You can be an excited newcomer to the world of freelancing, or a seasoned professional with an established clientele – in either case, you may be wondering how to best arrange your freelance business to suit your needs.
Meet Joe, a young freelancer who has recently started offering his web design services to small businesses, and Chloe, an experienced travel photographer who is thinking of expanding her freelance business. And, of course, you…!
The two most common business structures preferred by freelancers are to act as a sole trader or as a limited company.
So, what’s the best option for you?
Both options have key advantages to consider, and your choice would depend on your current circumstances.
These are the main factors to consider when making a decision:
- Turnover – What is a current turnover of your business and how much profit it makes?
- Future plans – Do you anticipate the business to grow significantly this year?
- Risk – Is the business exposed to a commercial and professional risk?
- Credibility – Do your customers prefer buying from a limited company? Are you planning to obtain funding for your business in the near future? Are you planning to sell your business at some point?
- Time and admin work – Do you have time and resources to manage a limited company and do bookkeeping?
- Tax planning – Are you planning to take advantage of tax planning?
Here is a detailed non-tax comparison of two structures.
Sole Trader: Freedom and Simplicity
- It easy to open and close a sole trader business. There are no set-up costs and very few forms to fill in.
- If you are a sole trader, you need to spend less time on admin work. You need to pay Class 2 and 4 National Insurance (NI) contributions and Personal Income Tax on your taxable profits. You have to submit a Self Assessment Tax Return each year that shows your income, expenditure and profits.
- You are allowed to use a personal bank account for trade.
- You can withdraw cash from your freelance business and no tax is applied.
- As a sole trader, you have less tax planning opportunities and you may pay more tax overall.
- You also have personal liability for your business if something goes wrong. You are personally responsible for business debts and your personal assets can be at risk.
Limited Company: More Admin Work but More Opportunities
- A limited company is a tax efficient way to trade as you can take advantage of tax planning and reduce your overall tax liability. It is arranged through a mix of a director’s salary and dividends.
- Your business can be perceived more favorably by lenders, investors, customers and suppliers. It is a more professional and credible option. Also as a company’s equity can be sold, limited companies can attract investment.
- Your personal risk is removed as a company is liable for its debts.
- You need to pay Corporation Tax on taxable profits. A director’s salary is subject to PAYE and National Insurance and you also have to pay Dividend Tax if you are a shareholder.
- If you want to withdraw cash, you can withdraw it in the form of a salary or dividends and it is taxed accordingly.
- To set up a limited company, you need to register it at Companies House and pay formation fees.
- You have to pay higher accounting and admin fees as you need to file company accounts and annual return with HMRC and Companies House every year.
You should have a business bank account in order to trade.
For a complete comparison we can also review taxes to be paid under each structure.
Below you can see taxes to be paid under a sole trader and a limited company if annual gross profits are equal to £12,086.59. In this case, either business structure is suitable as the same amount of taxes is to be paid.
Let’s look a bit closer at this example to understand how these taxes are calculated:
Sole Trader or Self-Employed
Suppose Joe’s total profits this year are £12,086.59. Joe will need to pay Income Tax on his profits and two NI contributions (Class 2 and Class 4).
This is how he calculates his taxes:
(Gross Profit – Personal Allowance of £10,600) x 20% Income Tax = (£12,086.59 – £10,600) x 20% = £297.32
NI Contributions (Class 2 and Class 4)
NI contributions are calculated on the basis of:
- Class 2 if gross profits are £5,965 or more a year
- Class 4 if gross profits are £8,060 or more a year
Class 2 contributions are calculated:
£2.80 x 52 working weeks = £145.60
Class 4 contributions are calculated:
(Gross Profit – £8,060) x 9% NI rate = (£12,086.59 – £8,060) x 9% = £362.39
Total NI contributions Joe will need to pay:
£145.60 + £362.39 = £507.99
As Chloe has a limited company, she will pay Corporate Tax, NI contributions and PAYE, and Personal Tax on her profits, which include dividends. Chloe wants to take advantage of tax planning and decides to have a salary of £8,060 and withdraw the remaining profits as dividends.
This is how she calculates her taxes:
(Gross Profit – Director’s Salary) x 20% Corporate Tax = Net Taxable Profit Excluding All Expenses x 20% = (£12,086.59 – £8,060) x 20% = £805.32
Directors are classed as employees and pay NI on annual income from salary and bonuses over £8,060, so no NI contributions need to be paid in this case.
Personal Tax / Dividend Tax:
- A. Total Gross Profit – Salary – Corporate Tax = Money Available for Dividends
- B. Money Available for Dividends x 10/9 = Gross Dividends
- C. Find a correct tax band for your gross dividends
If your dividends fall within the basic band, then you need to pay 10% Personal Tax. However, there is 10% tax credit, which is applied to each tax as shown in the table.
If taxable personal income that includes your salary and dividends is lower than £42,385, than you do not need to pay any tax as it is equal to zero.
When taxable personal income falls within higher and additional bands, than you need to apply tax rate minus 10% tax credit.
So based on these four points, here are Chloe’s calculations:
- £12,086.59 – £8,060 – £805.32 =£3,221.27
- £3,221.27 x 10/9 = £3,579.19
- The total taxable personal income is £3,579.19 + £8,060 (Chloe’s salary) = £11,639.19. No tax to be paid as the income is lower than £42,385.
Choosing the right structure for your business is an important task.
As in Joe’s example, who is just starting as a freelancer, a sole trader structure may work better.
However, if your profits are more than £12,086.59 and you are planning to grow your business like Chloe, then it is worth setting up a limited company to take advantage of tax planning and other important benefits.
After all, you need to be comfortable with whichever business structure you go for. If in doubt, give us a ring to discuss.
The information presented in the blog is for your guidance only. We advise you seek professional advice from a contractor accountant on your personal situation.