How are the self-employed taxed?

how are the self-employed taxed?- Butt Miller Chartered Accountants
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    Disclaimer: This article is based on legislation which was correct at time of publishing on July 29, 2022
    This page was last updated on September 21, 2023

    How to register with HM Revenue & Customs (HMRC)

    If you start working for yourself, you must register with HMRC by 5 October following the end of the tax year in which your self employment starts. Otherwise you may be liable to penalty based on the tax due to HMRC.

    There are three ways that you can register:

    •  Online – visit https://www.gov.uk/register-forself-assessment
    • Phone – call the Newly Self-Employed Helpline on 0300 200 3500
    • Post – download and complete form CWF1 or use the form incorporated in leaflet SE1 (Are you thinking of working for yourself?)

    Once you become self-employed, the tax rules are quite different from those that may have applied when you were an employee. Instead of tax (and national insurance) being deducted from your earnings at source, you must be prepared to receive a bill at some time in the future.

    This can be a nasty shock if you haven’t put enough money aside. We aim to give you as much warning as possible of the likely timing and amount of tax payments, but it is not easy to do this during the first year of your new business, or if you do not keep your records up to date.

    At Butt Miller, we have accounting services for self-employed people, to help you financially grow your business.

    What profits do HMRC tax?

    The starting point for the calculation of taxable profits is your profit and loss account. In calculating taxable profits you are entitled to claim deductions from your business income in respect of any expenses incurred for the purposes of trade (with a few minor exceptions).

    For most of the equipment you buy for your business, you will be entitled to deduct the full cost (up to a maximum of £1 million in the year to 31 December 2020 and then up to £200,000 from January 2021).

    For most cars, you can deduct only a proportion of the cost for each year you own them and use them in the business.

    If you take stock for your own use, the disposal should be shown in the accounts at market value, and not at original cost. It may be better to show the original purchase as private expenditure (drawings).

    Tax is payable on the whole of the profits of a trade, and so payments for your own ‘wages’ (drawings) are not deductible.

    However, if your spouse works in the business, the wages are an allowable deduction, provided they are actually paid and are a reasonable reward for what is done.

    How does HMRC allocate profit to tax years?

    The aim of the system is that over the lifetime of your business the profits will be taxed in full, once, and once only. But to make the system fair, there are certain complications you will have to cope with.

    The general rule is that the tax for a particular tax year is based on the profits of the twelve months to your accounting date in that tax year.

    For example, the tax for 2020/21 could be based on accounts for a year ending on various dates ranging from 6 April 2020 to 5 April 2021.

    This demonstrates that you get more time for the tax to be worked out if your accounts end early in the tax year, which is why 30 April is such a popular year-end for self-employed people.

    How is the tax collected?

    Tax returns

    Tax returns covering income for the year ending 5 April 2020 have to be submitted to HMRC by the ‘filing date’ which is 31 October 2020 for paper returns and 31 January 2021 for online returns. The return will include a self assessment of your liability to income tax and capital gains tax.

    There are automatic penalties for late filing of tax returns.

    Payment of tax

    Payments on account of income tax and Class 4 national insurance contributions (NICs) will be due on 31 January 2020 and 31 July 2020.

    These interim payments will be based on one half of the total liability (less any tax deducted at source) for 2018/19. You will have the right to reduce payments on account if you believe the income tax for 2019/20 will be lower.

    The balance of income tax for 2019/20 is due on 31 January 2021 (along with the first payment on account for 2020/21 and any capital gains tax for 2019/20). Interest and penalties will be levied for late payment.

    What about the complications?

    Opening years

    In the first tax year of your business, the tax payable is based on the profit arising between the starting date and the following 5 April. This is taken as the appropriate fraction of the profit shown in your first set of accounts.

    Say you started on 1 June 2019 and your first accounts run to 30 June 2020 with a profit of £13,000, then tax will be worked out (to the nearest month) on the profits of the following periods:

    2019/20  1 June 2019 to 5 April 2020 – 10/13 x £13,000 i.e. £10,000
    2020/21 1 July 2019 to 30 June 2020 – 12/13 x £13,000 i.e. £12,000

    You can see that the profit from 1 July 2019 to 5 April 2020 (9 months) has been taxed twice.

    The ‘overlap’ profit of £9,000 will be available for deduction when the business comes to an end, or (at least in part) if you change your accounting date to one nearer 5 April. Change of accounting date.

    If you decide to change your accounting date from 30 June 2021 to 31 December 2021, and the accounts for the 18 months ending 31 December 2021 show a profit of £27,000, the taxable profit for 2021/22 will be worked out as follows:

    Profit based on accounts (18 months)(18 months) £27,000
    Less overlap relief £ 6,000
    Profit for 2021/22 £21,000

    Cessation If you then cease trading on 31 August 2023, and your final accounts for the eight months ending on that date show a profit of £11,000, the taxable profit for 2023/24 will be:

    Profit since accounting date  in previous tax year £11,000
    Less balance of overlap relief not already used  £ 3,000
    Profit for 2023/24  £8,000

    What about national insurance?

    The self-employed are subject to a two-tier system of national insurance contributions (NICs).

    Class 2 NICs are at a flat rate of £3.05 per week, if earnings exceed £6,475 per annum. Payments for self-employed Class 2 NICs are due on 31 January following the end of the tax year. Profits between £9,500 and £50,000 are subject to Class 4 NICs at a rate of 9%.

    Any excess of profit above £50,000 is subject to Class 4 NICs at the rate of 2%, without any upper limit. Class 4 NICs are collected by HMRC and are payable at the same time as the instalments of income tax.

    Save for your tax

    It is essential that you make proper provision to ensure the availability of funds to pay income tax and Class 4 national insurance. Interest on unpaid tax is chargeable by HMRC and is not deductible from business profits.

    Please call us if you would like further help or advice on this matter.

    Cash basis for small businesses

    In order to try to simplify the calculation of taxable income for small businesses, HMRC introduced an optional alternative system for eligible unincorporated businesses. Such businesses may calculate taxable income figures on a simpler cash basis if this suits the business.

    They will not have to compile figures of debtors, creditors and stock, or distinguish between ‘capital’ and ‘revenue’ expenditure and will not have to compute capital allowances to arrive at taxable income.

    A second measure allows all unincorporated businesses to choose to use flat rate expenses for particular items of business expenditure.

    How we can help?

    Please contact us if you’d like further advice.

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