Business and organisational characteristics - Sole trader

Learning Outcomes

This article explains the sole trader business structure, including:

• The defining legal and commercial characteristics of a sole trader business, and how they differ from partnerships and companies.
• The scope and consequences of unlimited personal liability, including exposure of personal assets, bankruptcy risk, and practical risk management strategies.
• Key steps in formation and day-to-day administration, such as HMRC registration for Self Assessment and National Insurance, basic record-keeping, and when VAT registration is required.
• Core tax principles for sole traders, including profit calculation, allowable expenses, capital allowances, loss relief options, and National Insurance contributions.
• Regulatory and compliance obligations typically examined in SQE1, such as business names and trading disclosures, data protection basics, employer duties, and insurance requirements.
• The main advantages and disadvantages of operating as a sole trader, focusing on control, privacy, simplicity, continuity, and risk profile compared with incorporated business forms.
• Rules affecting business names, trading disclosures on documents and websites, and the impact of record-keeping and Making Tax Digital on compliance.
• Typical financing options available to sole traders, their limitations (including the inability to issue shares or grant floating charges), and how these influence decisions about future incorporation.

SQE1 Syllabus

For SQE1, you are required to understand the nature of different business mediums, including their setup, regulation, and key legal implications, as they apply to sole traders, with a focus on the following syllabus points:

• Business and organisational characteristics (sole trader)
• Legal personality and limited liability (specifically, the lack thereof for sole traders)
• Procedures and documentation required to form a business (specifically, the minimal requirements for sole traders)
• Taxation implications for the business owner (Income Tax and National Insurance for sole traders)
• VAT basics for unincorporated businesses (registration threshold, output and input tax)
• Insolvency outcomes for individuals (bankruptcy) contrasted with corporate insolvency
• Practical compliance (business names and disclosures, basic data protection, employer duties) relevant to unincorporated businesses

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following statements regarding the liability of a sole trader is correct?
   1. The sole trader's liability is limited to the capital invested in the business.
   2. The sole trader benefits from separate legal personality, protecting personal assets.
   3. The sole trader has unlimited personal liability for all business debts.
   4. Business creditors can only claim against the business assets, not personal assets.
2. What registration is mandatory for an individual starting a business as a sole trader in the UK?
   1. Registration at Companies House.
   2. Registration for Corporation Tax with HMRC.
   3. Registration for Self Assessment with HMRC.
   4. Registration with the local council only.

3. True or False: A sole trader business continues to exist legally after the owner's death.

Introduction

A sole trader represents the simplest form of business organisation available in England and Wales. It involves an individual carrying on business on their own account, without the need to create a separate legal structure like a company or a partnership. This structure is prevalent among small businesses, freelancers, and professionals operating independently. While “sole” refers to ownership, a sole trader may employ staff; what distinguishes the structure is the absence of incorporation and the absence of any separate legal personality.

Key Term: Unincorporated business
A business structure that does not have a legal identity separate from its owner(s). The owner(s) and the business are treated as one entity in law.

Sole traders enjoy flexibility, low start-up and administrative costs, and privacy. However, the trade-off is unlimited personal liability and limited options for raising external finance. If the owner retires, dies, or becomes incapable of managing the business, the business does not continue as a separate legal person; its assets and obligations remain those of the individual.

Key Term: Sole trader
An individual who owns and runs an unincorporated business by themselves. They are personally responsible for the business's debts and keep all the profits after tax.

Key Characteristics

The defining feature of a sole trader is the absence of legal distinction between the business and the individual owner.

Key Term: Separate legal personality
A concept whereby an entity is recognised in law as a person distinct from its owners/managers. Sole traders do not have separate legal personality.

This means the individual is the business. All business assets are owned personally by the individual, and all business contracts are entered into by the individual in their personal capacity. The sole trader sues and is sued in their own name; the business has no separate standing to litigate or hold property. There is no concept of “perpetual succession” for a sole trader, so continuity depends entirely on the owner.

