Setting up in business: ATT briefing note

 

 

Disclaimer

The following briefing note is intended to provide an introduction at a high level to some of the tax aspects that need to be considered when setting up a small trading business as a single individual or as a couple in the UK. This note is not intended to apply to setting up a property or investment business.

Please note that consideration of the interaction with Tax Credit and/or Universal Credit claims are outside the scope of this document.

This note is not a substitute for detailed professional advice. If in doubt, you should consult the underlying legislation and/or seek professional advice.

No responsibility can be accepted for the consequences of any action taken or refrained from based on this note.

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An introduction to basic business structures

One of the first things to decide when starting in business is the structure in which you want to operate. The business structure you choose will influence many matters including how you take money out of the business, your tax and other compliance obligations.

There are broadly three options when it comes to business structure:

  • Sole trader
  • Partnership
  • Limited company

Below we set out some of the key features of each of these structures.

Sole trader

  • A sole trader is in business on their own account.
  • The business is not separate from their own personal affairs. If anything goes wrong and there is a claim against the business, this is effectively a claim against the trader. A sole trader therefore takes on the risk of personal liability. (Some of this risk may be mitigated through appropriate insurance.)
  • The accounts of a sole trader are personal to them and are not available to the public.
  • A sole trader is not subject to the same strict accounting requirements that apply to a company. However, the business must still maintain adequate records sufficient to establish the sole trader’s tax position.

Partnership

  • A partnership exists when two or more people decide to work together with a common view to a profit.
  • A partnership is not a separate legal entity, so each individual partner is jointly and severally liable for the debts and liabilities of the partnership. An individual partner therefore has personal liability for the acts and omissions of the partnership as a whole.
  • It is advisable to have a written partnership agreement to regulate the dealings between the partners. This can cover issues such as:
    • the name of the partnership and where it will trade from;
    • what the partnership year end will be and where the records of the business will be kept;
    • what each partner will contribute to the business in terms of time and money and efforts;
    • how profits and losses will be shared;
    • how much each partner can take in drawings;
    • how new partners can/will be admitted;
    • what happens when the partnership comes to an end;
    • how the business might be wound up; and
    • what happens in the event of a partnership dispute.
  • Without a partnership agreement, the partnership will be considered to be operating on the terms set out in the Partnership Act 1890 which can result in unintended consequences. Under this Act, without specific provision to the contrary, profits will be assumed to be divided equally between the partners. The Act also allows for the partnership to be dissolved by notice at any time, and for the partnership to be dissolved on death of one of the partners. Having a partnership agreement allows the partners more control over how the business operates.
  • The partnership, and each of the partners, must each file a self-assessment return.  
  • Partnership accounts are not publically available and are not subject to the same strict accounting rules that apply to companies. This is the same as for a sole trader.

It is possible to set up a different form of partnership structure known as a Limited Liability Partnership (LLP). These are incorporated in a similar manner to a company and are registered at Companies House. Members of an LLP are taxed as individuals (effectively the partnership is transparent for tax), but benefit from limited liability in the same manner as a company. More details on the LLP structure can be found on GOV.UK. LLPs are not within the scope of this document.

Limited company

In this briefing note, we have assumed that the company will be a simple one or two-person company where the shareholders of the business are also the directors.

  • A limited company is a separate legal entity. A company is incorporated (created) by registering it with Companies House. The initial shareholders subscribe for shares issued by the company.
  • The company can have one class of shares, or different classes of shares for different groups of shareholders, which are differentiated by letters – for example ‘A’ ordinary shares for one spouse and ‘B’ ordinary shares for the other. This approach is often referred to as an alphabet share structure. Alphabet shares can allow greater flexibility for allocating dividends between different shareholders but also introduce more complexity and if this approach is being considered professional advice should be sought. Consideration of this structure is outside the scope of this document.
  • A limited company is owned by its shareholders and run by its directors. These can be two different groups of people or the same people. In a small business it is common for the shareholders (who may be family members) to also be the company’s directors.
  • Unlike a sole trader or partnership, the shareholders in the company are not usually liable for the company’s debts. This helps to reduce the personal liability for shareholders.
  • If the company becomes insolvent, only the money that the shareholders have invested in the company is at risk. Their personal funds outside the company will only be at risk if they have given personal guarantees to a loan creditor (the company’s bank for example) or in certain cases where they can be shown to have been negligent or acted fraudulently in their capacity as directors.
  • A company must file accounts which are prepared in accordance with specific accounting rules with Companies House. Accounts filed with Companies Ho
  •  
    • Address where the company keeps its records
    • Shareholders details
    • Details of individuals with ‘significant control’ – generally shareholders who have more than 25% of the shares.
  • A step-by-step guide to setting up a company can be found on GOV.UK.
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Taking money out of the business

Please note that the interaction of profit extraction with Tax Credits or Universal Credit is outside the scope of this document.             

Sole trader

When a sole trader withdraws money from the business for their personal expenditure the funds extracted are called drawings.

Regardless of whether or not the sole trader takes drawings from the business for their own use, they will pay tax on all the taxable profits of the business. The profits of the business are calculated before taking account of any drawings.

Partnership

As for a sole trader, the partners will take funds from the business as drawings. Regardless of whether or not they take drawings from the business, they will be taxed on their full share of the taxable profits of the business.
The accounts of the business will show how much each partner has withdrawn from the business and how much is left on their capital account. (See the accounts section below.)

Company

A company is subject to corporation tax on its profits in its own right. A shareholder is only taxed on the money that they take out of the company.

