You may have heard that sole traders have unlimited liability, but what does that actually mean” And how does that affect how a sole trader operates” In this article, we’ll uncover exactly what unlimited liability is and how it applies to sole traders, helping you to make informed decisions about the structure of your own business.
What is liability, anyway?
Liability refers to the amount that a business owes at any one time. This responsibility for these debts can fall on either the company itself or its business owners, depending on the structure of the business and where liability lies in that business structure.
Read on to learn everything you need to know about sole traders and unlimited liability.
What is a sole trader?
A sole trader is a self-employed individual who is responsible for the running of their own business. The business doesn’t have any legal identity separate to its owner, so the self-employed person and the business are legally the same thing.
Sole traders retain full control of their business. This means that any profits made as a sole trader are your own – you don’t need to seek permission from anyone to withdraw money from your business. However, this also means that sole traders have unlimited liability.
Many different types of business act as a sole trader. It is the most popular business model amongst tradesmen including plumbers, electricians and hairdressers, who work in their own right rather than being part of a wider company. However, you’ll also find many shops, consultants and manufacturers that are registered as sole traders.
What does it mean to have unlimited liability as a sole trader?
Sole traders have unlimited liability. This means that unlike the owners of a limited company, a sole trader is personally liable for their business’ debts. This is because the sole trader is their business, rather than the business having any legal identity in its own right.
This means that if creditors can’t be paid by a business, the sole trader is personally responsible, and their personal assets may be at risk. The sole trader has full responsibility for both the success and failure of the business.
What happens if a sole trader goes bust?
A sole trader is personally responsible for any debts that their business incurs. This means that if a business runs out of money, it is the sole trader that is held responsible for any debts owed.
The sole trader will need to pay any creditors who are owed. If they are unable to pay, they may be at risk of personal bankruptcy as a result. For this reason, it’s vital that sole traders remain on top of their business finances, avoiding the risk of becoming insolvent.
Limited liability vs unlimited liability: What’s the difference
We’ve already discussed how unlimited liability leaves a sole trader personally responsible for any debts that their business incurs. So, how does that compare to companies with limited liability, such as LLCs and PLCs?
Limited liability means that a business owner is only responsible for business debts up to the value of their investment. Therefore, a creditor is only able to take assets or finance which belongs to the company.
This provides a level of protection to business owners, as only the investment in the company can be lost. This means that the business owner cannot be declared bankrupt as a result of their company’s insolvency.
For example, Sara invested £20,000 into a limited company and owns 100% of the shares. If that company then goes £50,000 into debt, Sara would only lose her original £20,000 investment. Her personal finances and possessions would be protected as the debt is registered against the company rather than the business owner.
In comparison, a sole trader with unlimited liability faces a greater amount of risk. If their business goes into debt, the sole trader is personally responsible for the whole of the debt, putting their personal finances at risk.
If Sara was a sole trader and her business went £50,000 into debt, she wouldn’t just lose her £20,000 investment. She would also be responsible for paying the business’ debt using her personal finances and assets. If she couldn’t pay the debt, she would risk being forced to declare bankruptcy.
So, should you register as a company to limit your liability?
One of the biggest advantages of registering as a limited company is that your liability is limited. This means that your business is responsible for any debts, rather than the business owner. However, it’s important to weigh up all of the pros and cons of incorporating before making the right decision for your business.
Pros of incorporating
- A limited company is regarded as a separate legal entity, meaning that liability is limited. This means that you only stand to lose what you put into the company.
- Corporation tax is a lower rate than income tax, meaning that limited companies are usually more tax efficient than sole traders.
- Registering a company name means that no one else can use it. Sole traders do not benefit from this protection.
Cons of incorporating
- There are fees involved with incorporating, in comparison to registering as a sole trader for free.
- Limited companies have additional responsibilities. This includes filing a yearly annual return and keeping annual accounts.
- Company information is available freely on Companies House, meaning that details of directors and the company’s earnings are displayed publicly, reducing levels of privacy.
Pros and cons of being a sole trader
Although sole traders have unlimited liability, it is still the most popular business model in the UK, with 59% of businesses classified as sole traders. Here are some of the key advantages and disadvantages of trading as a sole trader.
Advantages of acting as a sole trader
- Quick and easy to set up as a sole trader.
- You can make own decisions without having to gain approval.
- Minimal paperwork required, other than an annual self-assessment tax return.
- Profits earnt by the business are your own, so you can withdraw money from your business at any time.
- Financial documents are not publicly available so you benefit from increased privacy.
Disadvantages of acting as a sole trader
- High level of responsibility as the business is in your name and you are legally responsible.
- Not regarded as a separate legal entity in UK law, meaning that liability is unlimited. This means that if the business gets into debt, the business owner is personally liable.
- It can be difficult to raise finance without the backing of a limited company, meaning that expansion opportunities are limited.
- Tax rates may become unfavourable as your income increases.
Unlimited liability vs limited liability
Many people opt for a limited liability business structure, as they feel safer in the knowledge that they have a layer of protection to keep their personal finances safe.
When you register as a limited company, a separate legal entity is created for your company, meaning that your personal bank accounts become separate to that of the company. Not only that, but the business’ assets and liabilities also become separate.
This is appealing to business owners who want to minimise their levels of risk and keep their personal finances completely separate to their business.
Unlimited liability means that the business owner is legally the same as their business; the business cannot exist in its own right. This means that the business owner or partners have responsibility for any debts if the business fails. This also means that business owners will be responsible for any legal proceedings, rather than the business.
If a business which is trading as a sole trader becomes insolvent, responsibility for any debts falls to the business owner. This means that their personal assets and finances could be at risk.
The decision of whether to register as a sole trader or a limited company is a personal choice which must be based on individual circumstances. It’s not just liability that should be considered, but also the wider circumstances of the business owner and the business itself.
If you’re unsure of whether you should begin a business as a sole trader or register as a limited company, it’s best to consult an accountant who will be able to talk you through your options.
Can a sole trader have two owners?
A company trading as a sole proprietorship has one business owner who is self employed. They are able to employ other members of staff – they don’t have to work alone. However, there can only be one business owner in a sole proprietorship. If a business has two owners, it becomes a partnership. A partnership still has unlimited liability but this liability is split between two or more business owners who form the partnership.
Is a self employed person a sole trader?
The majority of self-employed people in the UK are trading as sole traders. In fact, 59% of UK businesses are registered as sole proprietorships. However, you can also be a self-employed business owner of a limited company or a partnership, so not every self-employed person in the UK can be called a sole trader.
Can you sue a sole trader?
It is perfectly possible to sue a sole trader. In a sole proprietorship, the business owner holds liability for the business. This means that any debts or legal action fall directly onto their shoulders, rather than the business itself, so when you sue a sole proprietorship, you’re actually suing the business owner directly.
Does unlimited liability mean unlimited risks?
There are both benefits and risks of becoming a sole trader. This type of business comes with unlimited liability, meaning that the business owner is responsible for any debts or legal proceedings against the company.
However, sole proprietorship remains a popular business model in the UK, with around 59% of businesses currently registered as sole traders. This is a testament to the vast benefits that come with being a sole trader, such as the ability to withdraw profits from the business at any time and simplified accounting.
Ultimately, the choice of whether to trade as a sole trader or limited company is down to the circumstances of the individual business and its owners. It’s always a good idea to consult with an accountant before making a final decision.