In practice:

• Contracts, leases, and finance agreements are made by the individual, even if they use a trading name.
• The owner is entitled to all profits (after tax) and bears all losses.
• The business can hire employees, but the employer in law is the individual sole trader.
• Any goodwill or other business assets are personal assets; they can be sold or transferred, but there is no transfer of a separate business entity distinct from the person.

Key Term: Trading name
A name under which a sole trader carries on business that is different from their personal name. It does not create a separate legal entity.

Liability

The most significant legal consequence of the sole trader structure is the owner's liability exposure.

Key Term: Unlimited liability
The owner is personally responsible for all business debts and obligations without limit. Personal assets are at risk if the business cannot meet its liabilities.

Unlike shareholders in a limited company, a sole trader's personal assets (e.g., house, car, personal savings) can be claimed by business creditors to satisfy outstanding business debts. If the business fails and incurs significant debt, the owner could face personal bankruptcy. Business risk management, including appropriate insurance (e.g., public liability, professional indemnity for regulated professions) and prudent contracting, is therefore important. Where employees are engaged, employers’ liability insurance is compulsory.

Key Term: Bankruptcy
A court-based insolvency process for individuals who cannot pay their debts. It can be initiated by the debtor or by a creditor petition and affects all personal assets (subject to statutory exemptions).

Worked Example 1.1

Sarah runs a small bakery as a sole trader. The business struggles and accumulates £20,000 in unpaid supplier invoices. The bakery's assets are only worth £5,000. Can the suppliers pursue Sarah personally for the shortfall?

Answer:
Yes. As a sole trader, Sarah has unlimited liability. The suppliers can legally pursue her personal assets, such as her savings or potentially her home (subject to certain protections), to recover the remaining £15,000 owed.

Formation and Administration

Setting up as a sole trader is straightforward, with minimal legal formalities. There is no incorporation process or registration at Companies House and no constitution to draft.

Registration Requirements

No registration is required at Companies House. The primary administrative step is registration with His Majesty’s Revenue & Customs (HMRC) as self-employed for Income Tax (Self Assessment) and National Insurance purposes. Registration should be completed promptly after commencing trade to avoid penalties. HMRC typically requires registration by 5 October following the end of the tax year in which self-employment began. On registration, HMRC will issue a Unique Taxpayer Reference (UTR).

Key Term: HMRC
His Majesty's Revenue and Customs is the UK's tax, payments, and customs authority.

Key Term: Self Assessment
The UK system under which individuals (including sole traders) report their income and gains to HMRC and pay the tax due, usually via an annual tax return.

Sole traders file an annual Self Assessment tax return (online deadline 31 January following the end of the tax year; paper returns have an earlier 31 October deadline). Balancing tax and the first payment on account are due by 31 January; the second payment on account is due by 31 July. Depending on turnover, registration for Value Added Tax (VAT) may also be necessary or beneficial.

Business Names

A sole trader can operate under their own name or choose a trading name. If using a trading name, restrictions apply (e.g., certain sensitive words require consent, and a name must not falsely imply corporate status or government connection). Regulations require trading disclosures: business documents, invoices, and websites must state the proprietor’s name and an address for service. If a sole trader trades from premises, the proprietor’s name and address for service must be displayed at the place of business. Using “limited”, “ltd”, “plc”, or similar terms in a way that suggests incorporation is prohibited.

Record Keeping

Sole traders must maintain accurate records of all business income and expenditure for tax purposes and keep these records for the statutory retention period (generally at least five years after the 31 January filing deadline). VAT-registered traders must keep digital records and submit VAT returns using Making Tax Digital (MTD)-compatible software. MTD for Income Tax Self Assessment is being phased in; keep abreast of current implementation dates and thresholds.

