Sole trader vs limited company or partnership: which company structure is right for you?

If you’re debating whether to set up your business as a sole trader or limited company, then it’s important to understand the impact of each business structure. A business structure is the category your business is classed under. ‘Sole trader’ and ‘limited company’ are two of the most common for solo entrepreneurs starting out.

It officially determines who will be making the business decisions, how much tax you’ll pay (or tax breaks and deductions you’ll receive), how you’ll be allowed to raise funds and who has financial liability for the business — until such time that you outgrow your structure or choose to change to a different one.

If you have no idea where to start, don’t worry. We know you’re probably eager to start trading as soon as possible amidst the recession and the cost of living crisis where every lost moment counts.

There are other types of business structures (including public limited companies, co-operatives, offshore companies and franchises, for example), but in this article, we will be focusing on these four most common business structures, and by the end, you’ll be able to make a confident decision on which to choose to avoid costly and time-consuming mistakes.

Setting up as a Sole Trader vs as a Limited Company

Deciding whether to set up as a sole trader vs as a limited company can be a tricky and confusing decision to make, as it sets your business up on two quite different trajectories – and while you can always change your mind, it’s better to get it right the first time so you don’t have to worry about bothersome admin work later on.

As for partnerships, they can be designed with either a ‘two sole traders’ structure, or a limited company structure simply with two company directors.

Setting up as a limited company is often considered safer than setting up as a sole trader for you, because there is less risk if the business fails, in financial terms. It has more moving parts than setting up as a sole trader, however: including having to choose a business name (which sole traders don’t necessarily have to do), and potentially having to hire a solicitor to ensure that you fill forms out correctly — especially when recording who is the director, company secretary and people of significant control such as guarantors or shareholders are.

Setting up as a sole trader is simpler, quicker and easier to operate, but simply doesn’t hold the same prestige or credibility that a limited company holds in the eyes of the world: particularly when it comes to gaining investors or securing loans from the bank. Since sole traders carry the entire financial burden, it means that if any loans were to be taken out and the business was to fail, you would be solely responsible for paying that money back (whereas with a limited company, you would not have this liability).

To set up as a sole trader, you need to register for Self Assessment and file your personal tax returns every year. Limited companies also have to do this for their directors, but also their company accounts and corporation tax returns as well.

Should I choose to be a sole trader?

It’s a good principle to start out with the simplest structure your business will allow, which is why most business owners start as sole traders. It is the most commonly chosen route and where 99% of all business owners begin.

(For more information, we have the ultimate guide on how to become a sole trader for you here.)

How does it work?

As a sole trader:

• You and the business are considered one entity – that means your business profits are your profits, your business profits are your losses, and any legal issues you may encounter are also connected to you.
• You alone are also responsible for the majority (if not all) of the business operations, including ensuring that you register as a sole trader officially, keep the necessary records, and manage the entire success of the business.

Advantages of being a sole trader

• Ease of setup – thanks to HMRC’s government website, it is relatively easy to get started as a sole trader. You only need to fill in details for yourself, and the system allows for you to get started with your business almost straight away.
• You keep all the profits – Unless you decide to hire part or full-time staff to help you run your daily operations, you will be able to keep all of the profits you make from the success of the business.
• Flexibility – It is far easier to become a sole trader and scale up your structure when it’s necessary, as opposed to starting under any of the other business structures below, then having to dissolve the company structure due to wanting to downsize or simply changing your mind.

Disadvantages of being a sole trader

• Credibility – Most business establishments that you may want to work with in the future such as banks always prefer and favour registered companies than sole traders, because companies carry a larger sense of professionalism and longevity.
• Financial Risk & Responsibility – Sole trading involves the huge stress of having to juggle a hundred things at once. It also leaves you at risk of personal lawsuits or bankruptcy in the businesses’ worst-case scenarios, such as bad customer service or faulty products, for example.
• Legacy – In the unfortunate event of the death of the sole trader, the business also essentially ceases to exist.

What’s the tax situation?

• Class 2 and 4 National Insurance and Income Tax – Sole traders are required to pay on all taxable business profits (minus expenses) at HMRC.

What documentation is required?

• Balance Sheet – A document that records the businesses assets and liabilities.
• Profit & Loss account – A document that records the businesses revenues and expenses.
• Yearly Self-Assessment – A yearly assessment from HMRC that you fill out based on the above documentation for them to calculate your yearly taxes.

What business is a sole trader best for?

• Tradespeople – Plumbers, electricians, or gardeners.
• Freelance workers – Graphic designers, web designers, photographers.
• Independent contractors – Tutors, solicitors, private investigators.

Should I choose to be a limited company?

How does it work?

As a limited company:

• This business structure limits the amount of liability undertaken by the company’s shareholders.
• You are able to sell shares and have shareholders.

Advantages of being a limited company

• Increased protection – Similar to LLP’s, the word “limited” in these business structures actually works in your favour as it means you have increased protection of your personal finances against lawsuits and/or bankruptcy.
• Access to more financial opportunities – As mentioned above companies can sell shares which increases capital and boosts the companies chances of success due to the increase of people invested financially and emotionally.
• Credibility – A company is considered the most respected and credible business structure.

Disadvantages of being a limited company

• Additional Fees – You will be required to pay an incorporation fee to Companies House.
• Director restrictions – You cannot set up a limited company if you are an undischarged bankrupt or a disqualified director.
• Less control – You may have less control if you take on a board of directors who will govern the major decisions that guide the company, which is what corporations are constructed to have.
• Higher transparency – The financial information of a limited company is visible to the public, meaning you will most likely have a greater sense of responsibility and pressure to succeed from both your fellow directors and the general public.

