If you want to become self-employed, what are the tax considerations?
With the Pre-Budget Report due soon, many businesses may be holding their breath to see what horrors (or pleasant surprises?) the Chancellor may reveal. But before things change, what is the tax difference between some different types of business structure?
Unincorporated businesses profits
When you set up an unincorporated business, you are the business. There is no legal definition between you as an individual and you the business. Unincorporated businesses are chargeable to income tax on profits earned by the business.
In simple terms, profit is calculated by subtracting allowable business expenses from the sales made. Profit for tax purposes is also likely to be different from the accounts profit, as things like depreciation costs are not allowable for tax, but you may claim capital allowances instead. You do not necessarily need an accountant to prepare your accounts, but unless you know what you are doing it is probably advisable to get professional help. With your accounts that is.
What to put on a tax return
The details of the business profits need to be included on your self-assessment tax return.
Now, not everyone will draw up their accounts to 5 April each year, which begs the question of how you calculate which profits are taxable in which year. The answer is, surprisingly, relatively simple. With the exception of the first few or last years of trading, or periods of less than 12 months, the accounts assessed are those that end within the tax year. This means that for 2009/10, accounts ending on 31 March 2010, 31 December 2009 or 30 April 2009 will all be assessed.
The amount of any profit is included when computing your tax liability for the year and any additional tax due needs to be paid under the normal self assessment rules. Note, however, that while National Insurance is categorically not a tax, for the self-employed there is an additional levy applied to the profits declared on your tax return and paid over along with your income tax, as well as a stand alone charge.
National Insurance
Self-employed Fools normally need to pay two different types of national insurance contribution.
Class 2 contributions are calculated weekly and are currently set at a fixed rate of £2.40 per week. These are normally paid by monthly direct debit or quarterly payment. There is an exception to paying class 2 contributions; if you anticipate your profits will be less than £5,075 in the year, you may apply for exemption on the grounds of small earnings.
In addition to Class 2 contributions, Class 4 contributions are calculated with reference to the level of profits earned. The rate is 8% on profits between £5,715 and £43,875, with a 1% charge on amounts above this figure. This charge is included on your self-assessment return and forms part of your 31 January tax bill as well as any payments on account due.
Paying your tax liability
Normally, any underpaid liability is due on 31 January next following the end of the tax year, so for the tax year 2008/09 (which ended on 5 April 2009), underpaid tax is due on 31 January 2010.
However, where broadly less than 20% of any tax liability is deducted at source, e.g. under PAYE or net bank interest, you are also required to make payments on account in respect of next year's tax liability.
Each payment on account is equivalent to 50% of this year's liability in the vain hope that, if everything remains exactly as it is, there will be no balancing adjustment needed on the following 31 January. Of course that never actually happens, so an adjustment paying either more or less tax is usually required.
Note that the payment on account system keeps going so that even if you have overpaid tax through your payments on account, you will have to make your first one for the following year. And so on.
Other considerations
There are no formal reporting requirements for accounts of unincorporated businesses -- provided the business records are correct and complete such that a tax return may be completed. There is also no obligation to file accounts for public perusal -- the details of your business profits (or losses) should remain a closely guarded secret shared only with the taxman. Unless the details get left on a train or something.
However, the major disadvantage of unincorporated businesses is the unlimited liability of the proprietor(s). If a sole trader's business fails and is unable to pay its creditors, those creditors are perfectly within their rights to demand payment from the individual's personal funds, and may even make a claim on his home.
For partnerships, partners are similarly liable, but they are also jointly and severally liable to their other partners -- in simple terms any one partner can be held responsible for the debts of the whole partnership or even debts incurred by another partner. Scary stuff.
In my next article, I will look at the relative tax aspects of an incorporated business, which includes not only the tax treatment of the company, but also how Fools can get their money out!
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