The Tax Consequences Introduction
Anyone setting up a new business will have a long list of important matters to deal with (eg initial finance, premises, insurance, stationery etc). Income tax and National Insurance contributions may not be high on the list of priorities, although attention to these matters at the outset could save time and expense later.
Registering with HM Revenue and Customs (HMRC)
When you become self-employed you must register for income tax and National Insurance purposes with HMRC. This can be done in one of the following ways:
- by phoning the Newly Self Employed Helpline on 0845 915 4515; or
- by post using form CWF1 which can be downloaded from the HMRC website.
In order to register you will need your National Insurance number. In the case of a partnership all partners must register separately. Further information is available on the HMRC website.
When going though this process, it may also be necessary to register with HMRC for VAT and/or as an employer obliged to operate a Pay as You Earn (PAYE) scheme.
Anyone who becomes liable to pay Class 2 National Insurance contributions (see below) is required to notify HMRC immediately. A penalty may be charged if notice is not given by 31 January following the end of the tax year in which the liability first arose. In addition an individual is required to notify HMRC if they have a liability to income tax or capital gains tax for any tax year and this must be done before 6 October following the end of the tax year in which the liability arose. Failure to notify can result in a penalty.
The legislation requires businesses to keep minimum records as set out on the HMRC website.
New businesses are recommended to seek advice on a suitable bookkeeping system at the earliest opportunity.
All the profits earned over the lifetime of the business will be subjected to income tax although the timing of the assessments will be affected by the accounting period chosen.
The profits and losses of a tax year will be based on the 12 month period used for the accounts. There are however special rules applying in the first two and last tax years in business or if the accounting date changes.
In the first year of business the profits taxable will be those from the date the business started to the following 5 April.
For the second tax year, if the first accounting period is 12 months or more after the date the business started, the profits taxed will be those of the 12 months to the accounting date. If the accounting period is less than 12 months after the business started it will be those of the 12 months beginning on the date the business started. If there is no accounting date in that second year, the profits taxed will be those of the 12 month period to the 5 April of that tax year.
Accounts prepared to 5 April or 31 March
Where a new business chooses an accounting date between 31 March and 4 April the accounts for the opening years are treated, unless elected otherwise, as though they were prepared to 5 April.
The taxable profits will be based on the actual profits earned in the tax year so where a business starts on 1 October 2009 and prepares annual accounts to 31 March thereafter, the 2009/10 taxable profit will be the actual profits for the period 1 October 2009 to 31 March 2010 and the 2010/11 taxable profits will be the actual profits for the year ended 31 March 2011.
Accounts prepared to some other date
Assume new business started 1 May 2009 and accounts prepared to 30 April 2010. The assessment for the first year of trading (2009/10) will be based on the time apportioned profits for the period 1 May 2009 to 5 April 2010 - that is 11/12 of the full year's profit to 30 April 2010. The 2010/11 assessment will be based on the profit shown in the accounts for the year ended 30 April 2010.
Consequently the profit for the 11 months to 31 March 2010 will be assessed twice and this double counting is recognised as 'overlap relief'.
On ceasing to trade in the future (or if you decide to change your accounting year end at some stage) the taxable profit for the final tax year, or the year of change of accounting date, will be all the profits that have yet to be taxed, less any overlap relief available. The overlap relief is not increased to take account of inflation.
Tax payment dates
Under income tax self assessment, where payments are required they will generally be due as follows:
- first payment on account on 31 January in the tax year;
- second payment on account on 31 July following the end of the tax year;
- any balance due or refundable on 31 January following the end of the tax year.
An individual starting a new sole trader business may not previously have received self assessment returns, but their business involvement will result in HMRC including them in the self assessment system.
Someone who started a new business on 1 October 2009 will have an income tax liability payable on 31 January 2011 on the taxable profit for the period from 1 October 2009 to 5 April 2010. On the same day the first payment on account for the tax year 2010/11 will be due. Consequently best advice is to provide for the eventual tax liability on a current basis by putting funds in a separate account. See HMRC website for ways of paying tax.
