Sole Trader vs Limited Company: When Does It Make Sense to Switch?

Almost every successful sole trader reaches the same crossroads: profits are growing, the tax bill is climbing, and someone — an accountant, a business contact, a forum post — suggests that it might be time to set up a limited company. The logic sounds compelling. Lower tax rates, limited liability, a more “professional” image. But is it actually the right move for you, and at what point do the numbers genuinely work in your favour?

This guide breaks down the real differences between operating as a sole trader and running a limited company, compares the tax implications at different income levels, and gives you a practical framework for deciding when — or whether — to make the switch.

The Fundamental Differences

Legal Status and Liability

A sole trader and their business are the same legal entity. If your business incurs debts or is sued, your personal assets — your savings, your home, your car — are at risk. In practice, this matters less than it sounds for many freelancers and service-based businesses, but it is a genuine concern for anyone taking on significant financial commitments or operating in a high-risk industry.

A limited company is a separate legal entity from its owner (or owners). The company has its own legal identity, its own bank account, and its own liabilities. If the company fails, the shareholders’ liability is limited to the value of their shares — typically £1. Your personal assets are protected, provided you have not given personal guarantees on business debts or engaged in wrongful trading.

Tax Treatment

This is where the biggest practical difference lies, and where most of the “you should go limited” advice comes from.

Sole traders pay Income Tax on their business profits and Class 2 and Class 4 National Insurance contributions. All profits are treated as personal income in the year they are earned, regardless of whether you withdraw the money from your business bank account or leave it in.

Limited company directors can take a combination of a salary and dividends. The company pays Corporation Tax on its profits, and the director then pays Income Tax on their salary and Dividend Tax on any dividends they receive. Because dividend income is taxed at lower rates than employment income and does not attract National Insurance, this structure can be significantly more tax-efficient at higher profit levels.

Administration and Costs

A sole trader’s administrative burden is relatively light. You need to keep records of income and expenses and file one Self Assessment tax return per year. That is essentially it.

A limited company involves considerably more administration:

• Annual accounts must be prepared and filed with Companies House
• A Corporation Tax return (CT600) must be filed with HMRC
• A confirmation statement must be filed with Companies House each year (fee: £34 online)
• The director’s personal Self Assessment tax return must still be filed
• Payroll must be run if you take a salary (even if it is just for yourself)
• Statutory records including a register of shareholders, directors, and people with significant control must be maintained

Most limited company directors hire an accountant to handle this, which typically costs between £1,000 and £2,500 per year depending on the complexity of your affairs. This is a real cost that must be factored into any tax saving calculation.

Tax Comparison: The Real Numbers

Let us compare the tax position of a sole trader and a limited company director at three different profit levels. For these calculations, we will use 2025/26 tax rates and assume the limited company director takes an optimal salary of £12,570 (the Personal Allowance) and draws the rest as dividends.

Scenario 1: £30,000 Profit

Sole trader:

• Income Tax: £3,486 (20% on £17,430, being £30,000 minus £12,570 Personal Allowance)
• Class 4 NI: £1,045.80 (6% on £17,430)
• Class 2 NI: £179.40 (£3.45 x 52 weeks)
• Total tax: £4,711.20

Limited company:

• Director’s salary: £12,570 (no Income Tax due, within Personal Allowance)
• Employer’s NI on salary: £0 (salary at or below the Secondary Threshold with Employment Allowance)
• Company profit after salary: £17,430
• Corporation Tax at 19%: £3,311.70
• Remaining profit available as dividends: £14,118.30
• Dividend Tax: £0 (within the basic rate band and after the £500 dividend allowance, the effective tax is minimal at 8.75%)
• Dividend Tax calculation: (£14,118.30 minus £500 allowance) x 8.75% = £1,191.60
• Accountancy fees: approximately £1,200
• Companies House fees: £34
• Total tax and costs: £5,737.30

Result at £30,000: The sole trader pays approximately £1,026 less. The limited company’s additional administrative costs and Corporation Tax outweigh any dividend tax saving at this level.

