If you’re thinking of becoming self-employed, you may be weighing up the choice between incorporating a Limited Company or trading as a sole trader. One of the key things to consider is the amount of personal tax you’ll end up paying, how it is calculated and when you have to pay it. It is subtly different in each case and you also need to be aware of other taxes which apply.
Being a sole trader
If you’re a sole trader it means you invoice as you, not as a company. Whilst you can have a business name, it cannot carry a suffix as a company would e.g., Limited, LLP etc. Your documentation must make clear that any business name is a trading style and that you are the entity behind it. Where the incorporation process ensures that no one else can have the same business name as you, the only way a sole trader can protect a business name is by applying for a trademark. It’s an important distinction that the word ‘company’ refers to an incorporated business. A sole trader cannot be a company but can be a business.
As soon as you earn more than £1,000 from self-employment, you will need to set up as a sole trader. Whilst you need to maintain accounting records, tracking your income and expenses, you do not have to submit annual accounts to Companies House. Any profit you/your business makes is yours but will be subject to income tax. Equally, any losses also become your personal responsibility.
Like any other trading entity or limited company, if your turnover exceeds the VAT threshold, which is currently £85,000, you will also have to register for and pay VAT.
How much tax will I pay?
The tax you pay as a sole trader will be based on your profits i.e., the total of your sales/income less any allowable expenses. The rules around allowable expenses are clear, but numerous and will vary based on the type of work you are carrying out and therefore the ‘tools’ and costs directly associated with the delivery of that work. But effectively, anything that is left in the pot, after these expenses, is classed as your profit and therefore becomes taxable. The amount of tax you pay is based on the prevailing income tax rates.
So, subject to your tax code/personal allowance, the first portion of your profits will be free of tax. After that, you will then pay basic rate tax on the next tranche and higher rate tax if you go beyond that threshold. If you’re lucky enough to have more than £150,000 of profits, you will pay tax at the additional rate. Beware that the reduction in your personal allowance, which impacts any income above £100,000, still applies to sole traders. This means that by £125,000, you will have lost all of your personal allowance.
Example
Your ‘sales’ total £60,000 for the year
Your allowable expenses total £20,000 for the year
Your profit, therefore, is £40,000 (£60,000 – £20,000)
Based on the current rates of income tax (August 2022) and assuming you receive a full personal allowance, you would pay no tax on the first £12,570 and then 20% (basic rate) on the remaining £27,430. You will also pay NI contributions at the prevailing rate.
Calculating and paying tax
Where incorporated companies pay corporation tax on their profits (calculated on their annual accounts) income tax and NI through the PAYE system, VAT through quarterly returns and dividend tax for the shareholders; as a sole trader you will only pay VAT quarterly, if you are required to, and then income tax and NI on your personal income (profits) via self-assessment.
You’re required to make National Insurance (NI) contributions so you can continue to access benefits such as the state pension, job seekers allowance (JSA) and maternity allowance. National Insurance contributions (Class 2 and class 4) like your income, will be calculated via self-assessment.
Sole trader tax planning
Keep in mind that as a sole trader you don’t pay tax as you earn it. It will come as a single annual tax bill following submission of your self-assessment tax return. That is calculated after the end of the tax year, which is 5th April. You have until 31st January the following year (almost 10 months later) to submit your self-assessment tax return and pay the tax. That means you could end up paying your taxes well after you have earned and enjoyed the money! Needless to say, this requires a degree of careful management and forward planning to make sure the money is there to pay the bill, when it comes.
To help mitigate this issue, you can agree payment plans with HMRC and under self-assessment you will also be required to make a payment on account which sees you forward paying a portion of your tax for the next tax year. If you’re income and profits are likely to remain stable, then the amount of tax is rarely an issue. It can however, become an issue for sole traders if a poor year follows a good one, as the point at which you find yourself paying the tax on the good year may fall unhelpfully, in the middle of harder times!