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How to change from a sole trader into a limited company

June 7, 2021

The decision to make the switch from working as a sole trader to a limited company can be a tricky one. There are lots of things to consider, from the change in legal status to getting your head around different tax responsibilities.

Most businesses start out as a sole trader run by individuals or freelancers before switching to a limited company once their profits start to increase. There are certainly benefits in changing from a sole trader to a limited company, but it can be hard to know where and when to begin.

If you're starting to make a healthy profit from your enterprise and want to create a more formal structure around your small business, then setting up a limited company may be right for you.

In this article we'll run you through the key differences between operating as a sole trader and a limited company. We'll also take you through a simple step-by-step guide to setting up your first limited company, from choosing a name to registering your new business.

By the way, you can incorporate into a limited company with Ember, free of charge. Just click here to find out how.

Why should I change from sole trader to limited company?

There are plenty of benefits in converting from a sole trader into a limited company. For starters, you could pay less tax and can claim tax relief on some business expenses. There's also the peace of mind that comes from the legal separation between you and your business, since turning your business into a limited company makes it a separate legal entity.

You also have flexibility in how you pay yourself, whether via a salary, bonuses, dividends or a mixture of all these. If you're looking to attract investors, then this will be easier as a limited company since you'll have shares to sell.

If you're happily operating as a sole trader, you may feel that setting up your own limited company is a drag on your time and resources that you just don't need. There are a few administration and accountancy hoops you'll need to jump through, and you'll need to weigh up the pros and cons of starting a limited company carefully – however, the rewards are a powerful incentive if you decide that this is the right path for you.

There's no one right answer. What works for one entrepreneur might not work for you, but by having a thorough understanding of the key differences, benefits and drawbacks, you can make an informed decision when settling on the business structure for you.

Sole trader vs Limited company: what’s the difference? 

Most businesses start life as sole traders and plenty of limited companies operate as a one-man band, so you may be struggling to see the difference between the two legal structures.

What is a sole trader?

A sole trader is a business run by an individual who is registered as self-employed. If you've earned more than £1,000 from your business in the previous tax year then you will need to register your sole trader business, even if it's just a side-hustle alongside your day job.

Examples of sole traders include electricians, plumbers, freelance copywriters, or people who work in the gig economy like taxi drivers.

One of the big risks for sole traders is that your business is inextricably linked to you. There's no legal barrier between you and your enterprise, which means that you're personally responsible for any losses the business might incur, and any debts owed. This can mean that if your business goes bust, as the sole director your personal finances and personal assets are at risk.

While this is a concern for some people, others see the reduced regulation as an advantage. There are no company reporting obligations or corporation taxes to pay – you just have to register with HMRC and submit a yearly tax return. You'll also need to pay Class 2 and Class 4 National Insurance depending on your profits.

As a sole trader you get to keep all the profits you make, which is another reason many choose to stick with this structure. After all, why would you want to share the profits of your hard work? However, once your earnings go up you will find yourself pushed into a higher tax band, which is when many sole traders start to think about forming their own limited company.

Running your own company as a sole trader gives you greater control and privacy. You have complete say over how the business is run, with no input from anyone else if that's what you want. Your financial information stays out of the public eye, since it isn't published by Companies House. 

This level of personal control and reduced red-tape is very appealing to some people, and you'll need to decide if the trade-offs when forming a limited company are worth it before taking the leap.

What is a limited company?

A limited company is a company that has been incorporated, or registered at Companies House.

A limited company offers greater security to you as a business owner, because it is its own legal entity. This means that you, as the business owner, have limited liability and aren't liable for the company's debts. Your personal assets are protected, so there's no need to worry about losing your house if things go south for your startup. Obviously we all hope that our businesses will survive and thrive, but it's good to be prepared for the worst!

It's also a relief to know that you won't be held personally responsible for any legal disputes the company might deal with. This is yet another layer of protection for you and a weight off your mind when forming a limited company.

When you switch from a sole trader to a limited company there will be changes to your administration. This new paperwork can feel like a lot to wrap your head around, but doesn't have to be a barrier.

To start, you will need to submit a tax return for the company each year. The company will also need to complete a Confirmation Statement each year and notify Companies House of certain developments, such as the appointment of new directors.

You'll also need to pay Corporation Tax, which is currently set at 19%.

If all this extra administration is putting you off, then don't worry. There are other benefits that will decrease your stress levels and help you to keep more money in your pocket.

Firstly, in a limited company you are employed as a company director, and can pay yourself a salary. This means that you may be entitled to certain employee benefits, like maternity benefits and pension contributions. It also gives you some protection from global crises like COVID-19, since you may be eligible for furlough and other forms of government support based on your PAYE salary. 

You can also choose to pay yourself a small salary while also taking income from company dividends, subsequently lowering your tax burdens since dividends have a lower rate of income tax.

There are other tax efficiencies you can take advantage of, such as claiming tax relief on food and drink costs for employees. You'll also find it easier to borrow money as a limited company, and you may even find that customers prefer to deal with limited companies over a sole trader.

In short, there is work to do if you want to form your own limited company. For many it is an important step in the right direction, but it's up to you to make that call.

