This article was last updated on 11/06/2025
When you’re self-employed, there are pros and cons to setting yourself up as a sole trader or a limited company - but how does it compare in terms of cash?
As a self-employed journalist and blogger, I’ve been trying to work out if and when it makes sense to switch from being a sole trader to setting up a limited company. The two are taxed differently, so it makes a difference to the pounds in your pocket.
Sole trader: totally tax-free as you get started
Starting off as a sole trader makes life easier and less expensive. You don’t face paperwork beyond your own Self-Assessment tax return. There’s no need to wade through incorporating a company and then filing annual accounts, a confirmation statement and a company tax return each year.
There’s no requirement to pay for an accountant or fork out for a business bank account. You don’t have to justify spending any of your earnings, or shoulder the legal responsibilities of being a company director. You can also keep your company figures and office address private, rather than visible to all at Companies House.
On the money side, as a sole trader, the profits from your business are included on your own tax return. Personally, I earnt next to nothing when I first went freelance after maternity leave. I also couldn’t take on much work while juggling two children with less than two years between them.
Luckily, if you earn under £1,000 a year in gross income from your business, you can pocket the lot tax-free under the trading allowance. In this case, you also don’t have to tell HMRC that you’re self-employed.
Once your income starts stacking up, you can choose between deducting:
- the £1,000 trading allowance from your business income; or
- actual expenses.
Provided your profits, plus any other earnings, don’t pass the *standard £12,570 a year personal allowance (2025/26), you won’t pay a penny in Income Tax. While profits are still low, you won’t have to fork out for National Insurance contributions (NICs) either.
Once your earnings increase, you’ll need to pay Class 4 NICs at 6% on anything between £12,570 and £50,270 a year. If you earn anything over £50,270, you’ll have to pay Class 4 NICs at 2%.
*The personal allowance goes down by £1 for every £2 that your adjusted net income is above £100,000. This means someone’s allowance is zero if their income is £125,140 or above.
If your profits are less than £6,845 a year
You don’t have to pay anything but you can choose to pay voluntary Class 2 contributions. The Class 2 rate is £3.50 a week (2025/26).
This helps protect your National Insurance (NI) record and your eligibility for certain benefits such as Maternity Allowance and the State Pension. Once you earn over the ‘small profits threshold’ of £6,845 a year, Class 2 NICs are treated as having been paid. Plus, even if you don’t earn enough to pay Income Tax, you can still stash away up to £2,880 a year into a pension. You could see this topped up to as much as £3,600 with tax relief.
Sole trader: double whammy of income tax and NICs as profits soar
The tax bills really get going when you start paying Income Tax and self-employed NICs. The table below outlines how profits impact your self-employed NICs and Income Tax rates for 2025/26. Please note, if you live in Scotland these rates differ.
The silver lining is that higher earnings mean you can pay more into a pension, and benefit from extra tax relief. Most people can pay up to 100% of earnings, to a maximum of £60,000 a year (2025/26), into a pension and still benefit from tax relief. Basic rate tax relief adds 20p to every 80p you pop in your pension pot. If you’re a higher or additional rate taxpayer, you can claim back extra relief through Self-Assessment.
How does becoming a limited company compare?
Once you face paying 20%, 40% or 45% Income Tax on profits as a sole trader, the 19% lowest rate of corporation tax paid by limited companies doesn’t look so bad.
Corporation tax for 2025/26 is paid at:
- 19% on profits of less than £50,000 a year;
- 25% on profits of greater than £250,000; and
- on a sliding scale between the two, after calculating marginal relief.
Some people prefer to do it straight away for extra protection. As a sole trader, you and your business are lumped together. Legally, you’re one and the same. This means if your business goes belly up or you get sued, your creditors could come after your home or other assets. In contrast, when creating a limited company, you create a separate legal entity, which limits your liability. You can only lose what you’ve put into the company.
