It’s very likely your status as a taxpayer will change several times throughout your working life. As an employee, having tax deducted at source through PAYE makes your tax affairs relatively straightforward. But when your entrepreneurial spirit drives you to set out on your own, and you become responsible for reporting income and paying tax yourself, things become a little more complex.
Depending on whether you decide to operate your business as a sole trader, a partnership, or a limited company, the way your tax is calculated, how you pay it and when it’s due for payment will be different. And as your business evolves, you may well opt to move between models to suit your changing needs and optimise your tax efficiency.
Over the next few months, we’re going to look at the essentials of how tax works in different business models. In this blog, we start by considering tax from the perspective of a sole trader.
Sole Trader: Overview
Establishing yourself as a self-employed sole trader is the most straightforward route to setting up a business. If you do choose this option, you’ll be in good company. The number of sole traders in the UK has dropped during the pandemic, but it’s still the most popular option for running a business. Self-employment peaked at over five million at the start of 2020, and as of November 2021, there were just over 4.2 million self-employed workers in the UK (source Statista).
Getting started as a sole trader involves little paperwork. Once you’ve decided on your trading name and registered with HMRC to pay your tax through Self Assessment, you can start to trade.
When you operate as a sole trader, the crucial thing to be aware of is that you and your business are one and the same: this means you can keep all the profits your business makes after you’ve paid tax on them. But it also means you’re personally responsible for any losses your business makes.
How do you remunerate yourself?
You can pay yourself by taking any money you need to live on from your business account as ‘drawings’. It’s not a legal requirement to have a separate bank account for your business, but it’s good practice and will help to keep your business and personal finances from becoming entangled. It will also help to simplify your record-keeping.
It’s essential to be clear about the distinction between the money you take as drawings and the profit the business makes. How much you choose to take as personal drawings will have no bearing on your tax liability – your tax bill will be calculated on the amount of profit your business makes.
How is your tax bill calculated?
As a sole trader, you have to pay tax on any profit you make, i.e., the difference between your sales revenue and any costs you incur in making those sales. As already noted, you and the business are one and the same, so any profit the business makes is, for tax purposes, the equivalent of your salary.
Your Annual Allowance qualifies you to earn £12,750 tax-free. Profits between £12,750 and £50k will be taxed at 20%, and the higher rate of 40% will apply to any profits between £50k and £150k.
How & when do you pay your tax?
If you’re self-employed, you must complete and return an online Self-Assessment tax return to HMRC by midnight on 31st January following the end of the tax year – also the date by which you’ll have to settle your tax bill.
From our extensive experience working with start-ups, we know certain aspects of tax often catch out those new to self-employment.
- The time between starting up & paying your first tax bill
As a sole trader, your first tax bill will be due for payment at the end of the January following the tax year to which it relates. Depending on exactly when you start to trade then, it could be well over a year before your first tax bill is due. For example, a sole trader starting up in April 2021 won’t have to pay tax on their first year’s profit until January 2023 – a full 22 months later. The long time lag can lead to problems for sole traders who fail to set aside adequate funds to cover any accruing tax.
- National Insurance:
Something else that can come as a surprise to a new sole trader is having to calculate and pay their National Insurance (NI) contributions as part of their annual Self Assessment tax return.
When you’re self-employed, you’re subject to two types of NI: Class 2 and Class 4. If your annual profits are £6,515 or more, you’ll pay a flat rate of £3.05 a week for Class 2 NI. How much Class 4 NI you pay will depend on your profit – rates are currently 9% on profits between £9,569 and £50,270 and 2% on profits over £50,270. Note that this means Class 4 NI kicks in before Income Tax on profits which starts at £12,570.
All rates of NI are due to increase by 1.25% from April.
- Payments on account
For anyone new to self-employment, payments on account can be an especially confusing area. In a nutshell, if your tax bill is more than £1k, HMRC will require you to make two ‘payments on account’ – each equivalent to half your tax bill. The first instalment will be due by 31st January, the second by 31st July. In other words, in January, HMRC will require you to pay not only for the previous tax year but also make a 50% contribution to the current tax year as well – something that can come as a shock to a sole trader who’s not expecting to have to make additional payments.
In calculating payments on account, HMRC anticipates you will earn exactly the same amount of money in the current tax year as you did in the last. In reality, of course, this is unlikely to be the case.
If your profits are on a downward trend, you can apply to HMRC to have your second payment on account lowered or even cancelled. But on the flip side, if your business is doing better than it did in the previous year, there will be a shortfall of tax, and you’ll need to make up the difference in the following January.
It’s vital to remember your tax details are only updated when you file your Self Assessment return. So although your online record may show you as owing no tax, this won’t be an accurate reflection of your position if you’re trading is up year on year. For this reason, you should use accounting software that calculates your liability on an ongoing basis and put money aside for your tax bill.
What expenses can you deduct from your income?
Sole traders can reduce their tax liability by setting some of their running costs against profits. Allowable expenses include – but are not limited to – costs associated with running an office, travel, staff, stock and materials, marketing and advertising.
If you run your business from home, you are entitled to claim tax relief on a proportion of your expenditure for outgoings like heating, electricity, water, home insurance and council tax. The amount you can claim will depend on how much time you spend working at home and whether the space you use is a shared room such as a kitchen or dining room or is used exclusively for your business.
If your business involves high start-up costs and (like many people), you’re leaving salaried employment, setting up as a sole trader can present an opportunity to reclaim tax you’ve previously paid. Recovering tax paid in this way can provide a welcome cash flow boost to help kickstart your new business.
What records do you need to keep?
When you run your own business, you’re required by law to securely retain financial records in case HMRC should decide to take a closer look at your affairs. If you’re a sole trader, you must retain your financial records for at least five years beyond your next tax filing deadline.
Do you need help concerning tax and being self-employed? Whether you’re an established sole trader, newly set up, or about to start out in business and wondering if self-employment is the right model for you, Inca can help.
Specialising in working with small businesses – including many sole traders, we can advise on anything tax, finance or accounts related. We help our clients survive and thrive by providing all the tools, support and advice they need. It’s a proven formula that improves the odds of an Inca client reaching their 5th anniversary by 185% compared to the national average!