A change being made to the VAT Flat Rate Scheme on 1 April 2017 will force many businesses to leave the scheme.
This article provides guidance about how a self-employed sole trader will be taxed on their earnings as compared to how taxation works for an employee.
What Do You Pay Tax On?
Unsurprisingly, an employee is taxed on the wages or salary they earn from their employment. Most of these earnings are likely to be paid to the employee at regular intervals throughout the tax year, although there may also be non-regular payments (e.g. bonuses) and also non-monetary earnings too, such as the provision of a company car.
In the case of the sole trader, it is the taxable profits of their business that are subject to taxation, meaning the excess of trading income earnt over trading expenses incurred for the relevant period.
Where the business makes a taxable loss rather than a taxable profit, credit may be given for this loss against other taxable income of the trader in the current or previous tax years, or may be carried forward for use against future trading profits from that business.
For a sole trader, tax isn’t simply charged on the amount of money that they have withdrawn from their business for their own personal use; it is charged on the total profits generated by that business.
In What Year Are These Earnings Taxed?
The tax year runs from 6 April to the following 5 April; the 2017/18 tax year therefore covers the period 6 April 2017 to 5 April 2018.
Since tax rules, rates and allowances can change every tax year, it is important to have a basis on which to allocate an individual’s earnings to specific tax years in order to determine which tax rates and allowances should apply.
For an employee, this allocation is generally straightforward; for any particular tax year, their taxable earnings will be the amounts they have received, or were entitled to receive, throughout the period running from 6 April to the following 5 April of that tax year.
For a sole trader, however, the situation is not quite as simple. First, the taxable profits earned by their business must be allocated to specific periods of account; these periods, normally 12-months in length, will usually end on the same year-end date each year.
Then, for any particular tax year, the sole trader is taxed on the profits earned in the 12-month period of account that ends at any point during that tax year.
A sole trader can pick any date as their year-end; it does not have to be the 5 April. Normally, a month-end date is chosen for convenience. The date can only be changed in limited circumstances.
As an example, assume a sole trader has chosen 31 December to be their year-end date. Their taxable earnings for the 2016/17 tax year would therefore be the profits earned by their business during the 12-month period ending on 31 December 2016; this would be the only 12-month period of account that actually ends during the 2016/17 tax year.
Note that in this example, any business profits that arise in the period between 1 Jan 2017 and 5 April 2017 are not going to be subject to tax in the 2016/17 tax year despite the fact they will have been earned in that tax year; they will instead form part of the profits for the period ending 31 December 2017 and will therefore be taxed in the 2017/18 tax year.
To summarise, in any particular tax year the employee and the sole trader will both subject to tax on 12 months’ worth of earnings; but whereas the employee is always taxed on a strict April to April basis, the sole-trader can be taxed on a different 12-month period depending upon their choice of year end date.
If the sole trader chose a year end of 6 April, their period of account would, in this case, actually match up with the tax year. In practice, choosing the nearest month end date (31 March) will also achieve the same effect and can simplify tax matters.
The already complicated system of using periods of account for the taxation of a sole traders’ business earnings becomes even more complicated when considering the early and final years of a business, but these issues are not considered further here.
How Much Income Tax Is Payable?
Having considered exactly which earnings are subject to taxation, and in what specific year, we can now turn to what tax rates are actually charged on those earnings.
The taxable earnings of the employee and the sole trader are both subject to income tax and are therefore generally taxed at the same rates, although for some specific businesses undertaken by sole traders, such as residential lettings, the income tax rules may include additional provisions.
National Insurance Contributions
Both the employee and the sole trader will also have to pay National Insurance Contributions (“NI”) on their earnings. The way this is currently charged remains unduly complicated, but typically the NI rates that will be paid by each are as shown in Table 1 below.
|£0 to £8,164||0%||0%|
|£8,165 to £45,000||12%||9%|
The employee pays Class I NI contributions on their earnings at the rates shown above. This entitles the employee to certain welfare benefits, including a future entitlement to the state pension on retirement.
A sole trader instead pays Class IV NI contributions on their earnings at the rates shown above. As the table shows, these rates are slightly lower than the equivalent Class I rates paid by an employee.
Class IV contributions do not, however, entitle the self-employed trader to any welfare or state pension benefits. To get such an entitlement the sole trader must also pay a flat rate of Class II NI contributions equal to £2.85 per week (2017/18) where their taxable earnings exceed £6,025 in the year.
One final significant difference not to be overlooked is the additional amount of Class I NI contributions that are payable on an employees’ wages by the employer themselves. There is no such equivalent amount payable on the earnings of the sole trader.
How is The Tax Paid to HMRC?