Scenario 2: £50,000 Profit

Sole trader:

• Income Tax: £7,486 (20% on £37,430)
• Class 4 NI: £2,245.80 (6% on £37,430)
• Class 2 NI: £179.40
• Total tax: £9,911.20

Limited company:

• Director’s salary: £12,570
• Company profit after salary: £37,430
• Corporation Tax at 19%: £7,111.70
• Remaining profit as dividends: £30,318.30
• Dividend Tax: (£30,318.30 minus £500) x 8.75% = £2,609.10
• Accountancy fees: £1,500
• Companies House fees: £34
• Total tax and costs: £11,254.80

Result at £50,000: The sole trader still pays approximately £1,344 less when you factor in the full administrative costs. The gap is narrowing, but incorporation does not yet make financial sense.

Scenario 3: £80,000 Profit

Sole trader:

• Income Tax: £7,486 (20% on £37,430) + £5,946 (40% on £29,570 above the higher rate threshold of £50,270 minus the personal allowance) = wait, let me recalculate cleanly.
• Taxable income: £80,000 minus £12,570 = £67,430
• Basic rate (20%): £37,700 x 20% = £7,540
• Higher rate (40%): £29,730 x 40% = £11,892
• Class 4 NI: (£37,700 x 6%) + (£29,730 x 2%) = £2,262 + £594.60 = £2,856.60
• Class 2 NI: £179.40
• Total tax: £22,468

Limited company:

• Director’s salary: £12,570
• Company profit after salary: £67,430
• Corporation Tax at 19%: £12,811.70
• Remaining profit as dividends: £54,618.30
• Dividend Tax: First £500 at 0%, next £37,200 at 8.75% (basic rate band), remaining £16,918.30 at 33.75% (higher rate)
• Dividend Tax: (£37,200 x 8.75%) + (£16,918.30 x 33.75%) = £3,255 + £5,709.93 = £8,964.93
• Accountancy fees: £1,800
• Companies House fees: £34
• Total tax and costs: £23,610.63

Result at £80,000: The numbers are now very close, with the sole trader structure still marginally ahead after accounting for administrative costs. However, if the director does not need to withdraw all profits as dividends — leaving some retained in the company — the limited company becomes more tax-efficient because Corporation Tax at 19% is significantly lower than the 40% Income Tax rate a sole trader would pay on the same amount.

The Real Tipping Point

The exact crossover point depends on your specific circumstances, but as a general rule, incorporation starts to become genuinely tax-efficient when your profits consistently exceed approximately £40,000 to £50,000 per year — and crucially, when you do not need to withdraw all of those profits immediately.

If you are drawing every penny of profit from the company as salary and dividends, the tax saving is modest until profits reach much higher levels. The real advantage of a limited company emerges when you can leave profits in the business, either to reinvest, build reserves, or time your withdrawals tax-efficiently across multiple years.

The Salary Plus Dividend Strategy

The standard tax-efficient approach for limited company directors involves taking a modest salary — typically set at or near the Personal Allowance of £12,570 — and drawing additional income as dividends.

This works because:

• The salary uses up your Personal Allowance, so no Income Tax is payable on it
• At this salary level, there are no employee National Insurance contributions
• The employer’s National Insurance threshold means minimal NI for the company
• Dividends are taxed at lower rates than salary: 8.75% (basic rate), 33.75% (higher rate), and 39.35% (additional rate)
• Dividends do not attract National Insurance at all

The exact optimal salary figure can vary depending on your circumstances, particularly if you have other sources of income. An accountant can calculate the most efficient split for your specific situation.

Beyond Tax: Other Reasons to Incorporate

Credibility and Client Perception

Some industries and clients perceive limited companies as more established and professional than sole traders. This can matter when tendering for contracts, working with larger organisations, or operating in sectors where liability is a concern. However, this perception varies enormously by industry, and many successful freelancers operate as sole traders for their entire careers without it being an issue.

Liability Protection

If your business carries meaningful risk — whether from potential professional negligence claims, contractual liabilities, or financial commitments — the limited liability of a company structure provides genuine protection. This is separate from the tax consideration and can be a compelling reason to incorporate even if the tax savings are marginal.

