When you’re self-employed, there are pros and cons to setting yourself up as a sole trader or a limited company - but how does it compare in terms of cold, hard cash?
I’ve been mulling over the decision myself, as a self-employed journalist and blogger, trying to work out when it makes sense to switch from being a sole trader, to setting up a limited company. The two options are taxed differently, so it makes a difference to the pounds in your pocket.
Sole trader: totally tax-free as you get started
Starting off as a sole trader makes life easier and less expensive. You don’t face paperwork beyond your own Self-Assessment tax return. There’s no need to wade through incorporating a company, and then filing annual accounts, a confirmation statement and a company tax return each year.
There’s no requirement to pay for an accountant or fork out for a business bank account. You don’t have to justify spending any of your earnings, or shoulder the legal responsibilities of being a company director. You can also keep your company figures and office address private, rather than visible to all at Companies House.
On the money side, as a sole trader, the profits from your business are included on your own tax return. Personally, I earnt next to nothing when I first went freelance after maternity leave, and I couldn’t take on much work while juggling two children with less than two years between them.
Luckily, if you earn under £1,000 a year in gross income from your business, you can pocket the lot tax-free under the trading allowance, and don’t even have to tell HMRC that you’re self-employed.
Once your income starts stacking up, you can choose between deducting the £1,000 trading allowance from your business income, or deducting actual expenses. Provided your profits, plus any other earnings, don’t pass the £12,570 a year personal allowance (2024/25), you won’t pay a penny in income tax. While profits are still low, you won’t have to fork out for National Insurance contributions (NICs) either.
However, once your earnings from self-employment increase, you’ll need to pay Class 4 NICs at 6% on anything between £12,570 and £50,270 a year, and at 2% on anything over that.
If your profits are less than £6,725 a year
You don’t have to pay anything but you can choose to pay voluntary Class 2 contributions.
The Class 2 rate for tax year 2024/25 is £3.45 a week.
This helps protect your National Insurance record and your eligibility for certain benefits such as Maternity Allowance and the State Pension. Once you earn over the ‘small profits threshold’ of £6,725 a year, Class 2 NICs are treated as having been paid.
Plus, even if you don’t earn enough to pay income tax, you can still stash away up to £2,880 a year into a pension and see it topped up to as much as £3,600 with tax relief.
Sole trader: double whammy of income tax and NICs as profits soar
The tax bills really get going when you start paying income tax and self-employed NICs. The table below outlines how profits impact your self-employed NICs and income tax rates for 2024/25. Please note, if you live in Scotland these rates differ.
| Profits | Self-employed NICs | Income Tax |
|---|---|---|
| Below £6,725 | Can choose to pay £3.15 (Class 2) for every week you’re self-employed | 0% |
| £12,570 to £50,270 | 6% (Class 4) | 20% |
| £50,271 to £150,000 | 2% (Class 4) | 40% |
| Over £150,000+ | 2% (Class 4) | 45% |
The silver lining is that higher earnings mean you can pay more into a pension, and benefit from extra tax relief. Most people can pay up to 100% of earnings, to a maximum of £60,000 a year (2024/25), into a pension, and benefit from basic rate tax relief that adds 20p to every 80p you pop in your pension pot. If you’re a higher or additional rate taxpayer, you can claim back extra relief through Self-Assessment.
How does becoming a limited company compare?
Once you face paying 20% or 40% income tax on profits as a sole trader, suddenly the 19% lowest rate of corporation tax paid by limited companies doesn’t look so bad. Nowadays corporation tax is paid at 19% on profits of less than £50,000 a year, 25% on profits of greater than £250,000, and on a sliding scale between the two, after calculating marginal relief.
Some people prefer to do it straight away for extra protection. As a sole trader, you and your business are lumped together. Legally, you’re one and the same. This means if your business goes belly up or you get sued, your creditors could come after your home or other assets. In contrast, when creating a limited company, you create a separate legal entity, which limits your liability. You can only lose what you’ve put into the company.
Limited company: corporation tax from the first pound
On the financial side, setting up a limited company involves juggling extra taxes and makes more sense as your business gets bigger. As a limited company, you’ll need to pay corporation tax on any profits. The bad news is that there isn’t a handy personal allowance or £1,000 tax-free trading allowance with corporation tax. Instead, you face paying 19% corporate tax from your first pound in profits.
The good news is that you can claim a wider range of allowances and tax-deductible costs as a limited company, which will bring down your profits and therefore your tax bill. I suspect I may’ve been missing out by sticking as a sole trader, once my children started school and I took on more work.
Limited company: how to pay yourself
In reality, unless you have oodles of other income elsewhere, you’ll also need to take some cash out of your limited company to live on. The two main ways of taking money out of a limited company are as salary and dividends.
If you’ve set yourself up as a director and shareholder of your company, you can pay yourself a salary as a director and employee, and take dividends from profits as a shareholder. You can also make employer pension contributions from your company, to beef up your income in retirement.
