this amount tax applies after personal allowance at the rate as follows: basic rate band (to £37,700) – 8.75%, Higher rate band (£37,700- £ 125,140 – 33,75%, and Additional rate band -above £125,140 – 39.35%.
The self-employed would invest in his business from his private earnings. However, HMRC supports the business’s expansion and deducts annual investments from tax liability calculation upon claiming.
As we see above, personal and business income, expenses and tax allowances make up tax returns; all the information provided facilitates the calculation of Tax and NI liability.
One of the most significant advantages of running a limited company is its restricted liability for its debts. A limited company is liable to pay off the debts only to the number of unpaid shares to which they originally agreed to be liable.
On the contrary, a sole trader is responsible for all the debts incurred by the business and may have to sell personal assets, including their home, to meet these debts. This responsibility is typically shared in the partnership, apart from when one partner becomes bankrupt and cannot pay off his part of the debt. This limited liability for the business’s debts significantly takes off the burden of investment and entrepreneurship compared to self-employment.
A Limited Company must file with a Registrar, Companies House, a Memorandum defining its powers and objectives regarding dealings with others. This information, along with the company profile and finance, can be accessed by prospective investors. It adds to its status and credibility when approving loans and deciding about investments, putting a Limited Company in a better position when raising capital.