13.01 – Tackling Taxes for Different Business Types
The government treats sole traders, partnerships, and limited companies differently for tax purposes. Managing your tax position is an area where timely professional advice is essential, especially since tax rules can change every year. Good advice can help reduce your overall tax bill and increase the value of profits to your business.
Figuring Out Sole Traders And Partnerships
For tax purposes, a partnership is treated as a collection of sole traders, and each partner’s share of the collective liability must be calculated. If you’re a sole trader (self-employed), your income from all sources is combined, and the profit is taxed as a whole. Business income is one of the headings on your self-assessment tax return form.
In the UK, the key taxes to calculate are:
- Income tax on profits
- Class 4 NI on profits and Class 2 at a fixed rate per week
- Capital gains tax (on the disposal of fixed assets, such as property, or when the entire business is sold)
- Inheritance tax paid on death or certain gifts
Capital gains tax and inheritance tax are less likely to occur regularly and usually do not apply in the first few years of business. When these taxes do come into play, the sums involved can be significant, and professional advice should be sought.
Adding Up Income Tax
Under the self-assessment tax system in the UK, you pay taxes for your accounting year in the calendar year in which that accounting year ends. Special rules apply for the first and last year of trading to ensure tax is charged fairly.
Summarize your accounts to show turnover, gross profit, and expenses by account categories, such as vehicle running costs, advertising, telephone, and rent. If your turnover is less than £85,000 (current for 2021 to 2022), you can complete a Short Tax Return, declaring only four figures for your business: turnover, total allowable expenses, net profit, and annual Investment Allowance (capital purchases made).
As a sole trader or partnership, you can deduct a personal allowance amount from your profit figure, paying income tax on your profit minus your personal allowance. The personal allowance is the current threshold below which you don’t pay tax.
Calculating Classes 2 and 4 National Insurance
If you’re self-employed, expect to pay two types of National Insurance:
- Class 2: If your profits are £6,515 or more a year, at £3.05 per week.
- Class 4: If your profits are £9,569 or more a year. It starts at 9% on profits between £9,569 and £50,270, and 2% on profits over £50,270.
These rates and amounts change annually, but the broad principles remain the same. Visit the HM Revenue and Customs (HMRC) website for the latest NI contribution rates: HMRC NI Rates.
Looking at Levies on Companies
Companies have a legal identity separate from those who work in them. Everyone working in the business is taxed as an employee, and the company is responsible through the PAYE system for collecting and passing taxes to the authorities.
Directors’ salaries are a business expense, deducted from the company’s revenues in arriving at its taxable profits. Companies in the UK pay tax in three main ways:
- Corporation tax: Paid on the company’s profits for the year. The rate changes annually; in 2021, it was 19%. Check the latest rates: HMRC Corporation Tax.
- Dividend payment taxes: Levied on profit distribution to shareholders. This arrangement can appear to tax the same profit twice, but tax credits usually prevent this double taxation.
- Capital gains tax (CGT): Owed if a company sells an asset at a profit. This is taxed similarly to corporation tax, with lower rates for smaller companies.
There is a concession on CGT for business assets owned before December 2017 called Indexation, reducing taxable profit based on the duration of asset ownership. More details can be found at: HMRC Indexation Allowance Rates.
Assessing The Best Legal Structure
The primary rule is to never let tax considerations dictate your business structure. Tax is just one aspect of business life. If you prefer to keep your business finances private, the public filing of accounts required of companies might not suit you. However, if you want to protect your private assets from creditors, being a sole trader or partner may not be the best route.
Company profits and losses are locked into the company, so if you have several lines of business using different trading entities, settling losses in one area against profits in another isn’t easy. Sole traders, treated as a single entity for all income sources, have more flexibility for netting off gains and losses.
Consider the following points:
- Small Profits: If your profits are well below £50,000, you may pay less tax as a sole trader due to the personal allowance.
- Non-Salary Benefits: Sole traders receive more favorable treatment for non-salary benefits, such as tax relief on the business element of partially business-related costs.
Company structure decisions depend heavily on your business goals. For example, if maximizing pension contributions is important, incorporating might not be the best strategy. Seek professional financial advice before making decisions.
Ross Martin, a tax resource website, provides a comprehensive summary of the pros and cons of trading as a limited company: Ross Martin – Sole Trader vs Limited Company.
Choosing the right business structure and understanding tax implications are crucial for optimizing financial performance and stability.