There are a number of ways that a shareholder-director can extract money from the company for personal use:

  • Dividends – a company can distribute its retained profits after corporation tax (referred to as distributable reserves) by voting a dividend. Assuming that the shareholders all have the same class of share, they will be entitled to receive a dividend in proportion to their shareholding. For example a 25% shareholder would receive 25% of the dividend voted. Dividends are generally taxable at more favourable rates than salary or other forms of income. An individual can also receive dividends up to their dividend allowance (£2,000 for 2020/21) tax free.
  • Wages or salary - if the shareholder is also a director or employee of the company, they could be paid a wage or salary. The company will have to comply with any relevant PAYE reporting requirements such as Real Time Information (RTI) (see below) and also deduct income tax and Class 1 employee's NIC. The company may also have to calculate and pay employer’s Class 1 NIC. This can be a less efficient way of extracting income from the company but may be the only option if the company does not have sufficient distributable reserves.
  • Rent – if the shareholder owns property personally which the company uses then they can charge the company rent as a way of extracting money from the company. The rent payments will be tax deductible in the company and subject to income tax in the hands of the shareholder. Charging rent in this way can however impact on the amount of Entrepreneurs’ Relief that may be available to the shareholder in the future when the property from which the business has traded is sold. This could increase the tax on the disposal of that property in the future.
  • Loan account – if the shareholder has loaned money to the company, or transferred assets to the company when it was created, then the company may owe that individual money. The debt will be recorded as a loan account in the company’s books. Repayments of the loan account do not generally have tax consequences for the company or the individual – it is a simple repayment of a debt. Any tax consequences usually arise on the creation of the debt in the first place – for example if the individual has sold an asset to the company they may incur a liability to Capital Gains Tax. Care should be taken not to overdraw the loan account. There can be significant tax consequences if the shareholder draws too much out and ends up owing the company money.  
  • Interest – if the shareholder has made a loan to the company, they can charge interest on the loan. This is tax deductible in the company and taxable in the hands of the shareholder.

A common remuneration structure for company directors is for the company to pay a salary which sits between the lower earnings threshold (£6,240 per year for 2020/21) and the primary threshold (£9,516 per year for 2020/21) with the rest of their income from the company taken in the form of dividends, interest or rent.

The purpose of paying a salary within that range is that no employee’s or employer’s National Insurance Contributions (NICs) will be due, but the director will have received enough salary for the year to ensure that they receive NIC credits so that the year is a qualifying one for state pension and other benefit purposes. (See the section on NICs below.) 

How the shareholder takes money can also affect the company’s corporation tax position. If the shareholder takes the money out as rent or salary, then this is usually a tax deductible expense in the company which reduces the profits subject to corporation tax. If the shareholder takes dividends, then these are not a tax deductible expense in the company and dividends do not reduce the profits for corporation tax purposes.

All these different approaches to extracting money from a company have varying tax and legal implications which need to be considered in detail. This is outside scope of this document, and you may want to seek professional advice which is specific to your particular situation.

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Tax and tax rates

Introduction

For individuals, tax is assessed on a tax year basis. For historic reasons, the tax year starts on 6 April and runs to the following 5 April. The 2020/21 tax year runs from 6 April 2020 to 5 April 2021.

An individual is entitled to a personal allowance – this the amount of income that can be earned in a tax-year before income tax is due. For 2020/21 this is £12,500. There are also additional allowances for interest and dividend income. Note: The personal allowance is reduced by £1 for every £2 that an individual earns over £100,000. An individual earning over £125,000 will not therefore receive any personal allowance.

Assuming that the personal allowance is available in full, and not used by other income sources, an individual who is self-employed (sole trader or partner) will pay tax on their business profits for 2020/21 as follows:

2020-21    
Income Tax rate Known as
£0-12,500 0% Personal allowance
£12,500-50,000 20% Basic rate
£50,000-150,000 40% Higher rate
Income over £150,000 45% Additional rate

 

Since the personal allowance is abated for those earning over £100,000, earnings between £100,000 and £125,000 are effectively taxed at a rate of 60%.

Scottish and Welsh taxpayers are subject to Scottish and Welsh rates respectively on their non-savings, non-dividend income (which includes business profits).

Different rates apply to shareholders in receipt of dividends. An individual can receive dividends up to their dividend allowance tax-free. For 2020/21 the dividend allowance is £2,000.

Any dividends received in excess of £2,000 will be taxed at special dividend rates.

2020-21 Dividend rates  
Income Tax rate
Basic rate  7.5%
Higher rate 32.5%
Additional rate  38.1%

 

An individual can allocate their personal allowance between their different income sources in the most tax efficient manner. (Usually, but not always, this means setting the personal allowance against non-savings, non-dividend income such as business profits or employment income.) After that, the basic then higher rate bands will be allocated against the various income sources in the following order:

  • Non-savings, non-dividend income – including business profits, employment income, rental income, pensions
  • Savings income
  • Dividend income

Dividend income is generally taken to be the individual’s ‘top slice’ of their income. The interaction between the dividend allowance and the rate bands is complex.

In addition to income tax, the individual may also need to consider National Insurance contributions (NIC).

Sole trader

  • A sole trader is subject to both income tax and Class 4 NICs on the profits of their business and must file a self-assessment return annually.
  • The sole trader will also pay Class 2 NICs. This is collected as part of the self-assessment process.

Partnerships

  • Each individual partner’s share of profits is subject to income tax and Class 4 NICs as for a sole trader.
  • Partners are also liable to Class 2 NICs.

Company

  • A company pays corporation tax on its taxable profits. The rate is currently 19% and is expected to remain at 19% until at least 31 March 2022.
  • In addition to the corporation tax (and any employer’s NIC) payable by the company, the shareholder-directors will pay income tax (and employee’s NIC if appropriate) at the appropriate rates on any income received from the company.

What is the most tax efficient structure?

The most tax efficient structure for a business will depend on a number of factors including: 

  • The level of profits/losses
  • The amount of income that the individual needs to take from the business to live on
  • The number of people involved in the business and whether a spouse or other family members are involved.

The higher the profits of the business, the more likely it is that incorporation will be the more tax efficient. The point at which this occurs will depend on the number of people involved in the business and the level of profit extraction. A company is not always the most tax efficient structure, particularly if the individual wishes to extract all the profits from the business. It will often be necessary to prepare individual computations of the overall tax position based on the estimates of profit and cash required by the business owners.

