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What is a sole trader?

Becoming a self-employed sole trader is the simplest legal structure and the easiest way of starting and running a business. Anyone who starts working for themselves and does not choose another trading option, such as a partnership or limited company, immediately becomes classed as a sole trader.

However, a sole trader is personally liable for any business and financial risk, including any business debts, including paying tax to HMRC on the profits of the business. Sole traderships still require record keeping and are not the most tax efficient legal structure for a business.

Plus many potential customers, such as recruitment agencies and large organisations, won’t hire sole traders because of the risk that the worker may try to claim employment rights. That’s why most contractors and freelancers do not trade as sole traders.

How to start and run a sole trader business

An individual simply has to announce they are in business and they become a self-employed sole trader by default. Although it is advisable, sole traders do not have to open a separate business bank account, although they do need to register with HMRC. There are no ‘shares’ in a sole tradership nor are there any directors, although the individual running the business is often referred to as the ‘business principal’.

The regulatory and administrative burden of running a sole tradership is low. Apart from registering with HMRC for tax within three months of starting the business, and any regulatory requirements of the business, trade or professional performed by the sole trader, there is little additional regulation.

Sole traderships do not need a separate business name from the individual running the business, or require registration with Companies House. Sole traders do not have to file accounts but they do have to keep the business’s books and prepare an income and expenditure statement each year to calculate their profits and accompany their tax return.

Sole traders can grow their business beyond the founder, and hire employees, subcontractors and suppliers. The ‘sole’ in sole trader only means that a single individual is responsible for the business, not that they can’t employ staff.

What tax do sole traders pay?

A self-employed sole trader pays income tax on the profits of the business via the self-assessment system. For most sole traders, the profits of the business are typically calculated using a simple set of income and expenditure accounts.

A self-employed sole trader pays income tax on the profits of the business via the self-assessment system

If a sole trader business does have significant assets, such as plant and equipment and business property, then it may be advisable to use an accountant to prepare accounts so full advantage is taken of any tax reliefs available.

A sole trader must submit a self-assessment tax return online by 31 January following the end of the tax year, which is 5 April (paper tax returns must be submitted three months earlier, by 31 October). Any tax owed must be paid in full by the 31 January deadline.

Self-employed sole traders are subject to the same income tax bands as employees. So, they have a personal allowance of £10,000 on which they pay no income tax. Then they pay the 20% basic rate of income tax on the next £31,865 of profits, the higher rate of 40% on profits of between £31,866 and £150,000, and the additional rate of 45% on any profits over £150,000.

Sole traders also pay two types of National Insurance Contributions (NICs). Class 2 NICs are paid at a rate of £2.75 per week and Class 4 NICs are calculated as part of the self-assessment process, and are based on the amount of profit made.

Making tax payments on account

Once a sole trader has been in business for long enough to submit a self-assessment tax return, they will have to start making tax payments on account. This is essentially an advance payment on the forthcoming year’s tax paid in two instalments on 31 January and 31 July.

Payments on account are calculated based on the previous year’s profits and tax. That means if the sole trader is having a less successful year, they may be paying too much tax on account. It is possible to appeal the payment on account with HMRC, and have it reduced.

If a sole trader’s business has sales above the VAT threshold, currently £81,000, then the sole trader must register for VAT, and start charging VAT to their customers. A VAT return must be completed and submitted to HMRC alongside any VAT payment every quarter.

The risks of becoming a sole trader – unlimited liability

The major difference between a sole trader and a limited company is that the sole trader’s business is not a separate legal entity. In contrast, a limited company is a separate legal entity from its shareholders and directors.

This means the sole trader’s personal assets, such as their home and savings, are not ring fenced from the business and its assets. So, if a sole trader owes a large sum of money to a supplier, and their customer can’t or won’t pay, then the sole trader is liable for that debt personally.

Similarly, any legal action and resulting settlement against the sole trader’s business, and this could include a negligence claim by a customer or an employment tribunal instigated by an employee, must be paid for by the principal.

Securing work directly from clients/agencies

Outside of sectors such as construction and property maintenance, many sole traders may find it difficult to secure work from clients or requirement agencies. That is because if the client/agency engages the sole trader, they are hiring the individual directly. There is no intermediary, such as a limited company.

This situation is risky for the client/agency for two reasons. Firstly, in some circumstances because of the nature of the role and relationship, the sole trader may decide they qualify for employment rights. Without an intermediary, the worker may have a case. That’s why contractor clients and agencies insist on having a limited company or umbrella company as an intermediary.

It is also possible that, if the self-employed sole trader does not pay the income tax and NICs that they should, under some circumstances HMRC may come after the agency or the client for the unpaid tax.

For some low turnover trades and businesses, becoming a sole trader is the ideal solution, as it enables an individual to be self-employed without the administrative burden of incorporating and running a company.

However, for companies with growth potential and with higher fee potential, a sole tradership does not provide the tax efficiency or protection from financial risk that an alternative, such as a limited company, will deliver.

Published: 15 January 2015

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