Tax and Your Self-Employed Business: Sole Trader or Limited Company?

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You are listening to the I Hate Numbers Podcast with Mahmood Reza. The I Hate Numbers podcast mission is to help your business survive and thrive by you better understanding and connecting with your numbers. Number love and care is what it's about. Tune in every week. Now, here's your host, Mahmood Reza.

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Do you know the difference between the tax-man and a taxidermist? Well, the taxidermist leaves some skin, and certainly that's what it can feel like. My name is Mahmood. I am the host of your weekly podcast I Hate Numbers. I Hate Numbers is not about dissing or hating your numbers. Rather, it's my passion and ambition to share my love of numbers with you, business owners out there, so you can make money,

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you can survive and thrive, get a bit closer. Your numbers aren't going to lie to you. They're going to be there when you need them. They're going to be there in the background. They're going to be there to give you the lifestyle that you want and the business that you deserve. So, what are we talking about today? Well, today's topic is building up on last week's podcast, and in last week's podcast I talked about the different types of business structure that you can have.

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We’ve talked about self-employed and self-employed, remember, is where you are your own boss. You give yourself your own instructions. You admonish yourself. You reward yourself. You are the boss, you are the owner. And we've talked about whether you want to become a sole trader. We’ve talked about whether you want to become a company,

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a partnership, a joint-venture, community-interest company. We went over a few of the options and how to deal with them. I recommend you guys after this podcast replay last week's podcast. Get up to speed. What we're going to talk about today though is the world of taxation. How does tax affect your decision

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whether you become effectively a company or you run as a sole trader? For our purposes, a sole trader and a partnership are largely one of the same thing. The tax treatment and partnerships is pretty much the same as it would be for a sole trader, but more of that later on in the podcast. Let's make some assumptions like all tax people here, and in the world of numbers that I inhabit, which I love, one of the things that I deal with with businesses over the years is how tax affects them.

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We all work hard. We all make profits in our business. Well, certainly that should be one of our key objectives. We want to know what slice is our friendly neighborhood tax man or woman going to do with that cake of profit that we've made? How much are they going to take out of it? How much is left for us?

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So, here's the assumptions. When we are looking at this here, we're looking at the individual who maybe owns the company, and we look at the individual who might be a sole trader. So, we're looking at the collective pot, not just the tax on one area of the activity. And what does that mean? Well, let's have a go through. Now, a couple of terms, but just to emphasise, when we talk about a sole trader, we're talking about a business that is effectively the same as the individual who's running that.

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There's no legal formality, there's no creation. In real terms, the owner and the individual running the business are one of the same. When we're talking about a company, we've created something in law, something in legal terms that has its own separate personality. I just remember it's humorous, but it has its own separate identity.

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Fundamentally within this as well, when you run your own business, it's absolutely critical that you factor in of how you pay yourself, how you reward yourself. Now, you may decide to pay yourself a very modest amount of money to begin with as a business establishes itself. You may pay yourself quite a large, significant sum of money.

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So, when we factor all of this together, we're talking about the individual and the money that you are taking out, and we're talking about the company when we talk about corporate structures. Now, a few terms. Some of you may have come across this word called dividends. Sounds very weird, doesn't it? But effectively that word dividend applies

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when you have your own company. So, if you create a company, more specifically, if that company is what's called a private company, so you have what's called shares in that company, you are the shareholder of that company and you are also the director of that company. Obviously, if you've got partners, whether your partner i.e. sort of family member or somebody who's a friend or somebody completely disconnected, has shares also in that company,

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then it's a similar type of treatment. So, let's just come into another term. Now, when we hear the word wages and salary. If I'm going to be really officious here, which I'm going to be for the rest of this broadcast, we're talking about tax. It's a serious, but it's not a serious topic. So, when we talk about salary and wages, we're talking about the situation where a company, because it can only apply to companies, effectively has got a registered scheme

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with the government, a payroll scheme, it might be called, you may hear that word PAYE scheme, and effectively, you are rewarding yourself by being on the books of your company. Salary and wages may be a term that we use for sole traders, but in tax treatment, it doesn't exist. So, if you have a sole-trader business and you take money out that business for your own personal use, whatever that use may be,

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in legal terms and tax terms, they're not called wages. It's a strange word this here. It's been around for centuries. The word is called drawings. So, fundamentally, sole traders, when they reward themselves, you cannot have wages in terms of the tax treatment of that. When you have a company, you've got to have a what's called a registered scheme.

