In legal terms, the sole trader operates as an individual. Business finances cannot be separated from personal finances insofar as the sole trader carries unlimited liability and is personally responsible for obligations incurred.
By definition, the sole trader is the single owner of the business. As such, he takes all income and incurs all obligations. The legal framework smiles on this method of operation - the small business does not have to be registered and until the annual turnover reaches over £300,000, it does not even have to be audited. Those whose turnover remains lower than £50,000 in any twelve months do not have to register for VAT (though it may be of advantage to do so), and income tax returns are submitted through the self-assessment system. Income tax is payable on net profit. National Insurance contributions (Class 2) are usually paid by direct debit, with profit-related (Class 4) contributions paid alongside the income tax duties payable on a twice-yearly basis.
The advantages of being a sole trader lie in the self-sufficiency and independence of the person being able to “do his own thing”.
One major advantage is flexibility. Subject to existing business commitments, the sole trader can often respond to market needs quickly and may provide a highly-committed personalised service. In this way, many sole traders prosper by expanding through referred leads and recommendations.
There are several disadvantages of operating as a sole trader. The person cannot spread risk very easily without taking more owners on board. One source estimates that about 75% of small businesses cease trading in the first four years.
It is quite difficult for the sole trader to raise capital. So many such businesses resort to private borrowings from family and friends. Banks are understandably reluctant to lend without security, so the sole trader may have to raise funds by offering security in the form of the private residence. Business failure can therefore have drastic consequences for the sole trader and his family. For start-up businesses, bank finance is often a non-starter, as banks usually like to see a track record established before risking their depositors funds.
The sole trader can rarely reap economies of scale, as most such businesses operate on a small scale. They therefore operate at a distinct disadvantage when buying in stock or negotiating on price.
Seasonality can be a problem. The best examples here are provided by those working in construction and other outdoor jobs, as well as those producing goods and services dependent on seasonal demand (such as ski instructors).
What does the sole trader do if he is ill for a prolonged period? Often, valuable business is lost and it may be difficult to refer contracts to other providers without losing business to them altogether. This problem is compounded by the high cost and limited availability of insurance for the self-employed.
Lastly, the sole trader may suffer concentration risk. It may be possible to build a thriving business on the back of a few good customers, but if these customers do not renew their contracts, turnover can fall drastically and even destroy the business. Nearly all sole traders are constrained by a measurable key factor , for example, a consultant charging out his services at £500 per day is likely to find difficulty in increasing income beyond 250 working days per year multiplied by the daily fee, especially if increasing the fee makes the service uncompetitive.