The most tax efficient combination is to take a salary low enough to escape paying income tax with little or no NICs, plus some dividends and potentially some pension contributions. The perfect combo will depend on your own specific circumstances, and the tax bands at the time.
Taking a tax-efficient salary
Paying yourself a salary has a couple of perks. Salary, and any employer NICs paid on it, count as allowable business expenses that can be deducted from your profits, which then cuts your corporation tax bill. Plus, as long as the salary is above the Lower Earnings Limit (£6,396 for 2024/25), you should rack up qualifying years towards a State Pension even if you don’t pay any employee NICs.
To make the most of your money, there are three options:
Hassle-Free: £9,100 a year
Setting your salary just below the ‘secondary threshold’ for National Insurance, which is £9,100 (2024/25), means you avoid the effort and expense of any NICs at all.
Sole director and employee: £12,570 a year
One man band? It’s usually most tax-efficient to push your salary up to the ‘primary threshold’, which is equivalent to £12,570 in the current tax year 2024/25. You’ll save more in corporation tax than your business pays in 13.8% employer NICs, and you won’t have to fork out for employee NICs.
Only you can judge if the saving, of between £181 and £389 a year, depending on your profits and therefore where your corporation tax rate falls between 19% and 25%, is worth the National Insurance admin.
Two or more employees: also £12,570 a year
If your company has at least two employees and can claim the Employment Allowance, it makes financial sense to take your salary up to the £12,570 personal allowance.
This way, you earn the maximum possible without paying income tax or employee’s NICs, and the Employment Allowance covers the employer’s NICs. It also saves your business a more chunky £660 to £868 in corporation tax, depending on your corporation tax rate, compared to taking a £9,100 salary.
Paying into a pension
If you’re self-employed via a limited company, you can also make employer contributions into your pension. Pension contributions are usually an allowable business expense, so these pension payments will reduce your profits, and therefore cut your corporation tax bill. Plus, employers don’t have to pay NICs on pension contributions, which can save money compared to paying a salary.
It’s worth noting that contributions are subject to the ‘wholly and exclusively for the purpose of the trade or profession’ test, meaning they must be at a reasonable level. While most contributions aren’t challenged by HMRC, there’s a chance they could be questioned if they’re deemed excessive.
Unlike personal contributions to a pension, the amount you can pay into your pension from a limited company isn’t directly tied to your income. Instead, contributions up to the £60,000 annual allowance can benefit from tax relief (2024/25), while contributions above this are hit by a tax charge. This means that even if you’re taking a small salary from your company, you might be able to pay a larger amount into your pension via employer contributions.
Profiting from dividends
Dividends are a winner because dividend tax rates are lower than income tax rates, and you don’t have to pay any NICs on them, either as an employer or an employee. The limitation is that dividends are a share of profits - which means you can’t take dividends if your business is making a loss. You’ll also have to jump through the hoops of recording and declaring dividends, even if you’re the only shareholder.
Previously, company directors could withdraw up to £10,000 in dividends tax-free, to add on top of their normal personal allowance. However, after repeated cuts to the dividend allowance, only the first £500 a year in dividends is tax-free since 6 April 2024. This means that nowadays you could potentially only earn up to £13,070 a year without paying any income tax or dividend tax. Above £500 in dividends, you’ll pay dividend tax depending on your income tax band.
Dividend Tax Rates 2024/25
| Taxpayer | Rate |
|---|---|
| Basic Rate Taxpayer | 8.75% |
| Higher Rate Taxpayer | 33.75% |
| Additional Rate Taxpayer | 39.35% |
Flexibility as a limited company
The other big advantage with a limited company is that you can choose how much money to take out. You might, for example, leave a chunk of profits inside the company if taking higher dividends would push you into a higher income tax bracket. At the other extreme, you might choose to take the tax hit on drawing higher dividends plus salary, to improve your chances of getting a mortgage.
As a sole trader, all your profits get added up for income tax purposes, and you can’t do much about the resulting tax bill other than upping your pension contributions or giving money to charity.
Sole trader vs limited company: what’s the tipping point?
Becoming a limited company has become less attractive from a tax perspective in the last couple of years, due to corporation and dividend tax rates ticking up, and the tax-free dividend allowance and national insurance rates going down.
In 2024/25, you only pay less tax as a limited company once profits pass beyond the point where sole traders get hit by higher rate income tax, and you’re earning £50,000+. With higher profits, you might even be better off financially as a sole trader.
The best option for you will depend on your specific circumstances, including any income you might have on top of your business and whether you wish to protect yourself from liability if it fails.
Personally, the big relief for me is that although I definitely could have reduced my taxes as a limited company in the past, I haven’t missed out on massive amounts by staying as a sole trader. Given recent tax changes, I’m glad I don’t have to wrestle with the time, trouble and expense of running a limited company. If you’d like to run your own figures, try searching online for a tax calculator to compare being a sole trader to a limited company, or consult an accountant.
Faith Archer is a Personal Finance Journalist and Money Blogger at Much More With Less. Check out Faith and Lynn’s videos about spending during lockdown and after lockdown.
Risk warning: As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.
