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.
Class 2 National Insurance contributions (NICs) must also be paid. This amounts to a flat-rate of £3.05 for the tax year 2021/22 (£3.05 for 2020/21) per week, which is now collected via self-assessment.
Class 4 NICs must be paid on profits between the lower profit limit of £9,568 and the upper limit of £50,270 for the tax year 2021/22 (£9,500 and £50,000 for 2020/21). Class 4 NICs are paid at the same time as your self-assessment tax bill.
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 can provide a tax advantage. No tax is payable on the first £2,000 of dividend income. Income over this dividend allowance is taxed at 7.5% for basic rate tax payers, 32.5% for higher rate tax payers and 38.1% for additional rate payers. This allowance has reduced significantly (£5,000 prior to April 2018). 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 fixed income bands and is calculated over a fiscal year (starting 5th April). Wages falling within an employees personal tax allowance are tax free. Thereafter, earnings above that allowance attract tax. The basic rate of income tax (20%) is payable on the next tranch of earnings of up to £37,700 in 2021/22 (an increase from £37,000 in 2020/21). A higher rate of income tax (40%) is payable on further earnings of up to £150,000 (unchanged from previous years) above the personal allowance. At £150,000 the rate increases to 45%. Most employees qualify for different forms of tax allowance, including the personal allowance of £12,570 for 2021/22 (an increase from £12,500 for 2020/21).
Corporation tax of 19% must be paid yearly on company profits. This main rate will increase to 25% from April 2023 onwards. 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.
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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 VATable turnover exceeds the registration threshold (£85,000 per annum) you must become VAT-registered and comply with Making Tax Digital regulations which came into force in April 2019. 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.