National Insurance contributions
A self-employed individual is required to pay Class 2 contributions (£2.40 per week for 2010/11). However a claim for exception (using form CF10) may be made if profits are less than the threshold (£5,075 pa for 2010/11). Class 2 NIC must be paid direct to National Insurance Contributions Office (NICO) and a direct debit arrangement can be set up.
Payment of this contribution secures entitlement to a range of contributory benefits.
In addition individuals will be liable to pay Class 4 contributions (for 2010/11 these amount to 8% of profit between £5,715 and £43,875, plus 1% of profits in excess of £43,875). Class 4 NIC is collected as part of the income tax self assessment. Class 4 contributions do not secure any additional social security benefits and are effectively an additional income tax.
Use of home
Where an individual uses part of their home for business purposes for some or all of the time they will be entitled to claim a reduction of part of the household expenses.
HMRC have set out their interpretation of this rule in their Business Income Manual.
Before trading commences advice should be taken regarding whether to trade as a sole trader, in partnership, using a limited liability partnership (LLP) or via a company.
The individual's tax position will depend on which vehicle is chosen, but the decision should normally be made for commercial reasons.
Trading as a sole trader is relatively simple, but the individual will remain liable for all the business liabilities.
It is possible to start to trade in partnership with relatively few formalities, but unless the terms are carefully defined by a formal Partnership Agreement any disputes between the partners will have to be settled in accordance with the Partnership Act 1890. Each partner will be jointly and severally liable for the partnership liabilities. For tax purposes a partnership is treated as transparent and the taxable profits are allocated to the individual partners according to their profit sharing ratios.
An LLP is a distinct legal entity and the personal liability of the individual members for the LLP's obligations is limited. For so long as the LLP is trading it is treated as transparent and the taxable profits are allocated to the individual members.
A limited company is also a distinct legal entity and is liable to corporation tax on its profits. Remuneration paid to the directors will be an allowable deduction for the company and will be taxed on the directors under the PAYE system.
Involvement of family members
Where members of the family are involved in the business then they can be paid wages. Payment should be made separately from usual housekeeping payments and the PAYE system will need to be operated. Deductions against taxable profits for wage payments can only be claimed for expenses which are wholly and exclusively incurred for the purposes of the business and this means that the wages paid must be justifiable in the context of the work done. They also need to comply with national minimum wage rates.
Spouses and adult children could be involved in a partnership, LLP or company. However there is antiavoidance legislation designed to counter arrangements whereby one individual transfers a "right to income" to another. The Government has been considering ways of preventing income shifting between family members that is not caught by the existing anti-avoidance.
Special rules apply where (i) an individual provides services to an end-user through an intermediary (normally a partnership or a company) and (ii) if those services had been supplied direct to the end user the individual would have been regarded as an employee of the end user.
Where the special rules apply to any particular engagement the intermediary will effectively be liable to PAYE as if the earnings had been paid as remuneration.
Where taxable supplies are being made, registration for VAT is compulsory as soon as the value of supplies within the previous 12 months exceeds the threshold (£70,000 from 1 April 2010), or it is thought that turnover may go over the threshold in the next 30 days.
To determine whether the VAT threshold is exceeded, the business turnover for the previous 12 months should be calculated at each month end and compared with the registration limit. The calculation at the next month end excludes the first month of the previous 12 months' total, but includes the latest month's figure. If the VAT registration threshold is exceeded at the end of say July the business becomes liable to VAT one month later, ie with effect from 1 September.
Voluntary registration may be requested by any business even if the turnover does not exceed the VAT compulsory registration limit. It may not be requested retrospectively.
Examples of when voluntary VAT registration might be appropriate are:
- where the nature of the trade is such that businesses within it would normally be expected to be VAT registered (VAT voluntary registration might give the illusion to third parties of a larger organisation);
- if all customers are VAT registered and could reclaim VAT charged, a potential loss of recoverable input tax might arise if the business is not VAT registered;
- VAT input tax may be lost on assets or set up costs, but may be recoverable if compulsory VAT registration eventually taken up.
Remuneration paid to employees will be subject to the PAYE system. Normally an individual may earn up to the level of their personal allowance (£6,475 for 2010/11) before having to pay income tax, but there are National Insurance considerations, and even if earnings are less than this threshold it may still be necessary to notify HMRC that employment has commenced.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.