Written by Jonathan Norris of Crunch Accounting on 25 June 2013
When does a person become a business?
When operating as a freelancer, you have two options for your business. The first and most common option is to operate as a Sole Trader. This means you personally are the business; any income goes directly to you, and all tax is paid by you personally.
The other option, which is becoming more and more common, is to operate through a limited company. This means your company becomes a legal entity unto itself, and you will oversee its operations as Director and sole shareholder.
Traditionally sole tradership has been the legal setup of choice for most freelance designers and developers, however in recent years the burden of incorporation has been reduced significantly. Limited companies can now be formed in minutes online, and cloud accounting services mean much of the extra paperwork is no longer a problem.
With incorporating getting ever-easier, the number of freelancers operating their own limited company is growing quickly - by around 6.5% annually, according to ONS figures. According to figures from Companies House, around 250,000 limited companies have been formed so far in 2013.
So what can a limited company offer you that sole tradership cannot?
The most fundamental difference between the two setups is the legal structure. With a limited company you personally are legally divorced from your company. This means should the worst happen and your company goes under (which, unfortunately, is not uncommon in these troubled times!) your personal possessions (your house, car etc.) cannot be touched - you only stand to lose what you’ve invested in the company.
More flexibility for growth
As a limited company growth, investment and changes to your business makeup are, comparatively speaking, a piece of cake. Your company will have a PAYE scheme (which you pay yourself through), so taking on an employee is as simple as adding them to this scheme. Similarly if you want to take on investment in exchange for an equity stake in your company you can distribute shares with ease.
If you decide to shut up shop you can even sell your business lock, stock and barrel and walk away!
Go-faster tax stripes
Limited company directors also have more wiggle-room to reduce their tax bills compared to Sole Traders. We’re not talking Amazon and Starbucks-style offshore shenanigans - extra tax-efficiency can be achieved by means publicised and even encouraged by HMRC.
Allowable business expenses can be used to reduce profits, which will result in a lower Corporation Tax bill. Remuneration can be split between salary and dividends to reduce Income Tax and National Insurance Contributions, and spouses can be brought into the business to split income and avoid the higher tax thresholds.
A sole trader earning £35,000 per year will pay just over £7,500 in tax (a combination of around £5,000 Income Tax and £2,500 in National Insurance contributions). By switching to a limited company setup they would only pay around £5,400 in Corporation Tax - reducing their tax liabilities by over £2,000.
As you profit increases, so does the tax efficiency. Someone earning £50,000 could see their annual tax bill reduced by almost £4,000!