It is also possible to start the business as a sole trader/partnership and then incorporate at a later date once profits have been established. There are various beneficial tax reliefs available to the established business looking to incorporate. However, there are few reliefs for going the other way if the business later decides to disincorporate and return to a sole trader/partnership structure.

When considering the most tax-efficient structure it is also important to consider other taxes, not just income tax and NICs. For example, the owners of a business which owns property where the intention is to pass the property and/or business down the generations should also consider the impact of their business structure on their inheritance tax position. This would include considering the availability of Business Property Relief (BPR) or Agricultural Property Relief (APR) on any property used in the business. APR and BPR are very valuable reliefs which can exempt up to 100% of the value of agricultural property or trading property from inheritance tax. The rate of relief can be affected by the ownership structure.

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Registering for tax

Income tax

Sole trader

  • A sole trader must register for self-assessment by 5 October following the tax year in which the business has started. For example, if the business starts to trade on 1 May 2020 which is in the 2020/21 tax year, they must register by 5 October 2021.
  • Late registration penalties may be charged if this deadline is missed.
  • On registration for self-assessment, the individual will be issued with a Unique Taxpayer Reference (UTR).
  • Details on how to register can be found on GOV.UK.
  • The registration process will register the individual for both income tax and National Insurance contributions. It is important to register for both as records for income tax and National Insurance contributions are kept by HMRC on separate computer systems.

Partnership

In a partnership, both the partnership and the individual partners need to register for self-assessment within the same time limit as just explained for sole traders. You can register a partnership on GOV.UK.

Company

  • Companies are liable to corporation tax.
  • All companies are automatically issued with a Unique Taxpayer Reference (UTR) on incorporation. This is a 10-digit number which allows HMRC to identify the company. This should be retained carefully.
  • When the company starts to trade (or otherwise becomes liable to tax), it must register for corporation tax with HMRC within three months.
  • Details of how to register can be found on GOV.UK.

A shareholder may also need to register for self-assessment if they are receiving dividends. Details on how to register can be found on GOV.UK.

Managing your affairs online

HMRC offers various online portals to help manage your tax affairs.

Individuals

  • An individual can sign up for a Personal Tax Account (PTA) to manage their tax affairs online
  • A PTA can be used to file a tax return online, view tax payments made and tax that is due, check your NIC contribution record, manage tax credits etc. 
  • As part of setting up your PTA you will create a Government Gateway user ID and password. It is important to keep these credentials safe. Once the account has been created, you will need them to log in again in future.
  • PTAs are also secured by multi-factor authentication (also known as 2-step verification) in a similar manner to online banking. This means that in addition to your user name and password you will also need to link your PTA to your mobile or a landline which can receive a security code. You will receive a new code every time to try to log in to your PTA. If you cannot receive a code via a mobile or landline, then you will need to link your PTA to an authenticator app which will generate the necessary code when you want to log in.  
  • As part of the set up process, you will also need to verify your identity with either your National Insurance number or UK passport number. 
  • Details of how to register for a PTA can be found on GOV.UK.

Businesses 

  • A business of any structure can register for a Business Tax Account (BTA).
  • A sole trader can have both a BTA and a PTA and it is possible to link the two.
  • A partnership or company will have its own BTA.
  • A BTA can be used to manage the VAT, corporation tax and PAYE obligations for your business.

Other taxes

Taking on an employee

If you decide to take on an employee, you will have a number of legal and tax obligations including:

  • Ensuring the employee has the legal right to work in the UK.
  • Taking out an employer’s liability insurance policy.
  • Agreeing a contract with the employee. A contract does not have to be in writing, but it is advisable.
  • Whether or not an employment contract is put in writing, an employer must supply a written statement of the main conditions of employment within two months of the employee starting work. Details of the written statement can be found on GOV.UK and a template is available on the ACAS website.
  • Register as an employer with HMRC to obtain your PAYE reference number.
  • Pay your employee the National Minimum Wage (NMW)/National Living Wage (NLW) as appropriate.
  • Calculate your employee’s pay, operate PAYE (to deduct income tax and employee’s Class 1 NIC at source) and report the payment to HMRC on or before the date of payment under the Real Time PAYE Information (RTI) processes.

As noted above in the section on Taking money out of the business, a common remuneration approach for a company is to pay the shareholder-directors a small salary. If the rules on NMW/NLW applied, this approach would not be possible. However, a director who is remunerated for holding the office of director does not have to be paid the NMW/NLW. If they have a contract with the company as a worker or employee for services in that capacity, then the usual NMW/NLW rules would apply. Care should be taken therefore when it is intended to pay a small salary to the director/shareholder that it is paid in their capacity as a director.

More details on employing staff can be found on GOV.UK.

Acas also provide a guide to taking on a new employee.

Registering for VAT

If you make taxable supplies (supplies of goods or services which are not exempt from VAT) then as your business grows there will come a point when you need to consider VAT. The test for registration requires you to look both forwards and backwards.

You will need to register your business for VAT when either

  • Your taxable turnover in the previous 12 months exceeds the VAT registration threshold.  This is currently £85,000. To calculate your taxable turnover, you need to look back at the end of each month and add your taxable turnover together from the last 12 months; or
  • You anticipate making taxable supplies exceeding £85,000 in the next 30 days.

If you satisfy either of these tests your registration date (the point at which you will need to start charging VAT at the appropriate rate on your supplies) is:

  • Under the rolling 12-month test – from the 1st day of the second month following the month that you exceed the threshold. For example, if your taxable supplies exceed £85,000 by 31 October 2020, your registration date will be 1 December 2020.
  • Under the 30-day test – the date at which you first expected the supplies to exceed the VAT registration threshold.

More details on registering for VAT can be found in VAT Notice 700/1: who should register for VAT. Once registered for VAT, you will need to move to digital record-keeping in line with the requirements for Making Tax Digital (MTD) – see the ‘Record keeping and accounts’ section of this note.

