May 30, 2022

Freelancer, sole trader, contractor or employee: What are the pros and cons?

Written by Dinghy

The freelance insurance provider that helps freelancers build successful businesses

When you’re setting up solo, there’s a lot of new lingo to learn. Words that you previously took for granted that you understood – like freelancer – suddenly need to be backed up by the business know-how to understand the technical differences between different types of self-employment. Should I be a contractor or a freelancer? A sole trader or a limited company? Or should I just stick with being an employee? The way that your business is set up and registered can have a big impact on your earnings, taxes and reporting responsibilities. 

We’re here to help you find a way through the minefield – and understand the pros and cons of different types of business set-ups so you can get started on your freelancer journey.

This article does not constitute financial advice. To get advice tailored to your situation and circumstances you should consult a qualified accountant or financial adviser.

What is a sole trader?

A sole trader is probably the quickest and easiest way to set up as self-employed. In this model, you run your business as an individual. You are entitled to keep all profits (after tax), but you are also personally responsible for any losses made by the business. You can trade under your own name or create a name for your company. To register as a sole trader, you simply need to notify HMRC and let them know that you need to complete a Self-Assessment tax form.

Pros of being a sole trader:

  • Easy and quick to set up
  • Relatively little administration and simple accounting
  • Don’t have to worry about IR35 rules

Cons of being a sole trader:

  • Unlimited liability for losses – which could mean you lose your house or other personal assets to pay business debts
  • Usually less tax-efficient than being a limited company
  • Could be seen as less professional or official by clients

What is a contractor?

A limited company contractor sets up their own company and acts as the director. The business is a separate legal entity to the individual, which offers some protection from liability. Contractors usually work on fixed-term contracts for different clients. This can be more tax-efficient than being a sole trader because many contractors take a small salary from their business and then earn the rest in dividends. Limited companies must be incorporated by registering with Companies House and publish their accounts publicly each year, so they are a little more complex to set-up and run.

Pros of being a limited company contractor:

  • Business finances stay separate to your personal finances
  • Limited liability for losses – only up to the value of your initial investment in the business
  • Can be more tax-efficient

Cons of being a limited company contractor:

  • More complex to set-up
  • More onerous requirements of accounting/reporting
  • Taxes can be more complex
  • Bound by IR35 regulations which can affect tax savings

What is an employee?

When you’re an employee, you are under a contract to work for another business in exchange for money. It’s financially very simple, because your employer will pay you and deduct any tax and National Insurance owed through the PAYE (Pay As You Earn) system. Being an employee also brings you rights and protections that don’t apply to self-employment, like statutory sick pay and annual leave. However, you are likely to have little control over when you work and what jobs you have to do.

Pros of being an employee:

  • Have rights and benefits like annual leave
  • Secure hours and guaranteed wages

Cons of being an employee:

  • Far less freedom and flexibility
  • No tax relief
  • Have to negotiate salary and pay rises

What is a freelancer?

A freelancer is someone who works on a self-employed basis, offering their services to multiple clients at once. Often freelancers are paid per-job, per-day or work on very short term contracts. Freelancers have a high degree of autonomy over their working hours, workload and the jobs they decide to take on. Freelancers do need to register as self-employed for legal and tax purposes – and they can choose to set up either as a sole trader or as a limited company. Which one suits you better might depend on your finances, your industry, your projected takings and the type of clients you want to work with. If you’re unsure, discuss your business plans with an accountant or financial advisor to see what is the best option for you.

Pros of being a freelancer:

  • One of the most flexible ways of working
  • Can pick and choose the projects you find most interesting
  • Can mix different income streams
  • Can set up business in the way that works for you – sole trader or limited company

Cons of being a freelancer:

  • Income isn’t guaranteed and can be unstable
  • Not entitled to employee benefits like sick pay and annual leave

If you’re setting up as a freelancer, here’s a handy checklist of things to consider:

Do I want to set up as a sole trader or a limited company?

Newer freelancers with smaller takings may prefer the simplicity of being a sole trader – but if you are earning more, want more protection or are looking for the most tax-efficient solution, it may be worth the extra administration to set up as a limited company.

Does IR35 apply to me?

If you do decide to set up as a limited company, make sure you understand the IR35 rules and how they affect you.

Have I got a system in place for managing my accounts?

All self-employed people need to keep accounts of the business’s incomings and outgoings. For sole traders, these will need to be reported on your Self-Assessment tax return each year. Before you launch into trading, it’s a good idea to set up bookkeeping software or a spreadsheet to help you keep track of your earnings and business spending. As mentioned above, the accounting for a limited company can be more complex, so you might want to consider hiring an accountant to support you.

Have I sorted out business insurance?

Dinghy insurance looks after freelancers whether they are registered as a sole trader or running a limited company. You can choose from a range of policies to protect you and your business, including professional indemnity insurance, public liability insurance, business equipment insurance and cyber liability insurance. PI and PL insurance are often a contractual necessity for freelancers, and will help protect you against compensation claims and legal fees which might otherwise affect your personal finances if you’re a sole trader. We also include our unique Freelancer Assist service as standard with every policy purchased, which will give you support with legal issues, tax and help you chase unpaid invoices. Once you’ve decided how to set up your freelance business, you can get covered right away – and all our policies are pay-monthly with no hidden fees or charges. You can even dial down your cover if you’re on holiday or in between jobs. Get a quote now from our website.

About Dinghy

At Dinghy, our aim is to support existing freelancers and help more new freelancers build successful businesses. We do this with our specially designed freelancer insurance products, as well as sharing helpful articles like this one, full of useful tips and honest advice.

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