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SMALL BUSINESS:

Sole Trader - An Accounting & Tax Guide



As a sole trader you are operating a business as an individual, rather than through a company, which means that the income you receive from your business is assessable to income tax. You will pay income tax on all of your income, including your business profits, through the self assessment tax system. You are required to pay National Insurance Contributions (class 2 and class 4) on your earnings throughout the tax year.

As a person engaging in trading activities you will need to review your obligations with regard to registering for VAT – whether you are required to be registered and, if not, whether it is advisable. See our VAT Guide for further information.

If you employ someone to work for you it is your responsibility to determine whether they are an employee or self-employed in their own right. If they are an employee you are required to account for the PAYE taxes on their salary to HMRC. If they are self employed they are responsible for accounting for their own taxes. See our Employment Guide for further information.

Self Assessment Tax System.

Under the self assessment tax system your are required to make 2 payments on account of your estimated tax liability for a tax year. You are required to submit your self assessment tax return in October (paper returns) or January (online) following the end of the tax year and pay any additional tax (or claim a refund of overpaid tax) by 31 January following the end of the tax year.

For example – for the tax year 2013/14 ending on 5 April 2014 a sole trader will make the following payments and submissions:

  • First payment on account on 31 January 2014 comprising 50% of the estimated income tax liability for 2013/14 (the 2013/14 estimated income tax liability will usually based on final income tax liability for 2012/13).
  • Second payment on account on 31 July 2014 of the remaining 50% of the estimated tax liability for the tax year.
  • Income tax assessment submitted – 31 October 2014 for paper returns or 31 January 2015 for online submissions
  • Final balancing payment paid before 31 January 2015
Payments on account are required if the tax due for the previous year was over £1,000 unless more than 80 per cent of this is collected at source.

How are business profits assessable to tax?

The profits your business generates are subject to income tax as part of your annual self assessment tax return but are included by reference to the profits generated in the accounting period ending in the tax year being assessed. For example, if your business accounting period ends on 30 September each year and you are assessing your income tax for the tax year 2013/14 you will include the business profits generated in the accounting period ended 30 September 2013. There can be, thus, a cashflow advantage to sole traders choosing an accounting period ending early in the tax year (30 April) over those ending later in the tax year (eg 31 March).

The process for determining a businesses taxable profits is first to determine its business profits and then to make specific adjustments as required by tax legislation to determine the profits assessable to tax. Generally, a sole traders business profits are calculated using the accruals basis and the profit and loss statement prepared using accepted accounting standards. However, from 2013/14 certain eligible individuals or partnerships can elect to use the cash basis to calculate their business profits. The eligibility criteria include business turnover which must be below the VAT registration threshold.

As a sole trader you are not required to submit formal financial statements for your business to Companies House, as is the case for a limited company.

What expenses can I deduct in arriving at business profits?

The general rule that applies across all incorporated and unincorporated businesses is that expenses must be incurred ‘wholly and exclusively for the purposes of the trade’. From 2013/14 there is a simplified fixed rate deduction scheme that may be used to simplify the calculation of vehicle expenditure, business use of home and private use of business premises. The specific rules with regard to expenses do not apply where the fixed rate scheme is employed. As described in the section above, certain sole traders are eligible to calculate taxable profits using the cash basis which uses different rules for deducting business expenses, as highlighted below.

A sole trader or partner cannot deduct expenses incurred for both business and private use, for example clothing bought for business use but also used for private purposes (an exception exists for interest incurred when accounting using the cash basis).

Part of mixed expenses can be deducted, for example the business element of line rental and call charges and mixed living expenses where the business and private expenses can be accurately split. Reasonable expenses can be claimed for business travel.

Where an employee of a business (incorporated or unincorporated) gains a personal benefit from business expenditure the treatment is for the expense to be tax deductible in the businesses profits but it is taxed as a taxable earnings on the employee.

Accountancy expenses in relation to calculating profits and calculating the tax on those profits are generally held to be deductible although costs incurred preparing a traders tax return ( and capital gains) are not allowed and a distinction needs to be recognised when preparing the directors own personal tax return as opposed to the companys tax returns.

Capital or Revenue expenditure: under the accruals basis capital expenditure cannot be deducted in arriving at taxable profits. Relief is given on capital expenditure through capital allowances. Items are capital in nature if they acquired ‘for the enduring benefit of the trade’. The nature of capital items versus revenue items will thus depend on the nature of a trade for example cars used by traders will be capital items but cars held for sale by a motor dealer are trading stock. Similar issues arise in determining trading income from capital profit. Under the cash basis – capital expenditure that would qualify for capital allowances (excluding a car) is deductible in arriving at trading profits

Provision for future liabilities: under the accruals basis only, allowable deductions provided they follow accepted accounting practice.

Business entertaining and business gifts are generally not allowable, although expenditure on entertaining staff is allowable but the VAT treatment of entertaining expenses differs.

Bad and doubtful debts, under the accruals basis only, specific provisions for bad or doubtful debts is deductible but not general provisions. The recovery of previously written off debts must be included in calculating taxable profits.

Interest paid, under the accruals basis only, wholly and exclusively for the purpose of the business is deductible. Under the cash basis, there is a limit of £500 for the period but the interest is not required to be incurred wholly and exclusively for business purposes.

Leasing of cars where profits are calculated on the accruals basis have a number of restrictions in terms of the tax deduction allowable including the level of CO2 omissions.

Private use of good and services goods taken for private use are valued at saleable value. Services are valued at cost and therefore do not introduce a profit element. Directors of a limited company taking goods or services are charged under the benefits rules and the cost of the goods or services is an allowable deduction for the company.

Simplified flat rate deductions– was introduced in the Finance Act 2013 allowing qualifying individuals or partners to make fixed rate deductions for vehicle expenditure, business use of a home or private use of a business premises. For vehicles the deduction is a fixed rate per mile of business journeys. Deductions for business use of a home are a fixed monthly amount based on the number of hours worked ‘wholly and exclusively on the business. The fixed rate private use adjustment for business premises is a fixed monthly amount based on the number of ‘private’ individuals who occupy the premises

VAT - generally businesses registered for VAT will pay over the VAT they have raised on their customers and reclaim the VAT they have incurred on their supplies and thus VAT will not feature in the calculation of their profits. There are general restrictions in place regarding the input VAT claimed and output VAT charged on private use goods, services, and assets. Businesses not registered for VAT are entitled to include the input VAT as a business cost along with expenses that are deductible and also include the non recoverable VAT on the purchase cost of assets for calculating capital allowances. Adjustments to reported turnover and costs need to be made where the VAT flat rate scheme is used.

National insurance contributions – employers Class 1, Class 1A and Class 1B are all deductible but a sole traders or partners Class 2 and Class 4 are not deductible.

Tax Points

  • The mixing of private and business expenses should be avoided and the private use of a businesses goods should be avoided to prevent the creation of a taxable profit on the private use.
  • Wages paid after the end of the accounting period, for the accruals basis, must be paid within 9 months of the end of the accounting period to qualify for tax relief. Bonus payments after the end of the accounting period in relation to the accounting period will only be allowable where sufficient evidence exists before the end of the accounting period of the obliation to pay the bonus.li>
  • All business records relating to tax affairs must be kept for 5 years 10 months after the end of the tax year.

Next Steps
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Written by Accquant Chartered Accountants
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