It is possible to voluntarily register for VAT, even if you have not reached the VAT threshold. This means that you will have to charge VAT on your supplies, but may be able to recover VAT incurred on your purchases.

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Payment of tax

Self-assessment

It is important to set aside enough money to meet personal tax obligations as they fall due. This is particularly an issue in the first year of trading, when it could be many months before tax is due to be paid.

Income tax (relevant to sole traders, partners and shareholders in receipt of dividends), Class 2 and Class 4 National Insurance contributions (relevant to sole traders and partnerships) are calculated under the self-assessment system. Payments are made twice a year in January and July for most people unless the amount of tax due is less £1,000, in which case a single payment is due in the January following the end of the tax year.

Payments of tax in the first year of trading:

The timing of tax payments is best illustrated by an example.

  • 1 May 2020 – the business starts – this means that the individual will be within self-assessment for the tax year 2020/21.
  • 5 April 2021 – the end of the tax year, the individual must calculate their tax for 2020/21.
  • 31 January 2022 – the first payment date – the individual must pay all their tax due for 2020/21 plus a payment on account for the subsequent year as detailed below.

Once established, the individual will pay the tax for each tax year in three instalments:

  • 31 January during the tax year – 1st payment on account
  • 31 July after the end of the tax year – 2nd payment on account
  • 31 January following the end of the tax year – A balancing payment for the previous tax year, plus the first payment on account for the current tax year.

Payments on account are calculated as equal to 50% of the tax liability settled under self-assessment for the previous year (excluding any Capital Gains Tax).

A business that starts on the 1 May 2019 will therefore pay tax under self-assessment as follows:

1 May 2020 Business starts
31 July 2020 No payment on account as not previously in self-assessment
31 January 2021 No payment on account as not previously in self-assessment
31 July 2021 No payment on account as not previously in self-assessment
31 January 2022 Total tax due for 2020/21 plus 50% again as first payment on account for 2021/22
31 July 2022 Second payment on account for 2021/22
31 January 2023 Balancing payment for 2021/22 plus first payment on account for 2022/23

 

As can be seen, the new business will have been trading for some time before any tax is due.
The actual profits on which tax is calculated in each of the years above will depend on the year end that the business chooses. There is more detail on the choice of year end below.

Corporation tax

For most companies, corporation tax is due nine months and one day from the end of the accounting period. The end of the accounting period will generally be the year end of the company unless it has prepared a set of accounts exceeding 12 months.

However, some larger companies, and groups of companies will have different payment dates should they fall into the quarterly payment on account regime, so it is important to check the circumstances and apply the rules as they apply to each company. More information on paying corporation tax can be found on GOV.UK.

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Record keeping and accounts

The level of complexity of record-keeping required will depend on the scale and nature of the business and whether or not the business operates as a company.

At its most basic, an unincorporated business (i.e. a sole trader or partnership) which is not VAT registered may simply keep a list of transactions in a cash book or on a spreadsheet recording ‘money in’ and ‘money out’. As the business grows, records of stock, debtors and creditors may be required and the business might choose to move to specialist software.

In contrast, even a small company must comply with stricter, formal record keeping requirements.

HMRC have produced various guidance on record-keeping. An overview of record keeping for a self-employed business can be found on GOV.UK. A more detailed guide provides guidance on record keeping for all other aspects of the personal tax return. 

Records for a sole-trader or partnership

A sole trader or partnership needs to keep sufficient records of their business to support the figures on the self-assessment return on which the taxable profit or loss is declared. Records could include:

  • Bank statements for the business
  • Details of petty cash receipts and payments
  • Credit card statements
  • Sales invoices
  • Purchase invoices 
  • Stock records including year-end stock take
  • Details of any assets bought or sold used in the business
  • Records of personal cash introduced into the business
  • Record of cash removed from the business for personal use (drawings)
  • Records of business mileage
  • Details of goods taken for own use
  • Details of any barter transactions
  • Wages and payroll details for any staff
  • Payments to subcontractors
  • A record of any receipts from which deductions have been made under the Construction Industry Scheme (CIS)

The interest that the sole trader or partner has in their business is represented in their accounts by their capital account. The capital account is made up of:

  • All the amounts of cash/assets that the individual has introduced into the business,

Plus:

  • Their share of any accumulated profits in the business; and
  • Any gains on sales of business assets.

Less

  • Their share of any losses (including losses on sales of business assets); and
  • The amounts that they have taken as drawings. This includes any amounts that the business has expended on behalf of the individual such as for personal tax, or goods for own use.

Keeping a record of what each partner has in their capital account is particularly important in a partnership as it allows the partners to see how much each partner has invested in the business. It also allows the partnership to check that no one partner has taken more out of the business than they are entitled to. In that case they would be overdrawn, and owe the partnership money.

In a partnership, one of the partners should be ‘nominated’ as having responsibility for keeping records and managing the partnerships tax affairs. HMRC need to be informed of the nominated partner.

How long should records be kept for?

A self-employed individual must normally keep records of their business for five years after the filing date of 31 January. For example, the business records for the year 2020/21 should be kept for five years after the filing date of 31 January 2022 – i.e. until 31 January 2027.

The same limits apply to partnership returns.

Companies should keep their records for six years after the end of the accounting period. A company with a year end of 31 December 2020 should keep the records of that year until 31 December 2026.

Records should be kept for longer if HMRC are currently enquiring into the return. In that case, the records should be retained until the enquiry is closed.

For certain assets it is beneficial to keep records for much longer than the time limits above. When calculating Capital Gains Tax on the disposal of an asset used in the trade, it will be necessary to have records to support the purchase cost and date of that asset. In the case of land or property, the business could have to keep records for many years.

Penalties for failure to retain proper records  

If proper records are not retained for a given tax year or accounting period, then the business risks a penalty of up to £3,000 for each year in which they fail to keep records.

