Should you be a sole trader or a limited company? Top four things to consider

'Should I set up as a sole trader or a limited company?' is a question Paula Tomlinson, ICAEW accountant, Enterprise Nation member and founder of On The Spot Accountants, hears a lot on her travels.

Business owners often wished they'd known a few basic points beforehand so Paula shares the main points she likes to understand from clients before making a recommendation.

Do you need limited liability for commercial reasons?

Your suppliers and potential customers may expect you to be a limited company. Alternatively, are you a particularly risk-averse person?

As a sole trader enjoying credit from suppliers, and indeed HMRC, you are personally responsible for these debts. You should also consider the possibility of losing a legal case if your insurance doesn't adequately cover you. This could mean your personal assets such as your home are at risk.

Consider the industry you operate in and the way you'll be running your business. Many business owners make sure they pay their debts and aren't in a particularly risky industry, and are therefore very comfortable with being a sole trader.

With a limited company, assuming you act with integrity, most trading debts and legal claims stay within the company, so your personal assets are usually protected.

Are you making tax losses?

If you are a sole trader and you are in your first four years of trading, you can offset these losses against other taxable income you made in the previous three tax years or even in the same year.

For example, you might have given up a well paid employment to follow your self employed dream. Or you might have set up a side hustle while you're still employed. Let the tax system help you realise and fund that dream by getting a tax refund. This refund might be worth 40% of your tax loss. For example if you were or still are paying PAYE income tax of 40%, and your new business makes a loss of £10,000 in its first tax year, you can claim a tax refund of £4,000!

It isn't just PAYE income tax that can be refunded. If you rent out property and pay tax on the profits, that tax can also be refunded to help fund your start up.

Tax losses are different to accounting losses. For example, you might have made a trading profit, and invested in some equipment. The equipment's capital allowances might turn your trading profit into a tax loss, so before you dismiss this option, check it out the capital allowances rules.

If you ultimately want to be a limited company, you can start out as a sole trader, and once you are profitable incorporate your business into a limited company.

Do you expect to immediately make taxable profits of about £35,000 or more?

On the other hand, if you're likely to immediately make more than £35,000 of annual profits, as a sole trader you'd be paying £2,370 of Class 4 national insurance. It therefore becomes more worthwhile to consider setting up as a limited company taking a mixture of salary and dividends from your company without paying any national insurance.

The more Class 4 national insurance you expect to pay as a sole trader, the more tax you'll save overall from setting up as a limited company.

Importantly, you also get to control the timing of when you take out money for your personal use and therefore when you pay income tax. This alone can sometimes be enough of a reason to set up as a limited company.

The price is that more discipline is required in running a limited company, because its cash and assets aren't directly yours. You have to know how you're taking money out and why and record your decisions clearly. Also, some of your business' financial details are put into the public domain at companies house. For these reasons, a limited company doesn't suit everyone.

Are you planning to expand?

Expansion is possible through bank funding for a sole trader business, but you'll tend to be taken more seriously and have more options available to you through a limited company.

A limited company can offer shares providing an established route for others to share in its success. For example, you can attract external investors by offering them SEIS or EIS tax incentives. As these tax reliefs are very valuable to investors, it increases the pool of people who may be interested in your company.

You might also want to grant very tax efficient 'EMI' share options to incentivise a particular senior staff member to help your business grow, rather than attract them with high salary and bonuses which aren't affordable.

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