14 Jul 2021
Want to go it alone? You’re not the only one. The number of self-employed people in the UK has risen steadily since records began in 1959, and now stands at 4.1 million.
One of the main ways people work for themselves is through sole trader status, and this is a good route for those keen to set up as quickly and easily as possible. Working as a sole trader has many great benefits, but some risks too.
In the UK, a sole trader is defined as a self-employed person who is the sole owner of their business and runs it as an individual. The main alternatives are to have a limited company or a partnership.
When you start working for yourself outside a limited company or partnership, you are automatically categorised as a sole trader, even if you have not yet told HMRC.
It means you are not an employee of a company and you make your own tax and national insurance contributions (NICs).
As a sole trader, you must meet certain rules on running and naming your business.
You can trade under your own name, or choose another name. You need not register your name, but you must include it on official paperwork, for example invoices and letters.
Sole trader names must not include ‘limited’, ‘Ltd’, ‘limited liability partnership’, ‘LLP’, ‘public limited company’ or ‘plc’ - these are all alternative business structures. Your name must also not be offensive or the same as an existing trademark.
Your name also cannot contain a sensitive word or phrase, or suggest a connection with a government or local authority, unless you get permission. Register your name as a trademark if you want to stop other people from trading under your business name.
After establishing your name, it a good idea to open a business bank account. While it is acceptable for sole traders to use a personal account, a business account helps you keep your finances separate, take business payments, and apply for corporate loans.
Having a business account also makes bookkeeping much simpler and allows others, such as prospective acquirers or HMRC, to view your finances more easily. Plus it makes your business look more professional with clients and suppliers when sending invoices and payments.
Another important consideration for sole traders is insurance such as professional indemnity insurance. Whatever your line of work, you will probably need insurance, for example to cover public and employee liabilities, and or professional indemnity. If you’re concerned about illness or a dip in income for any other reason, you could also consider income protection and critical illness cover.
There is no legal definition of sole trader. But you must check you are self-employed rather than employed under IR35 rules, which aim to stop businesses engaging ‘disguised employees’ on a self-employed basis to reduce their tax bill.
One of the main tests to prove you are self-employed is if you can show you are not controlled by one client as to when, where and how you work. Working for at least two clients a month and having some choice over when and where helps.
If your employment status is not clear, it could ultimately be determined by an employment tribunal or by HMRC.
You need to become a sole trader if:
The way to register as a sole trader is to tell HMRC that you pay tax through self-assessment, and file a tax return every year.
Sole traders can keep all their business profits after tax. Make sure you record all your business sales and costs so you can calculate profits in your self-assessment.
You pay income tax on your profits, plus Class 2 NICs if your profits are £6,515 or more a year, and Class 4 if your profits are £9,569 or more. Class 2 NICs are £3.05 a week, and Class 4 contributions are 9% on profits between £9,569 and £50,270 and 2% on profits over £50,270.
Use HMRC’s calculator to work these out.
If your turnover is above £85,000, you must register for VAT and charge it on your goods and services. If your turnover is below that, you can still register if it suits you, for example, if you sell to other registered firms and want to reclaim the VAT.
If you register, you must choose whether to use the VAT cash accounting scheme or flat rate scheme, both of which have pros and cons. It’s a complicated choice, so you may want to speak to your accountant.
Sole trader is one of the easiest business structures to use, with much simpler tax affairs and administration compared to other types of business. Start-up costs are low and, unlike limited companies, you do not have to pay a Companies House registration fee.
You can change your business structure easily, for example, if you want to expand and become a limited company later.
Limited companies must publish information about their directors, shareholders and finances every year. Sole traders don’t – your information remains private. However, that can be a disadvantage if your clients require such transparency.
59% of Federation of Small Businesses members are sole traders – up from 45% in 2018. The rest are mostly limited companies and partnerships. Partnerships can be more specialist, so the choice for many small businesses is between sole trader and limited company.
One disadvantage of sole trader status is that you have no separate legal status and therefore you have unlimited liability for anything that goes wrong. For example, if your business cannot meet its debts, your personal capital, including your home, is at risk.
Another challenge is that sole traders can find it harder to secure funding and expand the business compared with larger companies. Sole traders are also reliant on one person and can struggle to compete against larger companies with economies of scale and different people in specialist roles.
But sole traders can be more nimble - and your clients always deal with the boss.
One benefit of limited companies is that their owners often take much of their earnings as dividends. The dividends tax regime is slightly more favourable, so they may pay less tax than sole traders.
However, as mentioned, a sole trader’s tax and administrative affairs are much simpler compared to a limited company – typically the only decisions sole traders must make on tax relate to VAT.
But you might want to become limited as your business gets larger, exposed to more debt and employs more people, or if you want a more formal structure, with say a managing, financial and marketing director.