What’s the tax situation?

• You file your accounts with Companies House and your Company Tax Return with HM Revenue and Customs (HMRC).
• You may be able to file them together if you have a private limited company that does not need an auditor.
• To file your companies accounts and tax return together you can use HMRC’s online service or if you choose your own quality accounting software.

What documentation is required?

• Memorandum of association – a legal statement signed by all initial shareholders or guarantors agreeing to form the company. If you register online, it will be created automatically – if not, you will have to include one using HMRC’s specific memorandum template.
• Articles of association – written rules about running the company agreed by the shareholders or guarantors, directors and the company secretary
• Register of People with Significant Control (i.e. the company directors)
• Register of members (shareholders or guarantors)

What business is a limited company best for?

Any business could benefit from being a limited company if you’re willing to take the few extra steps to incorporating one, particularly if you know you want to scale fast, with the ability to sell shares and not have personal liability as the biggest advantages.

Should I choose to be a partnership?

A partnership can be most essentially described as two sole traders working together. They are both still personally responsible for profit, losses and legal issues within the partnership.

Choosing to form a limited partnership instead of a regular one is the way to avoid personal financial responsibility in this business structure in particular, as described in further detail below.

How does it work?

As a business partnership:

• The partnership is formed between two or more individuals.
• The partners invest their money in the business, and each partner benefits from any profits and sustains part of any losses, as well as sharing the costs on expenses you buy for your business, such as stock or equipment.

Advantages of being a partnership

• Shared risk – The financial risks and burdens are split when you are in a partnership, as opposed to being a sole trader.
• Increased borrowing capacity – As a general rule, more capital and financial support will be available for the business from banks and investors with two or more credible partners.
• Collaboration and innovation – The saying “two heads are better than one” is prevalent here, as the likely increased volume of new ideas for your business may help in growth and success, as well as in how fast you can execute new ideas.
• Flexibility – The process to include more partners if you should so wish is relatively easier from this business structure as opposed to previous structures.

Disadvantages of being a partnership

• Interpersonal complications – Like any relationship, there is a likelihood of disagreements in vision and values for example that can lead to serious disruptions in the business and potentially lost profits or deadlocks, especially if you’ve chosen a partner poorly.
• Bureaucratic complications – Similar to being a sole trader, the partnership will have no legal existence distinct from the partners themselves. If one of the partners resigns, dies or goes bankrupt, the partnership must be dissolved. The business can still continue, but it will require work to change the business structure again.

What’s the tax situation?

• The partnership itself isn’t taxed.
• Partners are taxed on their share of the profits for the tax year, and the basis of tax is similar to that of sole traders.

What documentation is required?

• The ‘Nominated Partner’ is responsible for managing the Partnership Income Tax return and keeping the business records (as explained in the previous section).
• For that, a Partnership Income tax return (SA800) form is used to share HMRC how profits have been split between the partners.
• All partners will also have to submit their own Self Assessment tax return, just as if you were a sole trader.

See our guide on how to submit a tax return for more information.

What business is a partnership best for?

• Theatre directors who may want to form a troupe
• Freelancers who may want to come together for specific projects
• Modelling agencies & photographers

Should I choose to be a limited liability partnership?

How does it work?

While a partnership can be seen as two or more sole traders working together and taking on financial responsibility together, a limited liability partnership (LLP) is seen as two or more people forming a separate company.

Advantages of being a limited liability partnership

• Separate business entity – Since a company is a separate business entity, this business structure protects you from potentially devastating events such as bankruptcy and lawsuits. In such circumstances, the company can be dissolved with no liability on your personal finances.
• Easier accounting – With your business and personal life separate, you can see the expenses and profits of your company much easier in your business bank statements or via using some quality accounting software, allowing you to keep track with ease and even make the most of business tax breaks with the security in knowing you have all the proof covered in one easy-to-manage place.
• Increased borrowing capacity – Being an LLP also affords higher borrowing allowances and overdrafts when using a business bank account.

Disadvantages of being a limited liability partnership

• Interpersonal and bureaucratic disadvantages – All the disadvantages of a normal partnership are echoed here with this business structure (including the interpersonal and bureaucratic ones mentioned above).

What’s the tax situation?

• Register with Companies House – Unlike the previous business structures, that deal primarily with HMRC, LLP’s have to be registered and file accounts with Companies House.
• Companies House correspond with HMRC automatically on your LLP’s behalf.
• You will have at least two ‘Designated Members’ at all times – they have more responsibilities (for example, keeping company accounts).

What documentation is required?

• The LLP Agreement – An LLP agreement should be made as part of setting up your LLP, which sets out how the LLP will be run, to ensure that everyone understands their responsibilities. You can do this alone, with other members, or with a solicitor.

What business is a limited liability partnership best for?

• Food, beverage and alcohol producers
• Gym owners & athletic clothing designers
• Dog walking service providers with dog-grooming service providers
• Florists & funeral directors

…to name a few.

Conclusion

In conclusion, there are so many different ways you can set yourself up as a business owner, all with their own different pros and cons, benefits and drawbacks. However, with the right business plan, mindset and drive – any good entrepreneur will be able to smoothly navigate most of the obstacles that come with any of these company structures and overcome them to ultimately start and run a very viable and successful business.

It may all seem daunting to get started with at first, but once it is all done, having a business at the end of it is likely to be entirely worth it.