Why don’t IT contractors set up as sole traders?

it contractor sole trader

The most popular way to start a business in the UK is as a sole trader. In fact, according to the latest Department of BIS data, at the start of 2024, there were 3.1 million sole trader ships compared to 2.1 million limited companies.

So why do IT contractors avoid the sole trader route and work through their own limited companies or umbrella providers?

So, what is a sole trader?

The easiest way to set up a business in the UK is as a sole trader (or as a member of a partnership).

After informing the HMRC that you have become self-employed, you can start trading without the constraints associated with running a limited company.

However, as a sole trader, your liability if things go wrong is unlimited (unlike the limited company route), and your personal and business finances are treated as one for tax and liability purposes.

Why won’t agencies deal with sole traders?

Even if you wanted to set up as a sole trader, you would be unlikely to find a recruitment agency that would be prepared to do business with you.

You can become a PAYE agency employee or work via an umbrella or limited company.

Although you are legally entitled to work as a sole trader, you would probably only be able to work directly for clients who were happy to engage you on that basis.

Here are the key reasons why this is the case:

The Income Tax (Earnings and Pensions) Act 2003 – Chapter 7

The Income Tax (Earnings and Pensions) Act 2003 (and related legislation) does not allow ‘self-employment’ in this situation, as the recruiter would be obliged to make the contractor an employee, with the associated taxation and employment burden this would place on the agency.

Chapter 7, Section 44 of the Act states:

all remuneration receivable under or in consequence of the agency contract (including remuneration which the client pays or provides in relation to the services) is to be treated for income tax purposes as earnings from that employment.

This legislation could make the recruiter (or end client) liable if a self-employed contractor defaults on his or her tax obligations to HMRC.

IR35 doesn’t apply to sole traders, but employment status is still a concern

Introduced to tackle “disguised employment,” the IR35 and Off Payroll rules require businesses and agencies to determine whether a contractor is genuinely self-employed or operating as a “deemed employee.”

If you are a sole trader, there is no intermediary between you and the client, so IR35 doesn’t apply.

However, the concept of employment status is still a concern.

Employment status is significant if you’re working through a recruitment agency, as it may obscure the distinction between self-employment and employment – it could also invoke agency legislation.

If HMRC investigates and finds that a sole trader is really behaving like a hidden employee, the client could incur substantial tax and National Insurance back taxes plus penalties.

Most agencies and clients are unwilling to take on this additional risk. In fact, many will only take on umbrella company contractors – at the expense of even limited company workers.

Other reasons why being a sole trader isn’t a good idea for contractors

Even if you want to embrace the sole trader route, for the ‘hassle-free’ way you can start working, and agencies would hire you, there are several other key reasons why it’s not a suitable trading structure for professional contractors.

Limited liability protects your personal assets

As a limited company contractor director, you have limited liability for company debts if things go wrong. In contrast, the sole trader’s personal assets can be seized if the business owes money.

Tax benefits remain despite a narrowing tax gap in recent years

The tax gap between the take home pay of limited company directors and sole traders has narrowed significantly in recent years, due to steep hikes in corporation and dividend taxes.

However, distinct tax advantages remain if you go down the limited route.

You can split shares with your spouse to maximise each personal allowance and enjoy tax planning opportunities unavailable to employees or sole traders.

Summing up

As you can see, contracting as a sole trader is rare for many statutory and practical reasons. Try these guides to weigh up the benefits of working via your own company vs. using an umbrella provider.

Working via an agency (as PAYE) vs. using an umbrella company

Limited vs. umbrella company – the pros and cons for contractors

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