Production of accounts – sole trader or partnership

A sole trader or partnership will generally produce a set of accounts for the purposes of establishing their taxable profit for the period. Although the accounts might also be used for other purposes, such as monitoring profitability or to support applications for financing or loans, it is the requirements of self-assessment that will drive the structure of the accounts as sole trader and partnership accounts are not subject to the same reporting rules as company accounts.

Sole trader and partnership accounts can be prepared on a cash basis or accruals basis (also known as traditional accounting).

Under the cash basis, the business calculates its profits based on the actual cash in and out of the business. A business can start to use the cash basis provided that its annual turnover is less than £150,000. Once using the cash basis, a business can continue to use the cash basis until the total annual business turnover exceeds £300,000. At that point, the business must switch to the accruals basis.

More details on the cash basis (including when it may not be suitable for the business) can be found on GOV.UK.

Under the accruals basis, the business prepares its accounts on a matching basis. All the income and expenditure relating to the accounting period is taken into account, regardless of whether the cash has actually been received or payments actually made.

A business preparing its accounts under the accruals basis will make adjustments to its profit figure for items such as:

  • Opening and closing stock.
  • Debtors – these are amounts due to the business from customers at the year-end which have been invoiced but not yet received.
  • Creditors – these are amounts that the business owes to its suppliers at the year-end.
  • Prepayments – these are services that the business has paid for, which it has not fully ‘used up’ by the year-end.  For example, an annual insurance premium.

Production of accounts – company

A company is required to prepare its account on the accruals basis. A company is not permitted to prepare accounts on a cash basis. 

Company accounts must meet certain formal requirements set out in a reporting framework known as UK GAAP (Generally Accepted Accounting Practice). The specific reporting requirements that the company must comply with will depend on the size of the company. Accounts in the required format for the size of the business must be filed with Companies House each year within nine months of the year end of the company (or, for the first accounts for the company, within 21 months after the date that the company was registered at Companies House).

Companies House provide guidance on what your company accounts should contain which is available on GOV.UK.

Digital record-keeping and Making Tax Digital (MTD)

A non-VAT registered business generally has a choice over whether records are kept on paper or in electronic form, although there are certain documents (such as customs paperwork) that have to be retained in paper form.

A VAT-registered business which is subject to Making Tax Digital (MTD) obligations will have to keep a record of transactions that make up their VAT returns electronically. In practice, this means that the business will use some form of software to keep their records and submit returns to HMRC via an Application Programming Interface (API).

To keep digital records, the business can either:

  • purchase software which has been approved as compatible for MTD by HMRC (a list of software suppliers is available on GOV.UK)
  • use a spreadsheet which either has
    • a built-in API function, or
    • can be combined with bridging software to communicate the necessary information to HMRC.

Since 1 April 2019, any new business which exceeds the VAT turnover threshold and becomes VAT registered is required to keep their records digitally from the start of their first VAT period. As an example, if the business exceeds the VAT registration threshold at the end of November 2020, its VAT registration date will be 1 January 2021. On the face of it, this gives the business a month from discovering it needs to be registered for VAT to find suitable software. In practice, the timing will depend on the date that the first VAT period ends. If the first VAT return ends on 31 March 2021, that will be due for filing by 7 May 2021. As long as the business can record the transactions from 1 January 2021 to 31 March 2021 digitally by that time, then it will have met the requirements.

If you think that your business is likely to exceed the VAT registration threshold, then you may wish to consider using suitable software or a spreadsheet to keep your records from the start of the business. This avoids the need to transition at a later date when the business becomes VAT registered.

For those who cannot keep records digitally, there are exemptions from this requirement. A business may be exempt from MTD for VAT requirements if:

  • It is not reasonably practical to keep digital records because of age, disability, remoteness of location (i.e. lack of internet access) or any other reason
  • The business is run entirely by members of a religious society or order whose beliefs are incompatible with using electronic communications or keeping electronic records.

More details on MTD for VAT, including details of the exemptions and how to apply for an exemption, can be found in VAT Notice 700/22 Making Tax Digital for VAT.

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Choice of Year end

The choice of year end depends on factors including what date is convenient to the business and the timing of its tax payments. A discussion on the impact of the commencement rules can be found in ‘Payment of tax’ above.

Sole trader/partnership

Tax for individuals is calculated based on the income received or earned in a tax year which, as noted above, runs from 6 April to 5 April each year.

In a sole trade or partnership, a simple approach is to prepare accounts to 5 April each year (or to 31 March each year which is considered for tax purposes to be equivalent). This means that the business is preparing accounts in line with the tax year. The profits for the year ended 31 March 2021 will determine the tax payable for 2020/21, those for 31 March 2022 for 2021/22 and so on. Choosing a 5 April year end avoids the complex commencement and overlap rules detailed below.

A sole trader/partnership business can choose a different year end if that is more convenient – 31 March/5 April might fall in the middle of a very busy period for them for example. Choosing a different year end will:

  • impact on the timing of their tax payments; and
  • result in the creation of overlap profits in the early years of trade.

Overlap profits are profits which are taxed twice at the start of the business. Relief is then given at a later date when the business ceases, or changes its year-end so that over the life of the business, tax is only paid once on any profits earned. 

Once the business is up and running, it will pay tax each year on the profits for the 12-month period of accounts ending in the tax year. An established sole trader with a 30 June year end will declare:

  • their taxable profits to 30 June 2020 in their 2020/21 tax return
  • their taxable profits to 30 June 2021 in their 2021/22 tax return

and so on.

Where the business does not have a 31 March/5 April year end, special commencement rules are required to determine how profits are allocated for tax in the opening years as explained below.

In the first tax year of trading, the individual will be taxed on profits from the start of trade to the following 5 April. This may require a set of accounts to be pro-rated to establish the profits due.

For example, a sole trader who starts to trade on 1 October 2020 and draws up their first accounts for the nine-month period to 30 June 2021 will pay tax for 2020/21 on the profits from 1 October 2020 to 5 April 2021. The profits for the total period will be pro-rated on a daily basis, so that 186/272 of the profits in their first set of accounts will be taxable in 2020/21.