Other Common Compliance Points

• Licensing and local registration: some activities (e.g., food businesses, alcohol sales, taxi services) require specific licences or registrations with local authorities.
• Data protection: if processing personal data, comply with UK GDPR and the Data Protection Act 2018 and, where required, pay the ICO data protection fee.
• Employing staff: if hiring employees, register as an employer with HMRC, operate PAYE, withhold Income Tax and employee NICs, pay employer NICs, comply with auto-enrolment pension duties, and hold employers’ liability insurance.

Financial Aspects

Taxation

Sole traders pay Income Tax on trading profits through Self Assessment. Profits are computed by deducting allowable expenses (incurred wholly and exclusively for the trade) and capital allowances (e.g., the Annual Investment Allowance for qualifying plant and machinery) from trading receipts. From the tax year basis reforms, profits are assessed on a tax-year basis; transitional rules applied to align accounting dates where necessary.

Losses from the trade can attract reliefs (subject to conditions and caps), including:

• Sideways relief against general income of the same or previous tax year
• Early years loss relief (carry-back against prior years’ total income for new trades)
• Carry-forward against future profits of the same trade
• Terminal loss relief (carry-back on cessation)

Relief availability and ordering are subject to statutory conditions and anti-avoidance limits; always consider current HMRC guidance.

Key Term: National Insurance contributions (NICs)
Payments that fund certain state benefits. Self-employed people primarily pay Class 4 NICs on profits; voluntary Class 2 NICs may be paid to protect entitlement to contributory benefits.

Historically, self-employed individuals paid Class 2 and Class 4 NICs. From April 2024, most self-employed no longer pay Class 2 NICs (though voluntary Class 2 remains available to maintain benefits record); Class 4 NICs continue to apply at graded rates based on profit bands. Check current thresholds and rates each tax year.

Key Term: VAT
A tax on supplies of goods and services. VAT-registered businesses charge VAT (output tax) and may reclaim VAT they incur (input tax), paying the net amount to HMRC.

Sole traders must register for VAT when taxable turnover in a rolling 12-month period exceeds the registration threshold (currently £90,000). Voluntary registration is possible below the threshold, which allows input tax recovery but requires charging VAT to customers. Some supplies are zero-rated (rate 0% but input tax recoverable) and some are exempt (no VAT is chargeable, and input tax is generally not recoverable). VAT is normally accounted for quarterly; penalties and interest can apply for late filing or payment.

Worked Example 1.2

Alex, a self-employed graphic designer, invoices £8,500 per month for eight consecutive months and expects similar billings next quarter. Must Alex register for VAT now?

Answer:
Yes, if Alex’s rolling 12-month taxable turnover will exceed the VAT threshold (currently £90,000). At £8,500 per month, turnover will exceed £90,000 within 11 months, triggering mandatory registration. Alex must monitor rolling turnover and register with HMRC when the threshold is exceeded or is expected to be exceeded in the next 30 days.

Worked Example 1.3

Nadia starts trading as a sole trader in June. In year 1 she makes a trading loss of £12,000. What reliefs may be available?

Answer:
Nadia may claim early years loss relief (carry-back) to set the loss against total income of the three preceding tax years (starting with the earliest), or claim sideways relief against general income of the current or previous tax year, or carry the loss forward against future profits of the same trade. The best route depends on her other income and marginal tax rates, and the availability of relief is subject to statutory limits.

Raising Finance

Accessing finance can be challenging for sole traders. They cannot issue shares like companies and have no separate equity base. Funding typically comes from personal savings or personal borrowing. Banks often perceive lending to sole traders as higher risk and may require personal guarantees (which in this context confirm personal liability that already exists) or security over personal assets (e.g., a legal charge over a home or other property). The lack of a separate legal entity can restrict growth compared to incorporation or partnership.

Sole traders can grant fixed charges or mortgages over specific assets (e.g., land or equipment). However, they cannot grant floating charges; floating security is available only to companies and LLPs. Fixed charges over land must be registered at HM Land Registry to ensure priority and enforceability.

