Limited Company vs Sole Trader vs Umbrella Company for Freelancers: Which is Best for You?

Choosing the right business structure is a critical decision for freelancers, affecting everything from tax efficiency to record keeping.

According to a 2024 survey, there are over 4.3 million self-employed people in the UK, with freelancing becoming an increasingly mode of working. Once you’ve decided to work as a freelancer (and maybe even got your first client!), you’ll need to decide which business incorporation method is best for you.

The three primary options for UK freelancers—Limited Company, Sole Trader, and Umbrella Company—each have unique pros and cons which we look at below.

‍Limited Company

Key Features and Benefits

A Limited Company is a separate legal entity from its owners, providing a level of personal liability protection. This structure is popular among freelancers who want to present a professional image and benefit from potential tax efficiencies.

By setting up as a Limited Company, you can separate your personal finances from your business, limiting your liability such as going personally bankrupt if the business faces financial difficulties.

Tax Implications

Operating as a Limited Company often provides greater tax efficiency. The company pays Corporation Tax on profits under £50,000 at a rate of 19% (as of September 2024), which is generally lower than personal income tax rates. As a director, you can draw a salary and dividends, allowing you to optimise your tax position. Dividends are taxed at lower rates compared to income tax, making this an attractive option for freelancers earning above a certain threshold.

However, running a Limited Company does come with additional responsibilities and associated accountancy costs, such as submitting annual accounts, a Corporation Tax return, and a Confirmation Statement to Companies House. Failure to meet these deadlines can result in penalties, so understanding and keeping up with your tax obligations is crucial.

Record-Keeping Responsibilities

As a Limited Company, maintaining detailed financial records is essential. This includes tracking income, expenses, salaries, dividends, and any other financial transactions. You’ll need to keep receipts, invoices, and other supporting documents for at least six years.

To cut down on financial admin, many freelancers opt to use cloud accounting software such as Xero or Quickbooks to streamline this process and make life easier for them (or their accountant) to handle compliance and reporting.

Sole Trader

Key Features and Benefits

The most straightforward and quickest option for freelancers is operating as a Sole Trader, means you personally are the business. This structure is often preferred by people setting up a new business due to its minimal setup costs and ease of management.

As a Sole Trader, you have complete control over your business decisions and profits, but you also bear all the personal risks and liabilities if your business runs into financial difficulties.

Tax Implications

As a Sole Trader, your business income is treated as personal income, and you’ll pay Income Tax and National Insurance on your profits. The amount you pay will depend on your earnings and the applicable personal tax bands, which you can see below (correct as of September 2024):

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If you expect to earn up to £12,570, being a sole trader will be the best option as you pay no tax. Similarly if you earned £30,000 the first £12,570 would be tax free meaning you would only pay the 20% tax on £17,430 of earnings (£3,486 tax) – a significant saving on the 19% on the full £30,000 as a limited company (£5,700 tax).

While this structure is simple, it can become less tax-efficient as your income grows, especially if you move into higher tax brackets. There are fewer opportunities for tax planning compared to a Limited Company, and you may find you are hit with a bigger tax bill than expected after a particularly successful year.

Record-Keeping Responsibilities

Record-keeping is simpler for Sole Traders but still essential. You’ll need to keep accurate records of your business income and expenses, including receipts, invoices, and bank statements. These records are crucial for completing your Self Assessment tax return and must be retained for five years after the 31 January submission deadline of the relevant tax year.

Many freelancers working as sole traders will complete their self assessment themselves, although be careful of making mistakes that can lead to a higher tax burden or even an investigation by HMRC.

Umbrella Company

Key Features and Benefits

An Umbrella Company acts as an intermediary between you and your client, managing administrative tasks such as invoicing and tax deductions. Umbrella companies came to prominence after IR35 legislation was introduced banning employers from treating regular employees as freelancers for tax purposes (common in the construction industry). If you work on short-term contracts with only a few employers each year this may be the best option for you.

With an Umbrella Company, you become an employee of the umbrella firm, and they pay you through the PAYE (Pay As You Earn) system, handling your tax and National Insurance contributions. This simplifies your responsibilities, allowing you to focus on your work without worrying about accounting or tax compliance.

Tax Implications

While using an Umbrella Company simplifies tax administration, it is often less tax-efficient compared to running a Limited Company. Income is taxed at standard PAYE rates, with deductions for National Insurance and other employee-related costs.

You do not benefit from the ability to draw dividends or offset business expenses in the same way you would with a Limited Company.

For many freelancers, the convenience of an Umbrella Company comes at the cost of a higher overall tax burden. However, it can be a suitable choice for those who value simplicity or who are unsure about committing to a full-fledged business structure.

Record-Keeping Responsibilities

Record-keeping requirements when using an Umbrella Company are minimal, as the company handles most of the administrative tasks. However, it is still wise to keep copies of your contracts, payslips, and any communications related to your assignments. This can help ensure you have records of your work history and earnings.

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Limited Company vs Sole Trader vs Umbrella Company Comparison: Which Structure is Right for You?

Tax Efficiency:

• Limited Company: Offers the most tax planning opportunities, especially for higher earners. Drawing dividends can reduce your tax bill compared to a Sole Trader or Umbrella Company.
• Sole Trader: Simple but becomes less efficient as your income grows. Higher earners may pay more tax compared to those running a Limited Company.
• Umbrella Company: Simplifies tax but at the cost of higher deductions. Ideal for those valuing convenience over tax savings.

Record-Keeping:

• Limited Company: Most demanding, with comprehensive records required for tax and legal compliance.
• Sole Trader: Simpler but still essential. Accurate records are needed to complete your Self Assessment.
• Umbrella Company: Minimal, as most record-keeping is handled by the umbrella firm.

Liability and Risk:

• Limited Company: Offers limited liability, protecting your personal assets from business debts.
• Sole Trader: You are personally liable for all debts, which can be a significant risk.
• Umbrella Company: No personal liability for business debts, but no control over how your income is managed.

Unsure How to Set up your Business as a Freelancer? We Can Help!

Choosing between a Limited Company, Sole Trader, or Umbrella Company depends on your personal circumstances, income level, and willingness to handle administrative tasks.

Consulting with a professional accountant such as Linggard and Thomas means you benefit from tailored financial advice, ensuring you select the structure that best suits your freelance journey.

We love supporting businesses that start as freelancers right through their business growth journey, adapting our service level based on their needs. Get in touch today to see how we can help your freelancing business succeed.

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