In the second tax year of trading, there are two options:

  • If there is a full 12-month period of accounts ending in the year then the tax due will be based on that set of accounts.
  • If there is a set of accounts ending in the second tax year, but they are not 12 months long, then that set of accounts will form the basis of the assessment, but an additional period must be added on to bring the total period assessed in the tax year to 12 months.

Continuing the example above, in 2021/22 the business has a nine month set of accounts ending in 30 June 2021. To bring the total period assessed to 12-months, a further three months’ profits must be added. This is calculated by pro-rating three months’ worth of profits from the next set of accounts, which will be prepared to 30 June 2022. Practically, this means that it can be some time before the taxable profits can be established, and an estimate may need to be used until the accounts to 30 June 2022 have been prepared.

For 2022/23, the owner will pay tax on the full 12 month accounts to 30 June 2022. At this point, they will have paid tax on the three months of profits from 1 July 2021 to 30 September 2021 twice.

The overlap profits which are taxed twice as a result of the operation of the commencement rules are carried forwards and can be relieved (deducted from future profits) either when the business comes to an end, or if the business changes its year end.

For year ends that finish before 5 April, the closer the year end is to 5 April, the smaller the amount of overlap profits. A year end of 28 February would generate just over one month of overlap profits. For year ends which finish after 5 April, the closer to 5 April the more overlap profits are generated in the opening year. A year end of 30 April will result in 11 months of overlap profits.

In practice, if the business profits in the early years are low, then the overlap profits may not be very significant. Over time, due to inflation, the eventual relief for overlap profits will effectively decline in value.

Some businesses will opt for a 30 April year end (despite the significant period of overlap profits) because that increases the length of time before tax has to be paid on the profits. The final balancing payment for a set of accounts prepared to 30 April 2020 and assessable in 2020/21 is not due until 31 January 2022. This can be helpful for cash flow when profits are increasing, but can be difficult when profits are declining as the tax is then due when there is less money in the business to pay.

Where the business is loss making in the first year(s), then special rules apply to ensure that the business only gets relief for the loss once.

More details on calculating your taxable profits can be found in Helpsheet HS222 which is available on GOV.UK.

Company

When a company is first set up, Companies House will normally set its accounting reference date (which marks the end of the company’s financial year) as the first anniversary of the last day of the month the company was set up. The company’s first set of accounts has to be made up from the date of registration to this accounting reference date.

For example, a company set up on 11 May 2020 will have an accounting reference date of 31 May 2021. The first set of accounts for the company will have to be drawn up to cover the period of twelve months and three weeks from 11 May 2020 to 31 May 2020. In the following years, accounts will be drawn up to cover the twelve-month period from 1 June to 31 May.

Corporation tax is charged by reference to a company’s accounting period, which is often the same as its financial year. However, this will not always be the case as, for tax purposes, an accounting period cannot be longer than twelve months. Where a financial year exceeds twelve months (for example in a company’s first year) then two corporation tax returns have to be prepared – one covering the first twelve months, and the other running from the end of that twelve months to the end of the financial year.

Continuing the example above of a new company with a financial year running from 11 May 2020 to 31 May 2021, if the company starts trading as soon as it is set up the following corporation tax returns will need to be prepared:

  • a return covering the period 11 May 2020 to 10 May 2021; and
  • another return covering the short period from 11 May 2021 to 31 May 2021.

The filing deadline for both returns will be the same (twelve months after the end of the financial year – i.e. 31 May 2022) but the deadlines for paying the corporation tax return will differ and be:

  • 11 February 2022 for the period from 11 May 2020 to 10 May 2021.
  • 1 March 2022 for the period from 11 May 2021 to 31 May 2021.

The position can be more complicated if the company does not start to trade straight away and instead remains dormant. More guidance on first company accounts and tax returns can be found on GOV.UK.

It is possible to change a company’s accounting reference date at Companies House to something more convenient. This will have the effect of shortening or lengthening the company’s financial year, which will also have an impact on the corporation tax returns that will need to be filed. For example:

  • Lengthening the financial year beyond twelve months will result in more than one tax return having to be prepared.
  • Shortening the financial year to a period of less than twelve months will result in a return having to be prepared for the short period up to the accounting reference date.

Changes can only be made to a company’s current financial year, or the one immediately before it. A company’s financial year can be shortened as many times as desired. However, there are restrictions on lengthening the financial year:

  • The maximum length of a financial year is 18 months; and
  • The financial year can generally only be lengthened once every five years (subject to some specific exclusions).

Because corporation tax is charged by reference to accounting periods, meaning that commencement rules and overlap profits are not a consideration, the choice of year end has less of an impact on the tax position of a company than on that of a sole trader or partnership. The choice of financial year end is therefore normally driven by commercial factors such as when the company is best placed to draw up accounts and corporation tax returns and deal with other year-end matters. 

It should however be noted that most changes to corporation tax rates and allowances take effect from 1 April in a year. Therefore, if a company has an accounting date other than 31 March they may have to apply transitional rules or blended rates.

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Filing Deadlines

  Self-employed

Partnership

 Company
Individual tax return 31 January following the end of the tax year  31 January following the end of the tax year 31 January following the end of the tax year  – to report any income received from the company by the individual during the tax year.
Partnership return   31 January following the end of the tax year  
Company accounts      9 months after the end of the company’s financial year end.
Corporation tax return     12mths after the end of the accounting period* 

* As set out above, a company’s accounting period is generally the same as its financial year end, but a company’s accounting period for tax cannot exceed twelve months.

More details on filing for a company can be found on GOV.UK.

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Expenses

Understanding what expenses are deductible for tax purposes is very important to ensure that the business receive appropriate relief for business costs. This is a complex area with lots of case law to determine the position for specific costs and is beyond the scope of this guide.

Business expenditure can be divided into two types - revenue expenditure and capital expenditure (discussed below)

  • Revenue expenditure will relate to the purchase of goods or services that are consumed by the business– the purchase of stock for resale, office stationery or consumables, heating and lighting, rent, rates etc.
  • Capital expenditure is generally an expense which results in the business acquiring an asset which will have enduring benefit to the trade – for example office furniture, a computer or laptop, plant and machinery or even the purchase of business premises.

