What liability does a sole trader have?

When starting a business, you’ll have to choose a structure to work within. A sole trader is a straightforward business structure, and that’s likely why it’s one of the most popular types of business in the UK. 

But when it comes to business finances, what type of liability does a sole trader have? This article will look at liability and the different financial obligations for both sole traders and limited companies by looking at the following areas:

• What is liability?
• What liability does a sole trader have?
• What liability do limited companies have?

Liability in business often refers to the cash amount that a company owes. This debt could be money owed to suppliers, lenders, or banks. You’ll most likely see this term on your business balance sheet when adding up your assets and liabilities to understand the financial health of your business.

However, liability can also mean responsibility for the debt. Who is liable for debt depends on the business structure, and the liability can fall on the business owner(s) or the company itself. So let’s look at how it applies to different business structures.

So a sole trader is an individual who is self-employed and is responsible for running the business. Sometimes partnerships can also be set up as sole traders, and in this case, two people will be responsible for the finances and running of the business. 

When a business is set up as a sole trader company, the firm does not have a legal identity separate from the owner. The owner is the business in the eyes of financial law.

This means the sole traders can have complete control of the business and manage how to spend the profits they’ve made. In addition, this control means that the sole trader has unlimited liability.

Unlimited liability means that a sole trader is personally liable (responsible) for any debts the business builds up. The company and the owner are not separate entities financially, so there is no limit to the amount of debt that the owner is responsible for paying back if the business was to fail and be unable to pay what it owes.

So if the business is unable to pay its creditors, lenders or banks, then the sole trader is personally responsible for paying them back. To do this, first, the business assets would be sold off, such as cash, equipment, furniture or vehicles. Then, if there is still debt left after this, the sole trader will risk their personal assets such as savings, cars or their home being seized to pay off the remaining balance owed. In the case of a partnership, both parties would be liable to pay the remainder of the debt with their personal assets.

The risk of unlimited liability means that the sole trader is solely responsible for both the success and any failure of the business.

Limited companies are set up so that the business’s finances are a completely separate entity from the owner’s personal finances. This means if the company had to be liquidated, you’d lose the value of your share in the business, but limited liability would protect your personal assets from being seized to pay the business debt. 

Limited liability is a protection afforded to limited companies, where the investors are only liable (responsible) for what they put into the business. Their personal assets would be protected from being seized if the business cannot pay the debt.

Larger businesses are almost always set up with limited liability as this allows them to attract investors who have less responsibility, so investing is less of a risk to them. Since investors are often unwilling to risk their personal money as well as their initial investment amount, sole traders with unlimited liability may find it hard to gain independent investors.

If a business were to fail, then the owner or owners would only be responsible for a limited amount of the business’s debt. In addition, each shareholder (owner) would be limited to losing up to their original investment value, so they would not have to risk their personal finances being seized to repay the company’s debt.

For example, let’s say you start your own limited company and put £15,000 into getting things off the ground. You may also have other investors, who put in smaller amounts such as £5,000 or £2,000 and end up being part-owners of the business too.

If the business were to fail later down the line and ended up being £30,000 in debt, you would be liable for your original £15,000 investment, and the other owners would lose their £5,000 and £2,000 contributions. However, the limited liability structure protects your personal money, so instead of going after your finances, the business assets would be seized or liquidised to pay off the remaining £8,000 debt. 

If you do not have enough assets, the company will be liquidated if it cannot pay its remaining debts. The company would cease trading, and your authority as a director would be nullified and taken over by an insolvency practitioner who would manage the liquidation. Any businesses your company owed can then go through a court process to be paid.

Now that you understand the difference between the types of liability that different business structures can have, you can decide what sort of structure you should set up. Of course, you can change between structures, too, such as moving from sole trader to limited company later in your business journey. If you are starting to set up your business and thinking about limited liability, you could talk to an accountant to decide which business structure would work best for you.

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Countingup is the business current account and accounting software in one app. It can provide real-time profit and loss statements, as well as tax estimates and expense categorisation. With instant invoicing and automated bookkeeping features, it saves thousands of business owners across the UK hours of time-consuming admin so that they can focus on creating a successful business. Find out more here.