Worked Example 1.4

Ravi seeks a bank loan to expand his unincorporated retail business. The bank asks for a floating charge over his inventory and receivables. Can Ravi grant this security as a sole trader?

Answer:
No. Only companies and LLPs can grant floating charges. As a sole trader, Ravi may grant fixed security over specific assets (for example, a legal mortgage over his shop premises or a fixed charge over equipment), but not a floating charge over circulating assets like stock or receivables.

Operational and Regulatory Considerations

• Employers’ liability insurance is compulsory if staff are employed (statutory minimum cover and certificate display requirements apply).
• Consumer-facing sole traders must comply with consumer protection law. The Consumer Rights Act 2015 applies to contracts between traders and consumers and restricts or prohibits exclusion of certain statutory terms regarding goods and services and unfair terms. Attempts to exclude liability for death or personal injury due to negligence are ineffective.
• Maintaining a dedicated business bank account is not legally required but strongly advisable to simplify record-keeping and tax compliance.
• Business continuity planning matters: consider powers of attorney for incapacity and instructions for personal representatives about winding up or selling the business on death.

Worked Example 1.5

Yasmin, a sole trader plumber, trades as “City Plumbing Solutions”. What disclosures are required on her invoices and website?

Answer:
As she trades under a name that is not her personal name, she must disclose the proprietor’s name (Yasmin’s full name) and an address for service on business documents (including invoices) and on her website. If she operates from premises, the same information must be displayed at the place of business.

Worked Example 1.6

Owen operates a café as a sole trader and hires three staff. What immediate legal obligations arise from employing them?

Answer:
Owen must register as an employer with HMRC, operate PAYE to deduct Income Tax and employee NICs from wages, pay employer NICs, comply with workplace pension auto-enrolment duties, issue written statements of employment particulars, ensure employers’ liability insurance is in place, and observe health and safety and working time rules.

Revision Tip

When advising a client on choosing a business structure, always balance the simplicity and privacy of the sole trader model against the significant risk posed by unlimited personal liability. Consider the nature of the business, its potential liabilities, expected turnover (and VAT impact), and the client’s attitude to risk and financing needs.

Advantages and Disadvantages

Additional considerations that often inform the choice:

• Regulatory overlay: activities may require licences or impose compliance burdens (e.g., food hygiene, data protection, employer duties).
• VAT competitiveness: voluntary VAT registration can allow input tax recovery but may increase prices to consumers.
• Financing strategy: inability to issue shares and to grant floating charges can constrain growth; incorporation or partnership might suit expansion.

Key Point Checklist

This article has covered the following key knowledge points:

• A sole trader is an individual running a business without creating a separate legal entity.
• There is no separate legal personality; the owner sues and is sued personally and owns all business assets.
• Unlimited personal liability exposes all personal assets to business creditors; insolvency for a sole trader is dealt with through bankruptcy.
• Formation is simple, requiring primarily registration with HMRC for tax via Self Assessment; no Companies House registration is needed.
• Sole traders are taxed on profits as individuals; capital allowances and loss reliefs apply, and Class 4 NICs are payable (with voluntary Class 2 potentially relevant to benefit entitlement).
• VAT registration is mandatory once taxable turnover exceeds the threshold (currently £90,000); voluntary registration is possible.
• Record-keeping is essential; VAT-registered traders must keep digital records and use MTD-compliant software.
• Sole traders cannot grant floating charges; security is limited to fixed charges/mortgages over specific assets.
• Employing staff triggers PAYE, NICs, auto‑enrolment pension, and insurance obligations.
• The structure offers complete control and privacy but lacks continuity and can make raising finance more difficult than for incorporated entities.

Key Terms and Concepts

• Unincorporated business
• Separate legal personality
• Sole trader
• Unlimited liability
• HMRC
• Self Assessment
• National Insurance contributions (NICs)
• VAT
• Bankruptcy
• Trading name