In general, a business will be able to deduct any revenue costs which are wholly and exclusively incurred for the purposes of the trade including:

  • purchases of stock 
  • staff wages
  • rental of premises
  • insurance
  • heat and light
  • council tax and water rates

In many cases the rules for a sole trader/partnership and a company will be the same, but this is not always the case. For example, how travel costs are calculated for a sole trader is different from how they are dealt with for a director.

For many businesses, the simplest approach will be to keep a record of all potential business costs, together with supporting evidence such as invoices and then discuss the position with their tax adviser or accountant at the end of the year.

Capital Expenditure

Relief for capital expenditure is given through a system known as capital allowances. This is a way of treating expenditure on qualifying assets as a tax-deductible expense. Not all assets are eligible for capital allowances.

Where the asset is not eligible for capital allowances (for example the purchase cost of land) then relief for the costs of purchase may be given for the purposes of Capital Gains Tax or corporation tax when the asset is sold.

Capital allowances are available on assets such as:

  • Plant and machinery
  • Office furniture and equipment
  • Fixtures and fittings in buildings
  • Vans and motor vehicles (although special rules apply for cars)

Most small businesses will receive 100% relief on the cost of asset which qualifies for capital allowances thanks to the Annual Investment Allowance (AIA). This is the amount of capital expenditure which can be relieved in full in the year of purchase. From 1 January 2019, the limit is £1,000,000. This will reduce to £200,000 from 1 January 2021. The majority of businesses will not spend above this limit, however when the limit drops back, care must be taken if any big purchases are planned. Depending on the timing of the purchase and the business’s year end, there are circumstances where the AIA can be restricted (see the ATT press release).  

If the business spends more than its AIA then it will receive relief on a percentage of the cost of the asset each year over a number of years. The rate of relief will depend on the nature of the asset.  

There are special rules for capital allowances on:

  • cars
  • assets with private use
  • assets that you owned before the business started
  • assets that you were gifted
  • buildings and structures

More details on capital allowances can be found on GOV.UK.

Capital expenditure on the cash basis

A sole trader or partnership which is preparing accounts on the cash basis does not have to claim capital allowances. Instead, all capital expenditure is deductible as a revenue expense, subject to the following exceptions:

  • cars
  • land (although certain fixtures are allowable)
  • intangible assets (unless the asset has a definite, fixed life of fewer than 20 years)
  • financial instruments
  • acquisition or disposal of a business or part of a business
  • education or training
  • non-depreciating assets (assets with a useful life of 20 years or more).

A business using the cash basis can still claim capital allowances on any cars purchased.

Where the asset is used partly for business use and partly for private use then the amount claimed should be apportioned so that only the business portion is claimed.

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Additional tax considerations

National Insurance

Payment of National Insurance Contributions (NICs) helps you to qualify for certain state benefits, including the state pension. The type and amount of NICs that you pay will depend on your business structure. The type of NIC that you pay will influence the state benefits to which you are entitled.

National insurance is generally payable from the age of 16 until you reach state pension age, although the point at which the liability actually stops depends on which class of contribution you are paying. 

There are three main classes of NIC relevant to a business owner:

Class 1

There are two elements to Class 1 as both employers and employees will pay Class 1 NIC on the employee’s salary/wages.

  • Class 1 is the most expensive form of NIC, but entitles those paying it to claim the widest range of state benefits.
  • Payment of Class 1 can entitle you to contribution-based jobseekers allowance, which is not available to those who only pay Class 2/4.
  • Employees pay Class 1 at 12% on earnings over £183 per week (£9,516 per annum), dropping to 2% on earnings over £962 per week (£50,024 per annum).
  • Employers pay Class 1 at 13.8% on earnings over £169 per week (£8,788 per annum).
  • Employees pay Class 1 on earnings due to be paid before they reach state pension age. After that, subject to obtaining evidence of exemption, Class 1 will not be deducted.
  • Employers must pay employer’s NIC on all employees over 16 – without an upper age limit.

Class 2

  • This is paid by self-employed individuals (sole traders and partners).
  • Class 2 is paid as part of the self-assessment process with the individual’s income tax and Class 4 contributions.
  • Class 2 is charged at a flat rate on a weekly basis (£3.05 per week for 2020/21)
  • Class 2 is only payable if your earnings are above the small profits threshold of £6,475 (2020/21).
  • If you are trading but your profits are below this level, you can opt to pay Class 2 voluntarily, if you would like the year to count as a qualifying year for state pension or other benefit purposes.

Class 4

  • This is paid by self-employed individuals (sole traders and partners).
  • Class 4 is charged at 9% on profits over £9,500, dropping to 2% on profits over £50,000 (2020/21).
  • Payment of Class 4 does not usually entitle you to any more state benefits.
  • Unlike Class 1 and 2 where liability ceases once state pension age is reached, Class 4 is due on all profits earned in the tax year in which state pension age is reached, but not for subsequent years.

For many people, their main concern is ensuring that they have paid sufficient NIC over their working life to qualify for the state pension.

To qualify for any state pension, you need to have a minimum number of qualifying years. A year qualifies for state pension purposes if you have paid sufficient NIC during the year or because you are entitled to a credit for that year because you had caring responsibilities (bringing up children for example) or were claiming Employment and Support Allowance or Job Seeker’s Allowance.

The amount of state pension you will get, and how many qualifying years you need, will depend on your age. Anyone reaching state pension age after 6 April 2016 will receive the new state pension.

  • To receive any new state pension you need a minimum of 10 qualifying years.
  • To receive the maximum new state pension you will need 35 qualifying years. 

You can check when you will reach state pension age on GOV.UK.

A good way to check how many qualifying years you have already accrued is via your Personal Tax Account (PTA). This is an online portal which allows individuals to manage their tax affairs online. More details have been included in the section on ‘Managing your affairs online’ above.

