When starting a business, you have to decide what legal standpoint you must set it up as—whether a sole trader or limited company. Between the two, sole trading is the most common choice amongst new businesses in the UK as it takes on an easier process, such as less paperwork, no registration with the Companies House, and immediate start of business operation.
This article will guide you on which of the two works best for you, focusing on sole traders. We discuss the responsibilities you have as a sole trader, including the process of setting up as one, completing self-assessment tax returns, and the kinds of taxes you are liable to.
To Set Up as Sole Trader or Limited Company?
Both sole traders and limited company directors are classified as self-employed. Their main differences lie in their legal standpoint, processes, and kinds of taxes to pay. When you are a sole trader, you are basically one legal entity with your business and are not required to separate your finances.
Since your personal and business finances are usually one and the same, any debts and losses your business makes are solely your responsibility, unlike limited companies that are legally distinct and financially separate from their business, and so, are not responsible for their losses.
If you want to start operating your business right away, then you might want to consider setting up as a sole trader and, just like many other businesses, switch to a limited company when needed. Sole traders pay tax on their business profits, whilst limited companies pay corporation tax on all their taxable profits. The former pays tax through self-assessment whilst the latter through the PAYE system.
Both sole traders and limited companies can claim tax relief for the expenses they made wholly and exclusively for their business. If you choose to be a sole trader, then you can withdraw cash from your business tax-free. However, limited companies pay when they withdraw as their money is automatically considered a dividend.
Tax efficiency makes limited companies more advantageous than sole traders as the latter pays more in taxes, discussed more below.
How to Set Up as a Sole Trader
You will need to set up as a sole trader when any of the following applies to you:
- You have a turnover that exceeds £1,000 through self-employment between 6 April 2021 and 5 April 2022;
- You intend to prove your self-employment status, such that you want to claim tax-free childcare;
- You want to qualify for benefits and so contribute voluntarily to Class 2 National Insurance.
The process is fairly easy. Setting up as a sole trader, you inform HMRC that you are now going to pay your taxes through self-assessment and abide by the business naming protocol. You will then fill out HMRC’s registration form for self-assessment, either through post or online. HMRC will send you an email enclosing your Unique Taxpayer Reference (UTR) and activation code to activate your online account. From then on, you are held responsible every year for submitting your annual self-assessment tax returns.
Recently, HMRC announced that businesses use a new system of filing self-assessment, which is called Making Tax Digital for Income Tax Self-Assessment (MTD for ITSA). Keeping a record of your business and expenses is crucial so that you can accurately fill out your self-assessment and start paying the taxes you owe.
In naming your business, you need to adhere to HMRC’s guidelines. You can trade using your name or a distinct business name. Your name doesn’t have to be registered. As a sole trader, you don’t have to include ‘limited’, ‘Ltd’, ‘limited liability partnership’, ‘LLP’, ‘public limited company’ or ‘plc’ in your business name. Take note that your business name should be anything but offensive.
Moreover, your business logo or name should not be used or registered as a trademark yet by other businesses so that you avoid potential lawsuits. As much as possible, register a trademark for your business name and logo to prevent other businesses from copying yours.
How to Make Self-Assessment Tax Returns
The tax year will run from 6 April to 5 April every year. By the end of each tax year, HMRC will send you a self-assessment notice. Your deadline for submitting a paper tax return will be on 31 October.
If you file your taxes online, you will have a leeway of three months to complete your return, as the deadline is well ahead of paper tax returns—31 January. Whether you use paper or online, you must pay all taxes by 31 January. Be sure to do comprehensive tax planning so you can adhere with the deadlines at all times.
What Taxes Do Sole Trader Pay
Generally, as a sole trader, you pay the following:
- Income Tax
- National Insurance
- Value Added Tax
For income tax, the threshold for the 2022/23 tax year, or the allowance in which you don’t pay your taxes, is set at £12,570. Beyond this taxable income, already deducted by your allowable expenses, you should be paying income tax. The basic rate applies to you if your taxable income is less than £50,270, charged at 20 per cent. You will be charged the higher income tax rate when your annual taxable turnover is between £50,271 and £150,000, charged at 40%. Lastly, if your annual income is more than £150,000, you will pay 45 per cent of it on income tax.
You are also obliged to contribute to Class 2 and Class 4 National Insurance, which you pay according to your turnover. If you earn more than £6,725 for the 2022/23 tax year, you will be paying £3.15 every week. For Class 4 NICs, which are paid during the self-assessment process, you will be taxed at 10.5 per cent if your annual taxable profit is between £9,880 to £12,570. Whilst any profit above this amount will be taxed at 3.25 per cent. If you earn less than £11,908 per year, then you don’t have to pay Class 4 NICs.
On the other hand, registering and paying for value-added tax (VAT) is only required when your turnover is over £85,000. However, you can also voluntarily pay for VAT when your business needs it, such that you have a VAT-registered business customer and want to reclaim your VAT.
Sorting out your taxes as a sole trader can be time-consuming, given the plenty of responsibilities you already have on your plate. For tax assistance, reach our tax experts at Legend Financial anytime.