Pension Contributions

A limited company can make employer pension contributions that are deductible from the company’s taxable profits. This can be a very tax-efficient way to extract money from the company, as the contributions are not subject to Income Tax, National Insurance, or Dividend Tax for the director. The annual allowance for pension contributions is currently £60,000.

Retained Profits and Investment

If you want to build reserves within the business, invest in equipment or premises, or simply smooth your income across years, a limited company gives you more flexibility. Retained profits are taxed at the Corporation Tax rate rather than your marginal Income Tax rate.

The IR35 Consideration

If you work primarily as a contractor through a limited company — particularly if you work on-site with a single client for extended periods — you need to understand IR35. This anti-avoidance legislation targets arrangements where a contractor is essentially an employee in all but name.

If your engagement is deemed to be “inside IR35,” you must pay broadly the same tax and National Insurance as an employee, eliminating most of the tax advantages of operating through a limited company. Since April 2021, for medium and large private sector clients, the responsibility for determining your IR35 status sits with the client, not with you.

Before incorporating primarily for tax reasons as a contractor, get proper advice on whether your working arrangements would be caught by IR35. If most of your contracts are inside IR35, the tax benefits of a limited company are significantly reduced, and the additional administrative burden may not be worthwhile.

Additional Costs of Running a Limited Company

When comparing structures, factor in these ongoing costs:

• Accountancy fees: £1,000 to £2,500+ per year for accounts preparation, Corporation Tax return, payroll, and ongoing advice
• Companies House filing fee: £34 per year for the confirmation statement
• Registered office service: £50 to £200 per year if you do not want to use your home address (which becomes public record)
• Payroll software or bureau costs: Some accountants include this, others charge extra
• Bank charges: Business bank accounts for limited companies often charge monthly fees, whereas many sole trader accounts are free
• Time: The additional administrative work involved in running a limited company, even with an accountant, is meaningful

In total, the additional costs of running a limited company compared to a sole trader typically amount to £1,500 to £3,000 per year. Any tax saving must exceed this figure before incorporation is worthwhile on purely financial grounds.

Practical Steps to Incorporate

If you decide that incorporation is right for you, the process is straightforward:

1. Choose a company name. Check availability on the Companies House register. Your company name does not have to match your trading name.

2. Register the company. You can register online at Companies House for £12. You will need to provide at least one director (you), a registered office address, at least one shareholder (also you, typically), and details of people with significant control.

3. Set up a business bank account. You will need this before the company can trade. Most UK banks offer business current accounts for limited companies, and some challenger banks such as Starling and Tide make the process very quick.

4. Register for Corporation Tax. You must register with HMRC within three months of starting to trade. This is a separate process from your personal Self Assessment registration.

5. Set up payroll. If you are taking a salary, register as an employer with HMRC and set up a PAYE scheme.

6. Inform your clients. You will need to invoice through the new company rather than in your personal name. Provide clients with the company’s details and new bank account information.

7. Consider VAT registration. If your turnover is below the £90,000 threshold, registration is optional but may be beneficial if most of your clients are VAT-registered businesses.

8. Transfer any assets. If you have business assets (equipment, intellectual property, stock), you may need to formally transfer them to the company. Take advice on this, as there can be tax implications.

Making the Decision

The right business structure depends on far more than tax. Consider your risk profile, your growth plans, your need for flexibility, and how much administrative work you are willing to take on. A sole trader structure is perfectly adequate — and often optimal — for many freelancers and small business owners, particularly in the early years.

Do not incorporate simply because someone told you it saves tax. Run the numbers for your specific situation, factor in all the costs, and consider whether you actually need to withdraw all your profits each year. If the tax saving after costs is less than a few hundred pounds, the additional complexity probably is not worth it.

Speak to an accountant who specialises in small businesses and freelancers. A good accountant will give you an honest assessment based on your actual numbers rather than generic advice, and the cost of that initial consultation will be repaid many times over if it helps you make the right structural decision for your business.