For every individual taxpayer, final settlement of their tax and NI liability must generally be made within 10 months of the end of the tax year; in other words, by the 31 Jan following the end of the tax year. Penalties will be due if payment has not been made by that time.
An employer is required to deduct the income tax and NI due on their employee’s pay throughout the tax year and forward this on to HM Revenue and Customs (“HMRC“). Under this Pay As You Earn (“PAYE“) system, most of the tax liability due from an employee on their earnings is therefore being settled as the tax year progresses, rather than remaining outstanding at the end of the tax year.
Where an employee does not have any other significant amounts of untaxed income, small over or underpayments of tax that remain outstanding at 31 Jan can often be collected by HMRC in a future tax year by simply adjusting the employees’ PAYE tax code.
The PAYE system generally works well because most employees are taxable on regular amounts of earnings paid at regular intervals. By contrast, the business profits of a sole trader are much more variable, and are made up of many items of income and expense. This means there is no equivalent PAYE system in place to automatically calculate and pay to HMRC the income tax and NI due on the earnings of the business as the tax year progresses.
Unlike an employee, therefore, the tax liability of a sole trader can only be finalised once a tax return has been completed and submitted to HMRC; final settlement of the tax and NI liability of a sole trader will therefore be made after the end of the tax year, by the following 31 Jan at the latest.
Making Payments on Account To HMRC
There is one additional requirement that sole traders in particularly need to be aware of concerning the payment of tax.
Where an individual owes tax at the end of a tax year, HMRC will be annoyed that they have earned income during a tax year but have not had to pay to HMRC the related final tax bill until up to 10 months after that tax year.
In an attempt to prevent the taxpayer getting a repeat of this cash flow advantage next year, HMRC may require them to make two additional Payments On Account as advance payments towards next year’s tax bill.
These payments on account will each be equal to 50% of the outstanding tax liability from the current tax year and will be payable on 31 Jan and 31 Jul after this tax year. Once next tax year’s final tax liability is agreed, these payments on account will be deducted and only the balance remaining will be left for settlement.
HMRC will not require a taxpayer to make payments on account where either:
- the individual’s tax liability outstanding at the end of the tax year is less than £1,000, or
- at least 80% of the individual’s tax liability arising during the tax year was actually collected at source during that year.
For most employees, the PAYE system should ensure that much more than 80% of their tax liability has been settled at source throughout the tax year and, accordingly, they are unlikely to be required to make these additional payments on account.
For sole traders, however, the opposite is likely to be true, so unless their outstanding tax liability is less than £1,000, most sole traders will also need to make the two additional payments on account as described above. This therefore must always be remembered for cash flow budgeting purposes.
Finally, since these payments on account are meant to be an upfront payment of the next year’s estimated tax liability, where a sole trader knows that next year’s taxable business profits are turning out to be much lower, they can appeal to HMRC to make lower payments on account. HMRC will generally accept such an appeal without question, but if it turns out the taxpayer reduced these payments too much they will be charged late payment interest.
Where HMRC believe that a taxpayer deliberately made a claim to reduce their payments on account knowing that the claim was not valid, an additional penalty of up to 100% of the underpaid amounts can also be charged.
Submitting Tax Returns
Many employees will not be required to submit tax returns to HMRC since the PAYE system generally ensures that HMRC are aware of their taxable earnings as the year progresses.
For sole traders, there is no equivalent PAYE system and therefore every self-employed individual is required to submit a self-assessment tax return each year, completing the Self-Employment Supplementary Pages for each business they own. This information will inform HMRC of the earnings of the business for the period of account attributable to that tax return, enabling the income tax and NI liability to be calculated.
The completed return must be submitted to HMRC within ten months of the tax year end (31 Jan) if done online, or within 7 months if completed on paper (31 Oct). Penalties for failing to submit returns on time are imposed by HMRC.
In the second half of 2018 it is intended that the self-employed must begin providing HMRC with quarterly data on their business earnings, rather than wait until after the tax year to submit this data via a tax return.
Inform HMRC About Your Business
One final requirement should be mentioned for sole traders. They are required to register a new business with HMRC within 6 months of the end the tax year in which it commenced trading; in other words, by 5 Oct following the end of that tax year.
You commence trading from the date that your business becomes available to take on customers or clients; note that this is not simply the date on which the business actually gets its first customer.
Even if you miss this date, penalties will not be charged provided you submit a return online and pay all tax and NI due by the following 31 Jan.
Registration can be done online via the HMRC website, after which HMRC will send you a UTR number which you will need before you can submit your returns.
It is important to note that whilst many of the points outlined here can also be relevant for individuals who are members of a partnership, they do not apply to those situations where the individual operates their business through a limited company.