The tax system for the self-employed – what you need to know

Condies’ beginners’ guide to tax for the self-employed will help to keep you on the straight and narrow

Registering with HMRC
If you start working for yourself, you must register with HMRC within the first three full months of self employment. Otherwise you may be liable to a penalty. You may register online, by telephone or by using the form (CWF1 – Register if you are a self-employed trader) incorporated in leaflet SE1 (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 an unwelcome surprise 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.
The hardest thing to understand in the world is income tax – Albert Einstein
What profits does 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).
When you buy equipment or motor vehicles, you will be entitled to deduct a proportion of the cost each year you own them and use them in your business. Claims for such capital expenditure are known as capital allowances.
If you take stock for your own use, the disposal should be shown in the accounts atmarket value, and not at original cost. It may be possible to avoid this by arguing that such items never actually formed part of your stock and showing 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 2016/17 could be based on accounts for a year ending on various dates ranging from 6 April 2015 to 5 April 2016. This means that you have more time for the tax to be worked out if your accounts year-end is earlier in the tax year, which is why 30 April remains such a popular year-end for self-employed people. Although this can be a disadvantage if there is a business downturn and tax is then payable on the higher profits when maybe income has reduced.
How is tax collected?
Tax returns
Tax returns covering income for the year ending 5 April 2016 are to be submitted toHMRC by 31 October 2016 for paper returns or 31 January 2017 for online filing. The return will include a self assessment calculation of your liability to income tax and capital gains tax.
There is no such thing as a good tax – Winston Churchill
If you don’t want to work out your own liability, you should have sent the tax return back by 31 October 2016 or file online by midnight on 30 December 2015 if you wish HMRC to collect any tax you owe through your code, if you also receive income subject to PAYE. You can ask for this provided you owe less than £3,000. The final date for filing your 2016 tax return is midnight on 31 January 2017.
There are automatic penalties for late filing of tax returns.
Payment of tax
Payments on account of income tax and Class 4 NIC will be due each year on 31 January and 31 July. These interim payments will be based on one half of the total liability (less any tax deducted at source). You will have the right to reduce payments on account if you believe the income tax for the current year is less than the previous year.
The balance of income tax for 2015/16 is due on 31 January 2017 (along with the first interim payment for 2016/17 and any capital gains tax for 2015/16).
Interest and surcharges will be levied for late payment.
What about any 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 start on 1 June 2016 and your first accounts run to 30 June 2017 with a profit of £13,000, then tax will be worked out (to the nearest month) on the profits of the following periods:

2016/17 1 June 2016 to 5 April 2017 – 10/13 x £13,000 i.e. £10,000

2017/18 1 July 2016 to 30 June 2017 – 12/13 x £13,000 i.e. £12,000

You can see that the profit from 1 July 2016 to 5 April 2017 (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 2017 to 31 December 2017 and the accounts for the 18 months ending 31 December 2017 show a profit of £27,000, the taxable profit for 2017/18 will be worked out as follows:
Profit based on accounts (18 months)
£27,000
Less overlap relief
£6,000
Profit for 2016/17
£21,000

 

Cessation
If you then cease trading on 31 August 2018, and your final accounts for the 8 months ending on that date show a profit of £11,000, the taxable profit for 2018/19 will be:
Profit since accounting date in previous tax year
£11,000
Less balance of overlap relief not already used
£3,000
Profit for 2018/19
£8,000
What about national insurance?
The self-employed are subject to a two-tier system of national insurance contributions.Class 2 contributions are at a flat rate of £2.80 per week, payable against a quarterly bill or by direct debit from your bank account, if earnings exceed £5,965 per annum. Class 2 contributions secure your entitlement to state pension.
Profits between £8,060 and £43,000 are subject to Class 4 contributions at a rate of 9%. Profits in excess of £43,000 are liable to Class 4 contributions at the rate of 2% without any upper limit. Class 4 contributions are collected by HMRC and are payable at the same time as the instalments of income tax.
If you do not register your liability to class 2 National Insurance your liability will be up to a maximum of 100% of the lost contributions for a deliberate failure; concealed failure 70% and all other cases the penalty is 30%. There will be no penalty if there is a reasonable excuse for the failure to notify.
Click here for National Insurance rates for 2016/17
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.
If you need tax or accounting help in Fife, Edinburgh or the Lothians, contact Condies 

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Condies is a progressive chartered accountancy practice with offices in Dunfermline and Edinburgh. The firm was established in the 1920s and has a growing client base throughout Scotland, ranging from individuals and family businesses to professional partnerships and large commercial companies. Condies offers a range of compliance and value-added services and specialises in a variety of industry sectors.