What are the benefits of forming a limited company?
What are the benefits of being a sole trader?
Many who work for themselves, as contractors or freelancers, are often operating as Sole-Traders. For those starting out on their own, for financial reasons this is the simplest approach due to lower tax and accounting requirements, especially with regards to tax returns.
What are the benefits of setting up a limited company?
Once you’re up and running, and your earnings start to increase, many sole traders start to weigh up the benefits of creating a limited company instead. The move to a limited company and paying yourself as a director, from the position of a sole trader provides some significant savings for tax purposes. By forming a limited company, Sole traders can also transfer liability from themselves to a separate entity.
When should I set up a ltd company?
The question many sole traders ask: When does setting up a limited company provide savings for tax purposes? Depending on which accountant you ask, Sole traders should consider the move once their income is between £20,000 and £30,000 per year. Forming a limited company, and paying yourself as a director, will require the services of an accountant, which comes at a cost. Those with an income below this amount are likely to benefit from remaining a sole trader as the costs involved in forming the company and ongoing reporting will outstrip the tax savings.
What are the benefits of being a director?
One major benefit for directors of companies is their ability to pay themselves from a limited business in a way that reduces their personal income tax and national insurance liability.
How are sole traders taxed?
Sole traders are able to deduct allowable expenses from their income. This profit, after their tax-free personal allowance, is then taxed at standard income tax rates: 20%, 40% or 45%, depending on how much you earn. They also need to pay National Insurance rates starting at 6% and reducing to 2% over certain thresholds.
How are Directors of limited companies taxed?
On the other hand, Directors of Limited Companies can choose how they are paid. Many will pay themselves, as an employee of their own business, up to their tax-free personal allowance. The limited business will need to pay negligible national insurance contributions for this amount, with no income tax or National Insurance Contributions to be paid by the Director. This payment also entitles the Director to benefits received by those paying National Insurance on income above this amount, including the State Pension.
Beyond this, Directors can elect to pay themselves dividends from their business. The first £500 is paid free of tax, as this falls within the Dividend allowance, with dividends over this amount taxed at a lowly 8.75% within the basic rate band.
Dividends paid within the higher rate tax band are taxed at a higher rate of 33.75%, but this is still below the 40% higher rate tax that would be paid on profits by the sole trader. Theres still a saving on dividends at the additional rate, as they are taxed at 39.35%, rather than 45% for sole trader’s profits.
Sole traders and Directors compared
Let’s take a look at Harriet, a Sole trader with profits, after allowable expenses of £40,000 for the year. After the use of her tax-free personal allowance, she owes £5,499.96 in income tax and £248.26 in national insurance contributions. Of her £40,000, Harriet takes home £31,520.88
Now let’s consider Jessica, who formed a business and pays herself as a director. She too is able to pay herself £40,000 from her limited business for the year. She sets herself up on her own company payroll to pay her tax-free personal allowance as income from the company account.
She personally is not liable to National Insurance contributions on this income, although her employer, her company, will. The remaining amount she elects to receive as dividends. As this amount is within her basic rate band, she will only pay dividend tax of 8.75%. In addition to this the first £500 of dividends, the dividend allowance, are received tax free. She therefore pays tax of £2,356 on these dividends. As a Director, Jessica takes home £37,644 for the year, £6,123 more than Harriet.
In this simple example, it’s clear that, as a Director, Jessica is better off. What we’ve not addressed is the additional costs incurred by Jessica as a business owner. Although she’s saving more on tax from as an individual, her company still has to pay corporation tax on profits, which includes her dividends. She also has to juggle all the extra admin and costs that go along with managing her business.
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No financial decisions should be taken based on the content of this website or associated videos. The guidance contained within this website is subject to the UK regulatory regime and is therefore primarily aimed at viewers in the UK. Always take full individual advice first. Regulations and legislation governing taxation, investments and pensions may change in the future.
The content on this page is accurate as of the 2024-25 tax year.