When you decide to go freelance, one of your first tasks is to make it official, by registering with the Government as either a sole trader, or limited company. Both options give you the legal structure to operate and manage your finances as an independent professional. However, the route you choose does impact your responsibilities, workload, and how you pay tax.

For the uninitiated, this can all sound a bit daunting, so it’s vital to do your research before deciding which structure best fits your circumstances. To help you get started, here’s a rundown of the differences between the two, and the main pros and cons of each.

What’s the difference between a sole trader and a limited company?

If you’re a sole trader then you’re registered to work as yourself, in your own name, and as the sole owner of your company. It is the simplest structure of the two, with no shares or shareholders. As a result, you have personal liability for any debt you might find yourself in, as there is effectively no legal difference between you and your company.

On the other hand, if you decide to go the limited company route, it means setting up, or ‘incorporating’, a company through which to work. This company is a separate legal entity, made up of shares and with its own name. You will become a shareholder, director, and employee of your company, while being paid a salary and dividends from the business finances. As the name suggests, a limited company director has limited liability, meaning if the business gets into debt, you won’t be held personally responsible - more on which later.

Advantages of a limited company

Here are some of the main reasons why freelancers choose to work through a limited company:

More tax efficient

Probably the biggest benefit is the ability to become more tax efficient. Limited companies pay corporation tax, which has a lower rate than income tax, plus as a director you will take dividends - subject to lower rates than traditional earnings – and you don’t pay National Insurance. These differences can add up to significant savings over time.

Your personal assets aren’t at risk

Working through a limited company means that if your business becomes insolvent and can’t pay its debts, you only stand to lose what you put into the company. So, if the company runs into financial difficulties at any point, you have the peace of mind that you wouldn’t lose your house or your car as a result.

Easier to secure funding and investment

If you anticipate expanding your business in the future, then a limited company structure makes it more likely that you can secure externa funding, whether through a bank loan, or by selling a portion of your shares to an investor.

Disadvantages of a limited company

Having said all that, starting a limited company does also have its downsides:

More paperwork

Probably the biggest disadvantage is the admin involved, which includes filing business accounts, a Company Tax Return, and a confirmation statement on an annual basis. Plus, if you are VAT registered, this also involves quarterly reports (VAT is a legal requirement for limited companies with a revenue of over £85,000).

And it doesn’t end there. As an employee of your company, you will need to set up monthly payroll, and you will also have to file an annual self-assessment return for your earnings as an employee and director. If you manage it all yourself, it can add up to a big chunk of additional work. Or if you hire an accountant, that means extra costs for you and your business.

Less privacy

As a limited company your business accounts are publicly available on the Companies House register, so anybody can see what you’re earning from a quick Google search. So, if you like your privacy, that could be a big drawback.

Legal responsibilities

It’s also worth bearing in mind that you have certain legal duties as a company director, that you wouldn’t as a sole trader. These include acting in the best interests of the company and avoiding conflicts of interest, and directors can face serious penalties if they abuse their powers or act irresponsibly.

Advantages of operating as a sole trader

So, what are the main reasons for becoming a sole trader?

Less paperwork and admin

Unlike managing a limited company, setting up and operating as a sole trader is simple. You can register in a few minutes at Gov.uk, and there is no fee for incorporation, as there is with a limited company. The ongoing admin burden is also much lower, with just your annual self-assessment to worry about. As a result, many sole traders manage the paperwork themselves, without paying for an accountant to help them.

Disadvantages of operating as a sole trader

On the flipside:

Personal liability

If you do find yourself insolvent and struggling to settle debts, as a sole trader you will personally be liable for those. That means that you could lose personal assets, such as your house or car, if you don’t have the money to pay.  

Not as tax efficient

Sole traders pay tax in much the same way as an employee, so you’re tied to the same income tax bands and National Insurance contributions. As a result, you’re likely to be paying more tax than if you were working through a limited company, particularly if your earnings fall into higher tax bands.

Harder to raise finance

If you ever want to expand, as a sole trader securing external finance is likely to be a challenge. Banks and investors tend to see limited companies as a safer bet.  

Umbrella Companies

A final option to consider, umbrella companies make life easy by effectively acting as your employer for the purpose of taking on freelance contracts. They are responsible for invoicing your clients, paying your tax and national insurance, and managing your contracts, while paying you a salary at the end of the month.

Generally, this route makes sense if you are new to freelancing and want to get set up quickly, or if you want to take on freelance or contract placements between permanent roles. It can also be a good solution if you want to try out self-employment before committing to it for the long-term.

By taking away the entire admin burden, umbrella companies give you the peace of mind that everything is taken care of, while leaving you free to focus on your work. But bear in mind that you will pay the company either a fixed fee or percentage of your earnings, and you won’t get any of the tax benefits that come with being a limited company or sole trader.

Weigh up what’s important to you

Every freelancer has their own priorities and goals, so what works for you might be different to the next freelancer. Hate admin? Then the sole trader or umbrella company route might suit you better. Or want to maximise your earnings? Then you’re probably better off setting up a limited company. But whichever way you’re leaning, a qualified accountant can give you invaluable advice and help you understand the financial implications based on your own personal situation.