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So, our friends HMRC have got to be aware that you've got a scheme registered and you pay yourself a wage. Number three, we're going to mention three taxes now which are going to affect the calculations. Now, what I don't want to do is to overwhelm and make you lose the will to live. So, we're not going to discuss big, detailed numbers, but when you have a look at the podcast, have a listen.

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There'll be some show notes there, and I'll put those details with the show notes there. So, what we've got, first of all, is some idea of tax. Now, let me think about the individual. So, whether you are a company or an individual, when you have income that is for you as an individual, then you pay something called income tax on that individual.

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There's a bit of a clue in the title here. So, an individual who receives income in their own personal, right, their own personal capacity, they pay tax on that, and it's called income tax. The next thing we look at is where does that income come from? Now, let's imagine something really original, Mr. A. Let's imagine Mr.

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A has his own company. Now, Mr. A draws out a salary from that company and that's been regulated under what's called a payroll scheme, PAYE, and Mr. A, when he does his personal tax return, will record the salary from the company. Mr. A may have had a really good year and then says to himself, during the course of the year, I'm actually going to take dividends out that company.

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So, you imagine all those big-type, Google-type companies, iPhone, Apple companies, same idea, same principle. When you reward yourself, you reward yourself either with a salary and/or you pay yourself dividends. So, on that personal tax return, those two numbers will appear and that's it in an individual capacity.

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Now, Mr. A's company will be paying tax on the profits that business makes, and those profits will be subject to something called corporation tax. So, any profits the business makes when it's run as a company, that entity, that creation that we've made, and let's be really original, we call it Mr. A Limited, will be paying corporation tax on those profits.

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So, let's recap what we've got so far. The company will pay corporation tax on its business profits and Mr. A, who happens to be the individual that owns that company and the company director, will pay also income tax on the salary that's taken out that company and also pay tax on the dividends itself.

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So, that's the whole pot for Mr. A. We'll come back. I know you are waiting eagerly for some numbers. We'll come back to that in a moment. Now, this is you. Mr. A decided that he didn't actually want to set up a company to run his business. He actually, for his self-employed work, preferred to stay as a sole trader.

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And that's not necessarily a bad decision. It could be a perfectly good decision. So, Mr. A, any profits that he makes in that business will be subject to two slices. It'll be subject to income tax on the profits that he makes, anything he pays himself by, and here's the twist. It’s not seen in the eyes of the tax authorities as an expense of the business, and therefore anything that he pays himself is completely irrelevant for working out Mr.

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A's tax bill. So, whether he took something out of the business for himself, whether he took all of the profits out of the business, it makes no consequence, has no impact whatsoever on the tax that Mr. A will likely to pay. Now, here's the differential that distinguishes really which vehicle is largely going to be more advantageous, and the answer might surprise you when we come to play around with some numbers.

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Now, Mr. A, who's got a business that's a sole trader, Mr. A has made profits on that business. Mr. A will pay national insurance, business national insurance on those profits. So, now we've got three things to consider for Mr. A. Number one, national insurance will be paid on the business profits. Number two, Mr.

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A will pay income tax on those business profits. And thirdly, for Mr. A, the money that he takes out for himself, his own personal living, if you want, his own reward, is completely irrelevant for the taxation of Mr. A's business. Fast forward or, should we say, transfer back to a limited company, and we've got a slightly different perspective.

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The company that's made the same level of profits will pay corporation tax on those profits. Any dividends that Mr. A takes out, the company doesn't pay effectively any additional tax on that. They are ignored as business expenses, by the way. So, they're not seen as business costs, only the wages are, but they're still going to need

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national insurance, by the way, and national insurance will potentially be levied on the salary of Mr. A. Are you still with me? Hopefully, you are. Let's now overlay some numbers and recap. So, we're talking about company and we're talking about sole trader. Let's deal with the company first of all. Now, I'm going to throw two numbers at you.

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Let's assume, and this is where really, relatively speaking, there's not going to be a great deal of wiggle room between the two there as well. So, Mr. A's business generates a profit of about, let's say, 40 grand. The typical thing that most tax planners will do is to say, okay, Mr. A, let's pay you on paper, and in real terms, a small salary. Typically, I am not to pay national insurance

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and, therefore, what will happen is that'll trickle down with the employer, which happens to be Mr. A's company. We'll put that salary through the payroll. There'll be a tiny bit of national insurance paid over the course of year, which is always a good thing. Keep your national insurance record up. That 10 grand salary counts as a business cost, and let's assume Mr.

