Contracting - Why are so few of us sole traders?
Contractor's Question: Why are there so few sole traders supplying software services? Is it because the tax liability is greater for sole traders than it is for limited companies? Or is it because recruitment agencies, or client companies, won't touch sole traders who supply software, or other IT services ? If so, why is this?
Expert's Answer: There are many reasons why an individual may choose to operate via a limited company rather than as a sole trader. However the three which stand out are as follows.
Firstly you have suggested that agencies won't deal with sole traders. The reason for this lies within the Income Tax (Earnings and Pensions) Act 2003 under Chapter 7. This legislation states that where an individual personally provides, or is under an obligation personally to provide services to an end client via an agency, and that individual is subject to (or to the right of) supervision, direction or control as to the manner in which the services are provided; then the income received by the individual under the contract is to be treated for income tax purposes as employment earnings.
This means the agency is responsible for ensuring that the relevant employers' and employees' National Insurance Contributions are paid, along with income tax via the PAYE system where the individual meets the criteria above. Instead of the agency worrying about this legislation, it is much easier for them to insist that the individual operates via a limited or umbrella company rather than as a sole trader.
The second motive for the limited company option could be the limited liability which the director would enjoy. As a separate legal entity in law, a limited company is liable for its own debts, therefore the director, who is often also a shareholder, will escape unscathed provided he or she does not owe any money to the limited company and there have been no breaches of the directors' fiduciary duties. In contrast, an individual trading as a sole trader is not a separate legal entity to the business and is therefore personally liable for the debts. He or she is therefore putting their livelihood at risk which is not an option for a lot of people in these testing times. Both a sole trader and a limited company should always have adequate liability insurance in place to minimise potential losses.
Finally as you have hinted at, there are tax advantages to the limited company set-up. A sole trader will pay Class 2 National Insurance Contributions (NICs) at the set rate, and then Class 4 NICs and income tax on all profits of the business at the prevailing rates. A director of a limited company on the other hand has the ability to draw a proportion of his or her income out via dividends which do not attract NICs. Depending on the total income of the business, the available profits and the level of the directors' salary; the net take home of the director will likely be higher than that of the sole trader. It must be noted however that the director must take adequate measures to ensure that the contract and working practices which have been agreed with the end client are outside IR35 before drawing any dividends.
Both the sole trader and limited company options have advantages and disadvantages over one another; the key thing is to ensure that you get bespoke professional advice before deciding which option is best suited to you.
The expert was Nick Stevenson, Compliance Advisor at Freelance World, a specialist tax and accountancy firm.
Editor's Note: Related Reading -
Contractors' Questions: Why don't agencies deal with sole traders?
Contractors' Questions: Can I beat IR35 by being a sole trader?