When should I form a limited company?

If your profits are starting to grow, then it's time to think about changing from sole trader to limited company. You can pay yourself more creatively and stay in lower tax bands by drawing an income from a salary and dividends.

If you're worried about liability, then you should consider forming a limited company as this creates a legal barrier between you and the business.

If you want to attract certain clients, like those in the financial sector, then you may find that they actually need you to be a limited company before they'll do business with you.

If your earnings are still low then you can stay as a sole trader for a bit longer, and take advantage of the lower administration requirements.

If you've hit that "aha!" moment, and have decided that by operating under a limited company you'll have both peace of mind and more money in the bank, then it's the right time.

How to form a limited company: A step-by-step guide

If you've made the decision to form your own limited company, congratulations! 

Here at Ember, we can incorporate your limited company for you for free. If you want to do it yourself, we've also written a helpful guide for small business owners to help demystify the process for you.

What are the costs?

It costs £12 to register your company with Companies House, but by registering with Ember we'll cover the costs of incorporation for you! After filling in the form IN01 and paying the fee, by debit card, credit card or PayPal, your company will be registered in 24 hours.

If you want to register by post, then it gets a little more expensive. It costs £40 for an 8-10 day turnaround or £100 for a same-day service.

De-register as self-employed

If you've made the decision to no longer be a sole trader, you'll need to de-register as self-employed and send a final tax return. Here's a link to the form to tell HMRC about the changes you're making.

Choose a company name

This is the fun part of the company formation phase. What business name will you pick that gives a great impression and lingers on your clients' minds?

Before you get carried away, there are a few rules you need to abide by:

  • You can't pick anything offensive. Anything with swear words will be rejected by Companies House.
  • If it comes across as inappropriate (i.e. sexual connotations), it'll probably get rejected.
  • Certain words will need approval if you want to use them, like "Accredited" or "Regulator" or "Windsor" or "King".
  • It's wise to stay away from names with a religious affiliation, although a few have been approved in the past.
  • It can't be too similar to an existing company name.

You can see a list of names and words that need approval or are considered sensitive on the UK Government website.

Once you've selected your shiny new company name, make sure you get the domain name before anyone else can swoop in and steal it.

Appoint a company director

Now you need to appoint the captain of your ship: the company director.

A company director has to follow the rules of the company, as well as promote its success. They also have to act in the benefit of the company shareholders and employees. 

Company directors are responsible for paying Corporation Tax and keeping company records. They also have to file the company tax return and any accounts.

Once you've decided on who the director should be, you need to submit form AP01 to Companies House, with the following information:

  • Their full name (and any old names)
  • Date of birth
  • The date of their appointment as a director
  • Nationality
  • Business profession
  • Country of residence
  • Home address
  • Service address

You can also appoint a company secretary at this stage, but this is not mandatory.

Appoint shareholders or guarantors

Your limited company has to have at least one shareholder or guarantor. You can start with one shareholder (you) and then add more as you go. Shareholders can be individuals, groups, partnerships and even other companies.

There's no maximum number of shareholders, but before you start sending out invites remember that they will have certain rights and control over the company. For example, you will need to win shareholders votes if you want to make any changes to the company.

Identify people with significant control

You need to identify who is a person with significant control (PSC) in your company and tell Companies House. These are people who have:

  • more than 25% of shares in the company
  • more than 25% of voting rights in the company
  • the right to appoint or remove the majority of the board of directors

(Source: Gov.uk)

Prepare documents that say how you will run your company

If you're going to form a limited company, you can't just wing it. You will need rules to protect you, company shareholders and any staff. You need to prepare two specific documents that will say how your company will be run. These are:

  • A memorandum of association. This is a legal statement signed by the shareholders. It states that you all agree to form a company (even if there's only one of you). If you register your company online, then a memorandum of association is created automatically, so that's one thing off your to-do list.
  • The articles of association. This contains the rules about running the company that all shareholders, directors and company secretaries agree on.

There are templates and model articles that you can use on the UK government website to guide you when creating these documents.

Get your company records in check

There are specific company and accounting records you have to keep, such as the details of business assets, share transactions, or any loans taken out to name just a few.

If you're worried about the state of your accounting records, Ember provides an accounting solution with a human touch, allowing you to keep all your records neat, tidy and secure, whilst also giving you access to personal advice from real chartered accountants.

Register your company

You're now ready to register with Companies House. You'll need to let them know your company's registered address and the SIC (Standard Industrial Classification) code. This code gives Companies House a description of what your company does.

You can see the list of SIC codes here.

That's it, you're done! Once you get your Certificate of Incorporation, keep it in a safe place. Now you can get on with the important task of making your business venture the great success you know it can be.

Summary

Setting up a limited company can feel like a scary administrative burden, but it doesn't have to be. By arming yourself with information, following our step-by-step guide and getting professional advice from services like Ember, making the jump from sole trader to a limited company can be the best move you ever made.

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A full stack software engineer and designer by trade, Aaron has built a range of compelling web and mobile solutions for both small startups and large corporations across the globe, including the likes of Google, Red Bull and Unilever.