Why Smart Contractors and Freelancers Use a Limited CompanyPosted Monday, May 16, 2022
It’s common for us to hear from Freelancers who are operating as Sole Traders asking ‘what’s the difference between a limited company or a sole trader?’
We hear this question less from Contractors because they almost exclusively operate through limited companies, either their own company or an umbrella company, but if you’re reading this as a Contractor, this information is still really relevant to you too.
Before I get into the reasons why I always recommend using a limited company: some things you should know,
- accounting, tax, and compliance aren’t more difficult in a limited company. (Yes, there’s more to do, but when you’re with Contracting PLUS, we do everything for you).
- getting a mortgage is easier with a limited company once you have all the right paperwork in order (at Contracting PLUS we have a full mortgage pack we prepare for you, keeping admin simple).
- you don’t pay less tax as a sole trader. In fact, you pay more.
When I sat down to write this blog, I set out my lists of pros and cons. Then I started looking around the internet and there are hundreds of articles with the pros and cons of sole trader versus limited companies. They’re all pretty much the same and they tend to focus on the main differences from a legal and compliance side. While that’s important, it’s also a little boring and if you’ve got a good accountant, then they should have that covered for you.
So, I’m taking a different approach. I’m going to assume you’re a sole trader and cover all the reasons why it makes sense for you to change to a limited company.
It’s risky being a Sole Trader
As a sole trader you have full liability if anything ever goes wrong. No one thinks anything will ever go wrong, but things go wrong for people all the time. As a sole trader you have full liability which means if an amount of money ever needs to be paid out, it’s not just the business money or assets that are used. It’s your personal savings, your car, everything you own that is at risk.
As a limited company, all personal assets and wealth are protected. Limited liability massively reduces the risk. Why take unnecessary risks?
You’re paying more tax as a sole trader
As a sole trader you pay tax on business earnings (less expenses). That means you’re paying tax of between 52% and 55% on invoices you’ve given to clients, even if you haven’t collected that money yet. As a director in a company, you only pay tax on what you take out of the company. A sole trader could pay income tax of up to 55% of what you earn. A director only pays up to 52% (yes, it’s still a lot, but read on for some tips on how reduce the tax you pay).
A sole trader can’t get €500 tax free every year
As a director of your company, the company can buy any €500 voucher for you to use on anything you want. There’s no tax to pay. As a sole trader, if you wanted to have a €500 voucher, you’d first have to earn a little over €1000, pay tax of €540, and then be left with €500 to buy the same voucher. In a company, if there are 2 directors, then both are entitled to a €500 voucher each. In fact, all directors and employees can receive one €500 voucher tax free every year.
A sole trader gets less tax relief on pensions
You already know there’s tax relief on pension contributions. But as a sole trader, do you know how much tax relief you’re missing out on?
As a sole trader you get up to 40% tax relief on pension contributions. However, when you make the pension contribution through your limited company, you get 52% tax relief: an extra 12%…every…single…time.
A sole trader pays a lot more for their car.
Full disclosure: this one only works for an electric vehicle up to the value of €50,000. If you operate as a sole trader, and you want to own a family car, then you must earn money, pay tax, and then buy your car. Let’s say the car loan repayment, insurance, tax, and maintenance costs all add up to €800 a month on average over the course of a year. As a sole trader you need to invoice your clients a little over €1650 per month, pay tax of €850 and you’re then left with €800 for your car.
If you had a company, and you invoiced the same €1650, the company would pay €800 for all the car costs. Then the other €850; well, you could put that into your pension so you can retire with more money. Or you could take it out in salary and after tax have an extra €408 in your pocket each month. Or you could work less and just earn the €800. The extra time you’re spending as a sole trader to earn the extra €850 you’re giving away in tax could be used to spend with family and friends.
The reasons above are quick obvious reasons to stop being a sole trader and start operating through your company. But there are other benefits of having a company. Here are two of my favourites;
A sole trader can’t save as fast for a mortgage
For every euro you earn as a sole trader, you give the tax man 52% if you’re earning over €36,800. Let’s say you earn €80,000 a year but you know you could live on €60,000 and you plan to save the other €20,000 for a deposit for your new home, or some other big life event. As a sole trader you will pay tax of 52% on the extra €20,000. So, each year you’ll put away €10,000. After 5 years you’d have €50k. Not bad.
However, if you had a company, you could leave the extra €20,000 in the company. You’d pay corporation tax and then with the right planning you could avail of entrepreneurial relief. Over 5 years, the €20k each year would leave you with about €77,000. Much better!
As a sole trader, if you are ‘the business’, then you’ll probably miss out on retirement relief
Retirement relief allows you earn €750,000 tax free when you retire. If you’re a sole trader, you’d need to sell your sole trade business to someone to get this money tax free. But if your skill or knowledge is the business, which is the case with most professional freelancers and contractors, then this is unlikely.
However, if you operated through a limited company, you could be saving money in the company. Imagine leaving €30,000 a year for the next 25 years in your company. To break that down, if you took that money out of the company, it would work out at about €275 a week out of your pocket. In 25 years, after paying some corporation tax, you’d have about €607,000 which you could take from the company tax free. There’s a bit of tax planning required to make this work.
If you saved this money as a sole trader, you’d only have about €360,000. A limited company puts an extra €250,000 in your pocket.
So, there you have it. Running your business through a limited company makes a lot more sense. You’re safer, you’ll have better tax planning opportunities, and you’ll have more money in your pension, and in your pocket. Find out more about our specialised service for Freelancers.
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