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How to work out tax and NI

While it’s unrealistic to expect any small-business owner to have an in-depth knowledge of tax and National Insurance rules, here are some key facts you should know before you start up

Income tax and NationaI Insurance for the self-employed

Self-employed people pay tax on their business profits (not their earnings). After filing a self-assessment tax return – which must be completed every year – tax is payable on profits generated during the preceding 12-month accounting period.

Flat-rate Class 2 National Insurance contributions (NICs) must also be paid. This amounts to £2.75 (2014/15) per week, which is payable quarterly. Additional Class 4 NICs must be paid and these are linked to profit (the lower profit limit is £7,956, the upper limit is £41,865 2014/15). Class 4 NICs are paid at the same time as your self-assessment tax bill. Class 2 NICs will also be collected via self-assessment from 2016.

Tax rules for limited companies

After they set up a limited company, as well as a director, people become an employee of their company who pays income tax (as any other staff member) through a scheme called PAYE (pay as you earn). The salaries of company directors are usually enhanced with dividends, which provides a tax advantage, because you do not have to pay National Insurance on dividends. Tax and NICs are deducted via the company’s payroll, which the employer must set up. The company must also pay employer’s NICs for its staff.

The level of income tax for employees is decided by pre-tax income band. The basic rate of income tax (20%) is payable on wages of up to £31,865, after which 40% is payable (at £150,000 the rate increases). All employees qualify for different forms of tax allowance, including a personal allowance of £10,000 (2014/15).

Corporation tax must be paid yearly on company profits (20% for profits up to £300,000, 21% for profits over £1,500,000 - marginal rate relief applies for profits between £300,000 and £1,500,000 to ease the transition in 2014/15). You (or your accountant) must work out how much Corporation Tax is due and pay the money to HM Revenue & Customs (HMRC), usually within nine months of company year-end.

Business expenses and tax allowances

If you’ve told HMRC you’ve started your business, you can claim most expenses incurred as pre-trading costs (exceptions include money spent forming a limited company).

There are strict rules about allowances, reliefs and legitimate business expenses. If you’re self-employed, visit the HMRC website. The most common allowable expenses include: stock/materials, wages, premises costs, vehicle and travel, finance, administration, and professional fees.

When working out your tax bill, you can claim capital allowances on: plant and machinery (including vehicles, computers, equipment, tools, etc), fixtures and fittings for your premises, and certain types of building. The allowance is calculated as a fixed percentage of an item’s value and is taken off that item’s value each year. Capital allowances vary from a few per cent to 100%.

You can also claim the cost of using your own vehicle for business as an expense, either costed as a fixed mileage rate or actual expense. You can deduct from your taxable profits a proportion of some of your domestic overheads if you run your business from home. A word of caution: if you run a limited company and claim for vehicle use, it is classed as receiving a 'benefit in kind' for which income tax is payable, while the company incurs additional National Insurance.

If you're self-employed (ie a sole trader) and your business fails to make a profit, you can get tax relief by setting the loss against: other income from the same or previous year, business profit in subsequent years, or in the previous three years if your business ceases trading. 

Value Added Tax rules

VAT is a transaction tax levied on sale of most goods and services. The standard rate is 20%. If your turnover exceeds the threshold (£81,000 in 2014/15) you must become VAT-registered. Even if your turnover is lower, becoming VAT-registered can sometimes be financially beneficial for your business, providing your customers are VAT-registered (otherwise they’ll simply have to pay more).

All businesses pay VAT on most purchases (‘input tax’), while registered businesses charge VAT on their goods and services (‘output tax’). VAT-registered businesses pay HMRC the difference between the output tax charged and input tax paid.

The above provides a brief introduction to the likely tax and National insurance. There’s no substitute for professional advice from an accountant tailored to your specific circumstances.

Further reading

Find more detailed articles, videos and tools on income tax self-assessment, NICs, Corporation tax and VAT on the Tax Donut.