Sole Trader vs Limited Company: Which is More Tax-Efficient and When Should You Switch?

Starting a new business often comes with a wave of excitement as well as an overwhelming list of decisions. One of the most important early choices you will be faced with is deciding what structure your business will take. For many, operating as a sole trader is the natural first step, as it’s low cost, flexible, and has fewer legal and tax requirements for you to worry about so you can focus entirely on growing your business.

But as time goes on and your business starts to take off, you might start asking: could switching to a limited company reduce my tax bill? Will it make my business seem more professional? And when exactly is the right time to switch? Ridgefield Consulting, an independent chartered accountancy firm based in Oxfordshire, shares insights to help you decide whether, and when, switching is the right move.

Sole Trader vs Limited Company: The Key Difference

 If you are contemplating switching, before you make a decision, it’s important to understand the fundamental distinction between a sole trader and a limited company. As a sole trader, you and your business are legally the same entity. That means any profits the business makes are treated as your personal income, and you’re responsible for paying taxes on them through a self-assessment tax return. You’re also personally liable for any debts or losses, which could put your personal assets at risk. There’s no requirement to register with Companies House (but you do need to register with HMRC), and many sole traders don’t even set up a separate business bank account, although it’s still recommended for clarity for your business.

A limited company, on the other hand, is a separate legal entity. You become both a director and shareholder, and the business can own assets, enter into contracts, and be held liable independently of you. This structure offers limited liability protection, which means your personal finances are safeguarded if the company incurs debt or legal issues. However, it also comes with more responsibilities, including filing annual accounts and submitting confirmation statements to Companies House. You may also need to complete both personal and company tax returns.

How is a limited company taxed in comparison to a sole trader?

When it comes to tax, this is often the point where many business owners begin to reconsider their sole trader status. As a sole trader, you pay income tax on all profits after expenses. The more you earn, the more tax you pay, which can be up to 45% if you fall into the additional rate tax band. If this is your only employment and your earnings are over £6,725 but under £12,570, you will need to pay class 2 NICs to protect your national insurance record. However, if your earnings are above £12,570, you will pay class 4 NICs, the rate of which increases as your income rises. The advantage of this is simplicity, with there being only one tax return to file and generally lower accountancy fees, but this structure offers fewer opportunities for tax planning.

In comparison, Limited Companies operate under a different set of rules, instead, they are subject to corporation tax instead of income tax, which is currently set at 19% for companies with profits of under £50,000 and up to 25% for companies with profits of £250,000 and over. As a director, you can draw a modest salary and take the rest as dividends, which are taxed at significantly lower rates than income tax:

• 75% for basic-rate taxpayers

• 75% for higher-rate taxpayers

• 35% for additional rate taxpayers 

• Plus, the first £500 in dividends is tax-free

 This structure can lead to significant savings, especially once company profits exceed around £30,000–£40,000 per year. However, limited companies incur more costs than sole traders because of the additional costs involved, from filing fees and accountants to the administrative burden of staying compliant with Companies House. Keep in mind, dividends can only be paid out of retained profits, so if your business isn’t generating profit after tax, you won’t be able to take dividends.

What’s the Right Choice for You?

There’s no one-size-fits-all answer here. The best structure for your business depends on where you are on your journey, what your goals are, and how much time and money you’re willing to invest in compliance and administration.

For many, starting as a sole trader makes perfect sense. It allows you to test the waters without committing to a more formal and more costly setup. But once your business matures and starts generating significant revenue, moving to a limited company can bring a host of benefits, from tax efficiency to legal protection and professional credibility.

It’s important not to rush the decision, but don’t avoid it out of fear either. Speak to a chartered accountant who understands your business and can help you make the right call based on your individual circumstances. Tailored advice is always worth the investment.

Ultimately, the choice between a sole trader and a limited company isn’t about which is “better.” It’s about which is better for you and your goals.