Understanding the legal requirements of being a sole trader

Setting up a company as a sole trader is a popular way for people to start their journey in business, and it’s often how many people enter the world of business for the first time. 

However, as with everything in business, becoming a sole trader comes with several risks you should be aware of. 

In this article, we explain the legal requirements you must follow and the benefits and risks you should consider before becoming a sole trader. 

The legal requirements and rules for being a sole trader

One of the main characteristics of being a sole trader is that they’re an individual who runs their own business and will be classed as self-employed.

Being self-employed means that you can retain the profits the business makes once the tax has been paid, but you’ll also be liable to pay for any losses that the business suffers and will have to pay these from your pocket. 

The threshold for being classified as a sole trader is earnings of more than £1,000 from your self-employed business activities in any tax year. The current tax year started on the 6th of April 2022 and will end on the 5th of April 2023.

As a self-employed individual, you must adhere to various rules when running and naming your business. 

Registering yourself as a sole trader 

To set yourself up as a sole trader, you must inform HMRC and register for tax payment through Self Assessment. This involves filing a tax return each year to HMRC, which sets out how much profit the business made. 

Don't forget that as a self-employed sole trader, you’re responsible for keeping business records and expenses. If the business turns over more than £85,000 per year, a sole trader has to register for VAT. 

Naming your business

You can trade under your name or choose an alternative trading name. However, you must include your name and business name on all official paperwork, such as invoices and letters. 

To differentiate from any other form of company, the business name must not contain the words: 

• Limited or LTD
• Limited Liability Partnership or LLP
• Public Limited Company or PLC

Also, the name chosen must not be offensive in any way and must not be a registered trademark. Also, the name cannot suggest a link to the government or local authority. 

The benefits of being a sole trader

A sole trader has complete control over their business and is truly their own boss as they don’t have to speak with or agree with any business decisions with anyone else. 

Flexibility and speed 

Unlike a large organisation, there’s no need for every topic or issue to travel through various management layers and be discussed at the highest level of the business for a decision to be made, so the company moves forward quickly.

Adaptability 

A sole trader can adapt the business to the circumstances or customer. 

Being a sole trader means you’re closer to the customer, and sometimes, you even have direct contact with a service provider in a larger organisation. 

In some instances, the end customer will deal with different people, which can cause the customer to be frustrated by the lack of continuity in service provision. In contrast, a sole trader can provide a tailored service. 

Lower setup cost and administrative requirements

There is a far lower barrier to entry as a sole trader, as no administrative requirements are needed to get started.

Registering your sole trader company with Companies House as a limited company is not needed.

Consequently, there are also lower set-up costs than a limited company. There’s no need for a sole trader to employing professionals or company formation agreements to set up their company. 

Lower accounting burden 

The accounting burden is lower on a sole trader as there’s no need for formal accounts to be produced and submitted. A sole trader still needs to keep a record of invoices and expenses incurred and will be required to fill in a Self Assessment Tax Return each year. This is less accounting work than a company’s formal accounts. 

A sole trader also doesn’t have to file a yearly confirmation statement like a company, which means there’s less paperwork for a sole trader.  

The risks

Being a sole trader exposes a sole trader to personal liability. Unlike a company, a sole trader is not a separate legal entity. A sole trader is personally liable for all liabilities and debts, so if a sole trader’s income reduces or is lost, they’ll have to pay for it. 

It can be perceived as non-stable 

Some companies won’t deal with sole traders and prefer to deal with other companies instead. This is because sole traders are considered at higher risk than other established companies. 

All profits are taxed

The tax planning opportunities are also limited for a sole trader because all the profits a sole trader generates are liable to income tax.

Suppose a sole trader makes a significant profit. They’ll pay a higher tax than a company. A company owner can withdraw these profits via the declaration and dividends, which are generally taxed at a lower rate than income tax. 

Lack of funding opportunities

Sole traders may also find it difficult to gain funding to grow their businesses, and lenders are more likely to lend to an established company than a sole trader. 

Wrapping up

Being a sole trader has advantages and disadvantages and should be considered carefully. If you’re thinking of starting your business adventure as a sole trader, you’ll find it beneficial to count on some legal advice at the start of this journey. LawBite has helped thousands of people start a venture by providing expert guidance and business legal advice.

About the author 

Andrew Farrugia is an experienced contract lawyer at LawBite. He specialises in assisting startups and SMEs with their commercial and dispute resolution requirements. Find out how LawBite can assist you and advise you on the benefits of different business structures.