Why contractors rarely work as sole traders

For those new to the world of contracting, there are many things to consider and one of the biggest decisions you’ll have to make is whether to set up as a sole trader or a limited company, writes Matthew Fryer of Brookson Legal.

Here, exclusive for ContractorUK, I will look at why working as a contractor through a limited company is still attractive in certain circumstances and, often overlooked -- why sole trader structure is still the less preferred option.

What’s changed? Mainly IR35...

On April 6th 2021, under the off-payroll working legislation (found at Chapter 10, ITEPA 2003), it became the responsibility of the end-client to decide whether your working arrangements as a contractor were that of an employee, (i.e. caught by IR35 or ‘inside IR35’) if you were working via your own limited company.

 Essentially, since April 6th, the end-client will advise you (and your agency) via a Status Determination Statement to this effect. The impact of being decided as inside IR35 is that any funds you receive into your company get subjected to tax and National Insurance as employment earnings.

Usually in this case, the individual can opt to continue working through their limited company (also known as a Personal Service Company), or a recruitment agency-preferred option is for the individual to work via an umbrella company, or the agency’s payroll, whereby the operation of PAYE is dealt with accordingly.

But it’s not just Chapter 10

 Even before this change to IR35 last April, recruitment agencies generally did not deal with sole traders. The reason for this non-engagement of workers who are sole traders by agencies  lies within the Income Tax (Earnings and Pensions) Act 2003, specifically Chapter 7.

There, the 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.

As a result of both pieces of legislation, agencies prefer not having to worry about applying PAYE, and where the limited company is IR35-caught or the individual operates as a sole trader, it is much easier for the agency to insist that the individual operates via an umbrella company (or the agency’s payroll), to reduce their own risk.

The benefits of working via a limited company

By contrast to operating as a sole trader, working as a contractor through a limited company can still be attractive if you are not captured by IR35.

This is because the historically-dominant benefit of working via a limited company still holds true. Notably, the legal separation of the company from you as the individual director and related, the limited liability status of a company which means the company is liable for its own debts.

This will generally be the case as long as you (as the company’s director) act in the best interests of the company and you do not owe funds to the company. In comparison, a sole trader is personally liable for his/her business debts. Such sole traders should therefore strongly consider taking out appropriate insurance to mitigate any potential losses.

An additional advantage of running your contractor business as a limited company is that you legitimately pay less personal tax than a sole trader does (if you are not IR35-caught).

Limited company profits are subject to UK corporation tax, which is currently set at 19%. If you are the director and shareholder of a limited company, you may choose to take a small salary and draw most of your income from the business in the form of dividends. By doing this, you can minimise the amount of National Insurance Contributions you have to pay because limited company dividends are not subject to NICs.

As a director, you are taxed personally on funds taken from the company and you have the flexibility of retaining funds in the company you may not want to withdraw at the time. This is contrast with the sole trader structure, where income is taxed on an arising basis rather than on amounts you have taken out of the business to live on.

The benefits of working as a sole trader

Working as a sole trader as opposed to a limited company does provide some advantages, like the simplicity of setting up; less administration, more privacy, and lower costs.

In particular, if you are setting up to serve a small customer base, sole trading can be attractive as any initial losses can be absorbed against other income in the tax year.

That said, in the future, there will be greater compliance required of individuals operating as sole traders because from April 2024, a new way in reporting earnings will be introduced (under the government’s Making Tax Digital scheme).

In conclusion…

To summarise, as a contractor, having a limited company will invariably provide a more professional image; is more acceptable to agencies and end-clients and protects your personal assets, despite the fact that running costs are perceived to be more expensive. Greater take-home pay as a limited company director than a sole trader usually eases those concerned by such higher outlays as PSC owner . However, we would always advise that you obtain bespoke professional advice to discuss which structure is best suited to you before you take the plunge into professional contracting.