Limited company: corporation tax from the first pound
On the financial side, setting up a limited company involves juggling extra taxes. This might make more sense to do as your business gets bigger. As a limited company, you’ll need to pay corporation tax on any profits. The bad news is that there isn’t a personal allowance or £1,000 tax-free trading allowance with corporation tax. Instead, you face paying 19% corporate tax from your first pound in profits.
The good news is that you can claim a wider range of allowances and tax-deductible costs as a limited company. This will bring down your profits and therefore your tax bill. I suspect I may’ve been missing out by sticking as a sole trader, once my children started school and I took on more work.
As a limited company, it can also be easier to raise money. For example, by issuing shares, attracting investors or applying for bank loans and grants.
Limited company: how to pay yourself
In reality, unless you have oodles of other income elsewhere, you’ll also need to take some cash out of your limited company to live on. The two main ways of taking money out of a limited company are as salary and dividends.
If you’ve set yourself up as a director and shareholder of your company, you can:
- pay yourself a salary as a director and employee;
- take dividends from profits as a shareholder; and
- make employer pension contributions from your company, to beef up your income in retirement.
A tax efficient combination could be to take a salary low enough to escape paying Income Tax with little or no NICs, plus some dividends and potentially some pension contributions. However, the perfect combo will depend on your own specific circumstances, and the tax bands at the time.
Taking a tax-efficient salary
Paying yourself a salary has a couple of perks. Salary, and any Class 1 employer NICs paid on it, count as allowable business expenses that can be taken from your profits. This then cuts your corporation tax bill. Plus, as long as the salary is above the lower earnings limit of £6,500 (2025/26), you should rack up qualifying years towards a State Pension even if you don’t pay any Class 1 employee NICs.
Changes to NI from April 2025 have affected how much you might want to pay yourself as a salary:
- the rate of employer’s NI has increased from 13.8% to 15%; and
- the threshold when employers have to start paying NI for their employees has been pushed down from £9,100 per year to £5,000 per year.
To limit the impact of this cost increase on smaller companies with lower paid employees, the Employment Allowance has also been increased. Eligible employers can now claim up to £10,500 off their employer NICs bill, up from £5,000 before April.
To make the most of your money, there are a few different options.
Hassle-Free: £5,000 a year
Setting your salary just below the ‘secondary threshold’ for NI, which is when employers have to start paying Class 1 employer NICs, means you avoid paying any NICs at all. At 19% corporation tax, it’ll also knock £950 off your corporation tax bill.
However, keeping your salary so low also means you won’t build up qualifying years towards your State Pension.
Protect your State Pension: £6,500 a year
Setting your salary at the £6,500 Lower Earnings Limit for employee NICs will protect your entitlement to the State Pension, without having to actually pay either employee NICs or Income Tax.
Your company will potentially, however, have to pay 15% employer NICs on the chunk of salary between £5,000 and £6,500.
As both salaries and employer NICs can be taken from company profits, you’ll still save £1,052.75 on your tax bills, based on 19% corporation tax, even after forking out for employer NICs.
Sole director and employee: £12,570 a year
One man band? It’s usually most tax-efficient to push your salary up to the ‘primary threshold’. This is when employees and directors start paying Class 1 NICs, which is equivalent to £12,570 (2025/26). You’ll save more in corporation tax than your business pays in employer NICs, and you won’t have to fork out for employee NICs.
At 19% corporation tax, this salary will save a total of £1,468.55 in tax, after covering employer NICs.
Two or more employees: also £12,570 a year
If your company has at least two employees and can claim the Employment Allowance, it makes financial sense to take your salary up to the £12,570 personal allowance.
This way, you earn the maximum possible without paying Income Tax or employee’s NICs, and the Employment Allowance covers the £1,135.50 in employer’s NICs. The net tax saving is £2,388.30 per employee, at 19% corporation tax.