Losses

While some businesses may be profitable from the start, or from a very early stage, others may take some time to establish before they become profitable. Where a business is expected to be loss making in its early stages then consideration should be given to how tax relief will be given for the losses.

Issues to consider might include:

  • How quickly the business owners can obtain relief for their losses – i.e. whether they expect to be profitable in the near future.
  • At what tax rate relief is given for any losses.
  • Whether making a loss relief claim in a given year will result in the wasting of other allowances such as the personal allowance. 

Sole trader/partnership

A self-employed individual (sole trader or partner) who incurs trading losses can obtain relief for those losses in the following ways:

  • Carry forward the loss against future trading income.
  • Offset the loss against other income in the same tax year, or carry it back against other income in the previous year.
  • If the loss occurs in the first four tax years of the trade, the loss can be carried back and offset against general income in the preceding three tax years. This can be helpful where the individual has previously had employment or other income on which they have paid tax.
  • If they still have unrelieved losses after claiming relief against other income in the same or previous year (or both), an extended relief can allow the individual to offset the loss against capital gains in the current or previous year.

Note that for large losses, loss relief claims are capped at the greater of £50,000 or 25% of the individual’s income for the year of claim.

If any trading losses have not been fully relieved by the time that the business is incorporated into a limited company then, provided certain conditions are met, those losses can be offset against future income derived from the company, such as dividends, employment income, interest or rent.  

Company

The options to relieve losses incurred by a company are more limited than those for a sole trader or partner. In particular, company losses can only be set off against other income of the company (as set out below), and cannot be set against the individual owner’s income.

Broadly, if a company incurs a trading loss in a period that loss can be:

  • set against any other income of the company in the same period (e.g. capital gains, interest income);
  • carried back against any profits arising in the company in the previous twelve months; or
  • carried forward against any profits of the company in future periods.

It should be noted that:

  • Losses need to be set against profits of the current period first before being carried forward or back.
  • Relief for losses arising before April 2017 is more restrictive. In particular, trading losses arising before 1 April 2017 can only be carried forward against future profits of the same trade.

Employment status and Off-payroll working

Where the business involves the provision of the individual’s services (i.e. their time and labour) then it is often necessary to consider their employment status. An individual working for another person or business can be either:

  • An employee
  • A worker, or
  • Self-employed.

The individual’s status matters as it affects their rights under employment law and also how the income from their work is taxed.

An individual’s status depends on lots of different factors connected to how they carry out their work. Sometimes the position is straightforward – for example a plumber carrying out a number of jobs for lots of different individuals or businesses, who supplies their own tools, pays for their own trade insurance and invoices at the end of the job will normally be self-employed. However, sometimes it is much more difficult – for example an IT contractor could work for one company for a number of months or years using that company’s equipment and may, to all intents and purposes, appear no different from the individual sitting next to them who has been engaged under an employment contract.

It is possible to be both self-employed for some contracts and employed for others, depending on their terms and conditions. Each contract should be considered separately.

Sole trader

Where an individual is providing their services to an engager, then it is the responsibility of the engager to determine if the individual is doing work for them on a self-employed basis or if, in fact, they are a worker or employee of the engager.

Basic guidance on whether an individual is self-employed or not can be found on GOV.UK.

Partnership or Company

When an individual is providing their services to an engager via their partnership or company, then it is necessary to consider a collection of rules which are variously known as:

  • off-payroll working rules
  • intermediaries’ legislation
  • IR35.

We have used the term off-payroll working in this briefing note.

Off-payroll working rules apply if:

  • an individual (the worker)
  • personally performs services for another person (the client) and
  • instead of a direct employer-employee relationship, the services are provided through an arrangement involving a third party (the intermediary) and
  • if the services had been provided directly by the worker to the client, the worker would have been regarded for tax purposes as an employee of the client.

Generally, the intermediary in these cases will be the worker’s own company – known as a personal service company (PSC). The intermediary could be a partnership, but that is less common as that structure does not provide the same tax benefits.

Where the off-payroll working legislation applies, any payments that are made to the worker from the contract are deemed to be earnings from employment. This means that the intermediary or another party must tax them accordingly. Generally, this results in higher taxes and lower take-home pay for the worker.

Responsibility for applying the rules

Where the PSC is engaged by a public sector body (such as the NHS) then, since April 2017, the responsibility for determining whether or not the off-payroll working rules apply sits with the engager. If they determine that the rules do apply, then whoever is making the payment to the PSC (which might be the engager, or could be an agency) will need to apply PAYE to the payments made.

For contracts within the private sector, the responsibility for determining if the off-payroll working rules applies currently sits with the PSC. The PSC should consider if the rules apply for each separate contract or engagement that it takes on. If the PSC does not apply the off-payroll working rules correctly and HMRC determines that the rules do apply when the PSC considers that they did not, in addition to significant additional tax bills, the PSC may have to pay penalties and interest.

The Government is currently legislating to transfer the responsibility to determine whether the off-payroll working rules apply from the PSC to the private sector engager with effect from 6 April 2021. This will bring both the public and private sector into alignment. You can read more about the changes announced on GOV.UK

Note: There are also other structures such as managed service companies and umbrella companies, which are outside the scope of this guide.

  • A managed service company (MSC) is one where a company is formed and run to promote the services of individuals engaged by that company. The MSC will not generally be owned by those doing the work but will be run by a commercial enterprise that makes a profit from providing the workers’ services.
  • An umbrella company is a business that takes on agency workers and other types of temporary workers as their own employees with continuous contracts of employment to supply these workers to other businesses on short term contracts. 

Research and Development tax relief

For a business engaged in research and development work then the choice of structure is relevant, as only companies are entitled to R&D relief against corporation tax. R&D is a valuable relief as it allows companies that qualify to claim an extra £130 in deductions from taxable profit for every £100 that they spend.

Details on whether your project would qualify for R&D relief can be found on GOV.UK.

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