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A decides that anything left over after paying bills, he'll take out as dividends from the company over the year. Same scenario, same level of business profits whatsoever, completely, no different at all. I've assumed in this worked illustration about 40k when it drills down Mr. A as the individual is entitled to some money free of tax.

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Also, some of the national insurance is free of tax, but he will be paying tax and national insurance on his business profits and, therefore, he gets left over with that slice. Now, if we do a seesaw evaluation, pretty much up to about 40, 45 grand, there's about a 4% difference to his advantage as a company for the total tax that's taken in.

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So, yes, there is a difference, but this is without even considering the additional costs of running a company and all the other factors that we discussed in last week's podcast. So, the odds are slightly in favor of a limited company, but there's not a great deal in it. About 4%, probably about a grand.

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Where it does shoot to be a much better way for the company is when the profits go into making Mr. A what's called a higher-rate taxpayer. So, here's the numbers. Let's assume Mr. A has had a brilliant year. He's worked hard, he's put sweat into his company, he's getting the equity back and all that's paying off because he's listened to these podcasts and learning how to use his numbers to power his business through.

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Now, his business makes a much higher figure, about 70 grand. Now, as a sole trader, Mr. A would be classified as what's called a higher-rate taxpayer. What that means is government will step forward and they take a bigger slice of the profit as tax. He becomes what's called a higher-rate taxpayer. That trickles down,

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you pay more income tax, you pay more national insurance, and he's left with something that's all left to him. And remember, it doesn't make any difference whether Mr. A is being frugal and leaving that money in the business. If he earns it, he pays tax on it. Now, the same scenario for a company, typically a much high level of profit, 70 grand. Mr.

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A pays himself a modest salary. In my show notes, my modest salary is about 10k. That gives you enough to pay some national insurance, which is always a good thing. Effectively, we'll trickle it down. He takes a big chunk of those whatever's left over as dividends, and what it works out is that Mr. A is potentially about 10% better off, and that's about five grand extra he gets to keep.

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So, what did we conclude? Well, if it's such that you are on the trajectory to making good profits such that you take some of those profits and use them as you should be doing, then the company is more in your favor. If it's such that you've got, let's say, a secondary income, you don't actually need to take any money out the company.

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And again, I would certainly say short term, that's a definite thumbs up. Long term is not a good business model. But, let's say, we've decided to keep that money in the company. Well, the key thing is if the money doesn't come out the company to your own personal account, there's no dividends coming out.

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Therefore, there's no extra tax on that, and it will be in your favor to go to the company route. Now, that hopefully gives you a flavor, and if I had two takeaways from here. Number one, look at your profitability. If the profitability is such and is accelerating, if it's likely that you are going to be taking a significant sum out of the company

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for your own personal use, then a company structure tends to favor you. Number two, there's lots that we haven't discussed in this particular episode. Better, much more flexible, more powerful ways to remunerate yourself as a company better than it is a sole trader. If there's no big-deal reason from your clients, from your industry, why you should be either,

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here's a nice little tip to take away. One of the things that tend to be forgotten when we consider limited companies against sole traders is if we're in the unfortunate position or might, it's quite typical for a startup, that you are making losses i.e. you don't make business profits, but you actually make business losses, which is quite normal, especially for a startup.

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You've got high cost to get going. You haven't got a lot of customers. You may be making losses. Losses are much more flexible and more-tax advantageous if you remain as a sole trader. Take this away, ladies and gentlemen. You can change at any point. So, you could start life as a sole trader and then you could convert to a company.

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You can do it the other way around as well, by the way. It tends to be less common, but it can still be done. Hope you enjoyed the show. I've loved talking to you guys out there. So, this is Mahmood signing off on another week of I Hate Numbers. Have a look at the show notes. If you want to grab yourself a coffee, a stiff drink.

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Have a look at the numbers. It'll give you a better idea of what's going on. But remember, in all these things, don't rush into these things. Take the time, plan, and get some decent advice before you embark on the route that you're going down. Ciao. We hope you enjoyed this episode and appreciate you taking the time to listen to the show.

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