Tax and national insurance

In order to calculate your liability to income tax and national insurance accounts are prepared each year. If your turnover (that is, sales) is below £15,000 formal accounts are not required for tax purposes, just a note of any eligible expenses. Your accounts will be based on your accounting records and will reflect your income, expenses, assets and liabilities. Any amounts you draw yourself (such as wages) are treated as drawings from the business so that you pay tax on the difference between income and expenses.

We are often asked what expenses are allowable for tax purposes but that is not an easy question to answer. Essentially, any expenses which you incur wholly and exclusively for business purposes are allowable. There are, however, certain items which cannot be deducted and if you have paid any such items they are added back to the profit in calculating the tax due. They are:

• Entertaining;
• Capital expenditure;
• Certain legal fees;
• Private expenses.

Capital expenditure covers things like computers, plant and machinery, office equipment, vans and cars. In this case these are treated as assets and capital allowances are claimed. The rate of capital allowances varies from time to time, and for small businesses there is now an annual investment allowance that means that a 100% tax deduction is available.

Special rules apply if a car bought by the business is also used by the proprietor privately.

The cost of uniforms and protective clothing are allowable but not the cost of a suit or dress, even if only used for work.

If you run a business from which you habitually take goods for your own use (such as a pub or a restaurant) an adjustment is also made to account for that as you cannot claim tax relief for your own subsistence.

Travel to and from business meetings is allowable, though care must be exercised about hotel bills and if a spouse or partner accompanies you.

As a sole trader, you are liable to pay two classes of national insurance, called Class 2 and Class 4. Class 2 contributions are usually paid by direct debit on a monthly basis and are at a flat rate. Class 4 contributions are based on profits and are payable at the same time as income tax. Rates can be found in the Reference section of our website.

Each year after starting your business you must pay tax and national insurance on your profits. Payments on account are made on 31 January in the tax year and 31 July after it and then any balancing payment is due on the next 31 January, along with the next year’s first payment on account.  When calculating the payments on account the system assumes that the next year’s profits will be the same as the year before. If profits go up there will be a balancing payment the following 31 January; if profits fall you will be due a refund.

If you make losses, it is possible either to carry those forward against future profits or, if you have other income, to set the losses off against that income and reduce your overall tax liability.

Although you tax and national insurance is worked out on the tax-year basis, you do not have to prepare your accounts to 5 April each year. Instead, you can use some other date (normally the anniversary of starting to trade).  Special rules apply if you want to change your year end and when you dispose of or retire from your business.