Changing from a Sole Trader to a Limited Company

What is a Sole Trader and its Basics

All sole traders are self-employed. They alone are responsible for running their business: there is no need to register with Companies House and no need for a director.

A sole trader must, however, register with HMRC and complete a tax return each year. As a sole trader, you can keep all profits from your business but are personally responsible for paying tax and National Insurance on what you earn. You are also personally liable for any debts and other liabilities accrued by your business.

The Growth of a Sole Trader Business

Growth is the main reason people consider changing from sole trader to limited company. Managing your finances and workload can be relatively easy when you start out, but as your work and your revenue increase, things can become more challenging.

You may find that you need to take on additional staff. You may want to switch any liability to a business liability rather than held against you personally. You may be unsure as to whether working as a sole trader is your best option in terms of the amount of tax you pay.

It might be that you want to work alongside someone else to run your business or that you want to be able to pass your business on when you either retire or pass away. These are only possible by switching from sole trader to limited company.

Benefits of Transitioning to a Limited Company

There are four key benefits of changing from sole trader to limited company:

1. Tax efficiency. We explain this in greater detail further down. Once a sole trader reaches a certain earnings threshold, it may be more tax-efficient to switch from sole trader to limited company.
2. Limited liability. As a sole trader, you are personally liable for any business losses. A limited company, however, is a separate entity from its directors and shareholders: the liabilities lie with the business, not with you, protecting your personal assets.
3. Building credibility. You may find that some businesses prefer to work with limited companies rather than with sole traders. As a result, making this switch could boost your revenue.
4. Greater funding opportunities. For investors and business leaders, a limited company can be more appealing than a sole trader because of the tax benefits and legal protection that a limited company offers.

The Concept of Limited Liability

For many, limited liability is one of the major reasons for changing from sole trader to limited company. As a sole trader, you are personally liable for any business debts you accrue – meaning that your home and possessions could be at risk if things go wrong. In the most extreme cases, it may result in you filing for bankruptcy.

A limited company, however, is its own legal entity. As such, the company is liable for its own losses, debts and any legal claims brought against it, giving you limited liability as the business owner. Your only personal liabilities will be any money that you invest in or contribute to the company. Your personal assets will be protected if the business is sued or accrues debts.

Tax Benefits of a Limited Company

Those changing from sole trader to limited company will find there are many tax efficiencies in doing so. With corporation tax now rising to 25%, those sole traders at the lower end of the earnings spectrum may not notice much difference. However, those paying the highest rates of income tax may well benefit from the switch. Personal tax and NIC liabilities can also be reduced by lowering your salary and taking more in dividends instead.

Limited companies can also benefit from various tax allowances and expenses. Profits can be reinvested into the business, avoiding paying income tax on this profit.

Should you decide to sell your limited company, there will be tax implications in the form of Capital Gains Tax. However, you may be eligible for Business Asset Disposal Relief (or Entrepreneurs Relief), which could reduce your tax liabilities.

Raising Finance and Investment Opportunities for Limited Companies

When it comes to funding, limited companies may find that they have greater success in raising money from a range of sources than sole traders.

A limited company with multiple owners can raise money by selling shares to new investors. Moreover, many banks will only offer business loans to incorporated companies and not sole traders. These loans will generally be offered without the need for company directors to offer personal assets as collateral.

The Appeal of Working with Limited Companies

Depending on the sector in which you operate, you may find that certain businesses – especially large multinationals and those in the financial services industry – will work only with incorporated businesses, not sole traders. By changing from sole trader to limited company, you could find that you open up more business opportunities than were available before.

It may be that some businesses are concerned that they could fall foul of IR35 regulations by working with a sole trader. They may also be concerned about the lack of legal protection available to them by working with an individual rather than a registered business.

Capital Gains Tax Incorporation Relief

If you’re wondering, “Can I change from sole trader to limited company easily?” the answer is yes – but there are some things you need to consider. One thing to remember is that there could be deemed to be a capital gain depending on the market value of your business assets.

However, there are ways to change from sole trader to limited company without incurring a hefty Capital Gains Tax bill. If you transfer the entire business as a going concern, with all of its assets (except cash), either completely or partly in exchange for shares in the new business, you may secure Incorporation Relief.

This defers the CGT liability that transferring business assets would normally incur and is applied automatically if the relevant conditions are met.

Complexity of Operating a Limited Company

Operating a limited company is very different from acting as a sole trader – and there are certain steps you will need to take to make the switch.

The first step is to register your limited company with Companies House. In order to do this, you will need a unique company name and a registered business address, as well as the details of at least one director and at least one shareholder. You must provide a service address for each of these people, as well as give Companies House a Standard Industrial Classification (SIC) code that describes the nature of your business.

After incorporation, Companies House will notify HMRC of the formation of your business. You will receive a letter from HMRC explaining what you need to do regarding reporting and tax, including your Unique Taxpayer Reference (UTR).

This, along with your Companies House registration number, will be needed to register for Corporation Tax online, which you must do within three months of starting to trade.

Depending on your forecasted profits, you may also need to register for VAT. If you plan to employ staff in your new venture, you will also need to register as an employer and set up Pay As You Earn (PAYE).

Steps to Transition from Sole Trader to Limited Company

After incorporating your new business, you must inform HMRC that you are no longer a sole trader. This can be done via an online form: you must provide your sole trader UTR, National Insurance number and your personal details.

Once this is complete, you must also file a final tax return to cover the final period you worked as a sole trader. Finally, you will need to notify your stakeholders of the change in business structure. These stakeholders may include banks, clients, suppliers, service and finance providers, and any debtors.

Changing from sole trader to limited company involves much work but often brings great rewards. What’s certain is that you’ll want to ensure you do it right.

Before making that switch, consider the pros and cons of transferring your business to a limited company versus maintaining your position as a sole trader. Clarify everything you need to do – legally, financially and ethically – when making that change. Missing vital steps in the process could result in you being penalised for a genuine mistake.

If you’re considering migrating from sole trader to limited company, QAccounting can help. We can help you to establish which option is right for you. Moreover, should you decide to proceed, we can help you register your limited company, complete the necessary tax registrations, and set up business bank accounts. Click here to learn more.