Sole trader vs limited company: how do the tax savings stack up?

Faith Archer

by , Personal Finance Journalist and Blogger

at Much More With Less

30 June 2022 /  

June 2022

Man wearing suit in front of golden scales.

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.

Changes to National Insurance thresholds from July mean people can earn more before starting to pay National Insurance contributions (NICs), whether they are self-employed or employed by a limited company.

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 (2022/23), you won’t pay a penny in income tax. While profits are still low, you won’t have to fork out for NICs either.

Changes to National Insurance thresholds from July mean the self-employed don’t have to pay Class 2 or Class 4 NICs until they earn more than £11,908 during the tax year (2022/23). That £11,908 figure isn’t plucked out of the air. It’s equivalent to 13 weeks since the start of the tax year at the threshold of £9,880, before it increases to £12,570 for the remaining 39 weeks. From April 2024 things will become a bit simpler, with both income tax and employee NICs due to kick in above £12,570 a year.

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. Please note, if you live in Scotland these rates differ.

Profits Self-Employed NICs Income Tax
Over £11,908* 10.25% (Class 4) £3.15 (Class 2)
for every week you’re self-employed
£12,571 to £50,270 10.25% (Class 4) plus £3.15 (Class 2)
for every week you’re self-employed
£50,271 to £150,000 3.25% (Class 4) 40%
Over £150,000+ 3.25% (Class 4) 45%

*This figure changes to £12,570 on 6 July 2022. £11,908 is the annualised figure

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 £40,000 a year, 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-rate taxpayer, can you 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% corporation tax paid by limited companies doesn’t look so bad. So when does it make sense to make the leap?

Some people prefer to do it straight away for extra protection. As a sole trader, you and your business are lumped together. Legally, you are 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 have 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 2022/23), 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 (2022/23), means you avoid the effort and expense of any NICs at all.

Sole director and employee: £11,908 a year

One man band? It’s usually most tax-efficient to push your salary up to the ‘primary threshold’, which is equivalent to £11,908 in the current tax year. You’ll save more in 19% corporation tax than your business pays in 15.05% employer NICs, and you won’t have to fork out for employee NICs.

Only you can judge if the £190 odd overall saving is worth the National Insurance admin.

Two or more employees: £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, the Employment Allowance covers the employer’s NICs and you only have to fork out about £88 in employee NICs. It also saves your business a more chunky £660 in corporation tax, compared to taking a £9,100 salary.

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.

The first £2,000 a year in dividends is tax-free, and can be added on top of your normal personal allowance. This means you could potentially earn up to £14,570 a year (2022/23) without paying any income tax or dividend tax. Above £2,000 in dividends, you’ll pay dividend tax depending on your income tax band.

Dividend Tax Rates 2022/23

Taxpayer Rate
Basic Rate Taxpayer 8.75%
Higher Rate Taxpayer 33.75%
Additional Rate Taxpayer 39.25%

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 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.

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 £40,000 annual allowance can benefit from tax relief (2022/23), 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.

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?

Crunching the numbers, you should start saving tax as a limited company rather than sole trader once your profits tip over £17,200 in the current tax year. This assumes that you’re the only director and employee of the company, and pay yourself a £9,100 salary to avoid tangling with National Insurance, with the balance as dividends. However, it also ignores extra costs associated with a limited company, such as accountancy and payroll fees, let alone the extra time and paperwork involved.

In practice, you might be better off considering the leap to a limited company as your profits reach £30,000 a year (saving over £500 in tax) to £40,000 (saving nearly £950 in tax). The tax benefits really accelerate once profits pass the point where sole traders start paying higher rate income tax, set at £50,270 until April 2026.

However, that difference will shrink slightly next year, if the government ploughs ahead with plans to increase corporation tax for companies that make more than £50,000 profits a year. Currently corporation tax at 19% applies to all companies regardless of size, but the government has threatened to push rates for larger companies as far as 25% from April 2023.

Personally, the big relief for me is that although I definitely could have reduced my taxes as a limited company, I haven’t missed out on massive amounts by staying as a sole trader. 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.

Faith Archer is a Personal Finance Journalist and Money Blogger at Much More With Less.

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.

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