Paying into a pension
If you’re self-employed via a limited company, you can also make employer contributions into your pension. Pension contributions are usually an allowable business expense, so these pension payments will reduce your profits, and therefore cut your corporation tax bill. At 19% corporation tax, for example, every £1,000 you pay into your pension will reduce your company’s corporation tax bill by £190. Plus, employers don’t have to pay NICs on pension contributions, which can save money compared to paying a salary.
Unlike personal contributions to a pension, the amount you can pay into your pension from a limited company isn’t directly tied to your income. Instead, contributions up to the £60,000 annual allowance can benefit from tax relief (2025/26), while contributions above this are hit by the annual allowance tax charge. This means that even if you’re taking a small salary from your company, you might be able to pay a larger amount into your pension via employer contributions.
It’s worth noting that contributions are subject to the ‘wholly and exclusively for the purpose of the trade or profession’ test. This means they must be at a reasonable level. While most contributions aren’t challenged by HMRC, there’s a chance they could be questioned if they’re deemed excessive.
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Profiting from dividends
Dividends are a winner because dividend tax rates are lower than Income Tax rates, and you don’t have to pay any NICs on them, either as an employer or an employee. The limitation is that dividends are a share of after-tax profits - which means you can’t take dividends if your business is making a loss. You’ll also have to jump through the hoops of recording and declaring dividends, even if you’re the only shareholder.
Previously, company directors could withdraw up to £10,000 in dividends tax-free, to add on top of the standard personal allowance. However, after repeated cuts to the dividend allowance, only the first £500 a year in dividends is tax-free since 6 April 2024. This means that nowadays you could potentially only earn up to £13,070 a year without paying any Income Tax or dividend tax. Above £500 in dividends, you’ll pay dividend tax depending on your Income Tax band.
Dividend Tax Rates 2025/26
Flexibility as a limited company
One of the other advantages with a limited company is that you can choose how much money to take out. You might, for example, leave some profits inside the company if taking higher dividends would push you into a higher Income Tax bracket.
At the other extreme, you might choose to take the tax hit on drawing higher dividends plus salary, to improve your chances of getting a mortgage.
As a sole trader, all your profits get added up for Income Tax purposes, and you can’t do much about the resulting tax bill other than upping your pension contributions or giving money to charity.
Sole trader vs limited company: what’s the tipping point?
Becoming a limited company had already become less attractive from a tax perspective in recent years. This was due to corporation and dividend tax rates ticking up, and the tax-free dividend allowance going down. From April 2025, the increase in the rate of employer NICs, and the decrease in the threshold when employers have to start paying them, adds extra expense if you’re the sole director and employee, and therefore can’t claim the Employment Allowance.
In 2025/26, you only pay less tax as a limited company once:
- profits pass beyond the point where sole traders get hit by higher rate Income Tax;
- you’re earning over £50,000; and
- you’re the sole employee and director of the company and take a £12,570 annual salary with the balance as dividends.
With higher profits, you might even be better off financially as a sole trader.
However, the difference isn’t big. If you can afford to take some of the compensation from your company as pension contributions, rather than dividends, the limited company can become more attractive financially.
In practice, the best option for you will depend on your specific circumstances, including:
- any income you might have on top of your business;
- how much you want to pay into a pension; and
- whether you wish to protect yourself from liability if your business fails.
Personally, the big relief for me is that although I definitely could have reduced my taxes as a limited company in the past, I haven’t missed out on massive amounts by staying as a sole trader. Given recent tax changes, I’m glad I don’t have to wrestle with the time, trouble and expense of running a limited company. Especially now that Companies House has greater powers to give financial penalties on registered companies who don’t meet their legal requirements, such as filing documents accurately and on time.
If you’d like to run your own figures, try searching online for a tax calculator to compare being a sole trader to a limited company, or consult an accountant.
Faith Archer is a Personal Finance Journalist and Money Blogger at Much More With Less. Check out Faith and Lynn’s videos about spending during lockdown and after lockdown.
Risk warning
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.
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